Updated: Sep 30, 2021
Decentralized (DeFi) finance is a concept that has become extremely popular from the middle of 2020. What is it and what benefits does it provide?
How Decentralized Finance Works
Decentralized finance is used to describe an ecosystem of financial applications that rely on the blockchain and take advantage of the decentralized networks upon which public blockchains are based. Blockchains are often open-source software. These public blockchains are permissionless and trustless, which opens access up to everyone regardless of location, wealth or social status. This is the result of attempting to apply the founding cryptocurrency principle of decentralization to the world of finance.
Benefits of Decentralized Finance
Decentralized finance holds the promise of being more accessible than the traditional financial system. There are millions of people who don’t even have a bank account. This greatly compromises their ability to build wealth and transact financially in a reliable and affordable way.
One of the most appealing advantages of blockchains for financial services is that they eliminate the middleman. With the blockchain as a neutral third-party, a buyer and a seller can transact with each other and save substantially not only on fees but also time. These advantages also extend to other financial services like lending and borrowing.
Decentralized finance currently offers loans at much higher interest rates than seen in the legacy financial system. With the coronavirus crisis and the subsequent economic aftermath, governments have been printing money like gangbusters in an attempt to keep economic activity flowing. This increase in the supply of money decreases its demand and this, combined with near-zero interest rates, makes it extremely cheap to borrow.
So, if fiat currency is so cheap to borrow, why bother borrowing cryptocurrency?
Decentralized finance is more accessible than the traditional financial system. A traditional financial institution like a bank might not consider you a suitable borrower for a loan. Decentralized finance relies on smart contracts, which automate the administration of loans and pay out the interest. This automation also removes middlemen like banks from the equation, which makes the whole process cheaper and less complicated.
Many of the most popular cryptocurrencies have skyrocketed in value since they were first launched. Adopters who invested early are hesitant to cash out. Consequently, there has been a large amount of cryptocurrency held for long periods of time in anticipation of it gaining even more in value. The ability to loan out this cryptocurrency creates an income stream that gives those who are long-term cryptocurrency investors an income even when cryptocurrency doesn’t gain in value.
Right now, the focus in the world of decentralized finance is lending, borrowing and derivatives. But this will eventually expand to cover other areas like stocks, bonds and other assets that can be traded. Insurance is another area of finance that is often hard to access for many people in various parts of the world. Decentralized finance products like iXledger and VouchForMe hope to address this global need.
The Risks of DeFi
In June 2020, decentralized finance garnered a great deal of attention through the rise of decentralized finance platforms like Maker, which was then overtaken by Compound. As of July 11th, the entire decentralized finance space holds $2.26 billion (USD) worth of value locked into it.
Much of this growth has been the result of yield farming, in which a lender or a borrower earns money for participating. The amount of money one could earn through borrowing and lending escalated with the advent of the COMP token and the bonuses the blockchain paid out to both lenders and borrowers. Through the tokens earned just by participating in a loan, you can earn more in rewards than the cost of borrowing.
Many question how sustainable this is. It does not make fundamental sense to borrow money and make more in rewards than it costs you to service the loan. There are also concerns about the tremendous pace at which this market has grown.
If the fundamental underlying value of cryptocurrency is debt, then it brings about many serious questions. The founding principles of cryptocurrency are at odds with fiat currency, which is built upon manipulation of national currencies in order to stimulate or cool economic activity. If a large portion of cryptocurrency begins to represent debt, then the supply of cryptocurrency could be somewhat manipulated just like fiat currency.
Bitcoin was conceived around the time of the Great Recession of 2008 and 2009 when governments provided large bailouts to companies deemed "too big to fail." So, it was created with a healthy fear of inflation and centralized monetary power. The sub-prime loan crisis which created much of the turmoil of the Great Recession involved the packaging and re-packaging of risky loans. Now that crypto derivatives are beginning to package and re-package crypto loans, it seems a parallel is developing.
If the decentralized finance market grows too big, too fast, or becomes so large that it begins to overshadow the role of cryptocurrency as a store of value, we could see a repeat of the financial crises in 2008 and 2009 or the cryptocurrency bubble of 2017 and 2018. When the unsustainable bonuses and rewards for participating in lending and borrowing on DeFi platforms disappear, how many of the yield farmers who now enjoy returns of up to 100% will remain and support the platform?
Decentralized finance offers a more accessible path to the financial services that the traditional financial system currently dominates. Many people all over the world lack access to a bank account and other basic financial services. If they do have access to financial services, they are oftentimes unreliable and expensive. Decentralized finance gives them an alternative to a traditional financial system that has left them behind.
Decentralized finance has exploded in popularity with the rise of Maker and Compound. They offer rewards that make lending and even borrowing profitable in and of itself. While the massive returns are great for the short term, only time will tell whether these rewards are sustainable and whether the demand for their services continues after the rewards disappear.
The rapid debt-driven growth of decentralized finance (DeFi) platforms conjure up parallels of the subprime mortgage crisis that sparked the financial crisis of 2008 and 2009. If these debts are continually repackaged to where even experts can’t identify how risky they are, there will be no basis for establishing their fundamental value and that is a danger that can lead to bubbles and rough days ahead. One can only that if this does happen, decentralized finance can recover and establish itself as a reliable alternative to the legacy financial system.
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