For those not already in the know, DeFi is short for ‘decentralised finance’ - an alternative approach to financial infrastructure, angling away from the historical approach of keeping every part of every process under one roof. If you know even a little about the concept of blockchain, this will sound at least a little familiar. What you might not know is that this sector of the market has been growing in value exponentially over the past few years.
Part of what makes DeFi so interesting is that it is almost the exact opposite of the financial structures that we have been using for at least the entire 20th century and even a considerable amount of the centuries before that. Even to this day, most of the infrastructure behind the financial applications we use each and every day are based on centralised systems - the same systems that the United States has been developing for most of the last 100 years and that the British Empire was developing before that. You can keep tracking them back further and further, from one financial powerhouse to the next.
But what exactly is DeFi and, perhaps more importantly, why should you care?
What’s wrong with the old system?
The reason why those with a passing interest in cryptocurrencies and the technology behind them will recognise the concept of DeFi is that it's basically built on blockchain. The major difference between centralised and decentralised financial infrastructure is the location of the ledgers that keep a record of where and how money is moving.
Under the traditional systems, core banking systems in historical financial institutions hold the absolute record of all transactions. Their ledgers are the one and only truth of who has what money, with the ultimate ledgers being found in each nation’s central bank - the US Federal Reserve, the UK’s Bank of England and so on. This system has its obvious advantages, with its simplicity being a significant one. Anyone who has worked under more than one manager can tell you how difficult it is to have multiple sources of the absolute truth. However, the system also has several very significant flaws. Chief among these is how limited its security is.
Think of these traditional ledgers like a vault. Its security is formidable - a sturdy door with complex locks. However, once you breach that door, the plunder behind it is yours for the taking. By contrast, blockchain’s decentralised approach is like millions of little vaults, each containing just one small piece of the puzzle.
How is blockchain different?
Tortured analogy aside, blockchain’s biggest benefit is its complexity. As the ‘decentralised’ part of the name suggests, this approach works on the principle that, rather than there being only one ledger in the main bank, everyone has a copy of it. Each time a transaction is conducted, every copy of the ledger needs to be updated to ensure that there is universal agreement on this particular movement of money.
This has two significant implications:
- Every transaction is completely open and transparent. It is effectively impossible to secretly move money since the transaction needs to be entered on every version of the ledger, so everyone can see it.
- It is effectively impossible to hack the system and create a fake transaction to add money into an account since you would have to hack every ledger at once in order for the transaction to be recognised. If you failed to do so, the hacked ledger would be compared to all of the others and found to be erroneous, instantly raising red flags.
It’s worth mentioning that we said “effectively impossible” for a reason - no digital system is completely immune to infiltration. However, the decentralised nature of the blockchain makes it as close to immune as it is currently possible to be.
Is DeFi a viable contender?
The fact remains that, even 30 years after its initial conceptualisation and 13 years since it was actually implemented, blockchain remains a comparatively niche system. The cryptocurrencies that have made the most use of it, while popular and often highly profitable, have yet to overthrow traditional currencies. However, that may be changing.
According to DeFi Pulse, the value of digital assets within DeFi systems in 2019 was less than $1 billion. That might sound impressive, but it’s a frankly feeble sum when you consider that the gross domestic product of the Seychelles - a nation of tiny scattered islands with a population of less than 100,000 - is about $1.5 billion. However, by 2020, DeFi assets were up to $10 billion in value (about the same as the GDP of Guinea) and, within the first half of 2021, had peaked at over $80 billion (Ethiopia’s GDP). It’s still some distance from the trillions transacted through traditional, centralised infrastructures, but an increase of over 7,900 per cent in two years is not to be sniffed at.
Fintech vs DeFi
The fact that DeFi is based on blockchain - a largely open source system - makes it considerably easier to develop apps and systems for. Traditional financial systems being largely secretive is a major obstacle to development and it often creates problems when multiple systems attempt to work together since closed systems are rarely conducive to interoperability.
However, this is far from the only advantage of DeFi. Others include:
- Assets are held directly by users instead of by institutions
- Transaction settlement is sped up and available 24/7 instead of only during bank opening hours
- Clearing is facilitated directly through the blockchain transaction instead of via clearing houses
- Governance and auditing are both open to anyone instead of just to regulators and auditors
- Transactions generally require over-collateral, reducing impact of downturns
Seems too good to be true…
It’s often said that anything that sounds too good to be true is usually exactly that and, to be completely fair and accurate, DeFi is not a faultless system. For one thing, you have perhaps noticed that those making the most use of blockchain technology are, for the want of a better term, tech nerds. The reason for this is simple: the customer experience for most DeFi apps is extremely confusing and complex. Even our incomplete and oversimplified explanation of the technology behind it in this article requires a certain amount of background understanding that is beyond the typical user. The average punter wants to deal with their finances without needing a computer science degree and a decade of experience in the fintech world.
Where traditional banks have the edge is in providing a friendly face to the world of finance, generally in the form of customer relationship management. This doesn’t have to be a literal friendly face - it can be artificial intelligence studying customer data to find the best products and services for individuals.
AIs are also proving effective at spotting fraud, which leads to one of the other edges that traditional finance has over DeFi - the ability to roll transactions back, returning lost money to the customer. With blockchain, there’s no such option.
While DeFi still has a long way to go before it overtakes traditional financial infrastructure, the last few decades have clearly shown just how rapidly technology can develop. It is perhaps too early to say with absolute certainty that the former will replace the latter, but it’s certainly going to be an interesting sector of the industry to watch in the coming years.