Before embarking on a detailed explanation of DeFi, it is important to understand the two underlying terms finance and decentralization.
Finance is a broad concept that refers to the management of money. It takes into account spending, borrowing, but also income and investments. Finance also refers to a set of instruments, tools and services used to handle this money.
As far as the concept of decentralization is concerned, it refers to the idea of giving power back to the people at the end of the chain, in this case the users. In other words, the ideological presupposition of decentralization rejects a system that would be limited to a privileged few and that would not de facto respect the democratic ideal.
Let’s take the opposite example. Platforms like Meta or Youtube are deeply centralized. Only the developers employed by these companies have the ability to make changes to the protocols. These are the same algorithms that define or at least advise what the user will see. In other words, these platforms have control over their user’s data. Although free, these digital giants exploit this data and sell it to advertisers. In short, if it’s free, you are the product. It is precisely this scheme that decentralized finance wants to get rid of by allowing each user to regain control over their data, money and property.
To put it simply, moving from the era of CeFi (centralized finance) to that of DeFi.
💡 Concepts To Master
- Blockchain: The blockchain is a digital database. It acts as a decentralized ledger, where all financial transactions are recorded. DeFi is built on this technology and particularly on the Ethereum ecosystem.
- Stablecoins: Stablecoins seek to maintain a constant value of a crypto asset against a traditional asset, most often the U.S. dollar. A stablecoin is therefore a token whose value is equivalent to that of the dollar. 1 USDC/USDT/DAI = 1 dollar (although there are sometimes small fluctuations during intense speculative phases).
- Smart contract: a program developed on a blockchain that executes if pre-established conditions are met.
- DAO: A Decentralized Autonomous Organization is a governance structure without central authority. Members of the DAO usually hold a governance token that allows them to exercise voting rights as a stakeholder in the community. These organizations are the spearhead of DeFi.
- Exchange platforms: These are online platforms where users can exchange fiat currency (euros, dollars, etc.) for cryptocurrency or cryptos between them. In DeFi, we talk about DEX (decentralized exchange platforms). These DEXs are peer-to-peer marketplaces on which transactions are made directly between cryptocurrency traders. No market operator (such as Nasdaq for example) is needed to certify the financial flows.
Before understanding what DeFi is, we need to ask ourselves what traditional finance is?
Traditional finance operates on a deeply centralized system. The provision of financial services requires validation by numerous intermediaries or a central authority. Finance is historically a very closed and private sector, in which the user is not informed of what the bank does with his deposits. In short, banks are based on a heavy administrative system that sometimes lacks transparency.
Let’s take a real-life example. If you want to take out a loan, you need to fill in a lot of personal information. This includes authenticating your identity, your address, your tax documents and your banking history. Once you have provided your banker with this file, you are awaiting validation of your loan project. However, there is no guarantee that the bank will grant you the loan. The bank is free to accept Mr. X’s file and to refuse Mr. Y’s, even if both people have exactly the same history and the same guarantees. And all this without justification. There can thus be a certain discrimination of borrowers.
It is a central authority, over which you have no say as to whether you are eligible or not. The process to be followed to realize a loan is heavy, both from an administrative and financial point of view. The borrower must go through many intermediaries: bankers, lawyers, notaries, insurers. The administrative burden is significant since each of these actors has a financial interest in the transaction. The first consequence of this system is the lengthening of the procedure. We are generally talking about several months before the loan is effective.
You are ready to dive into what DeFi is all about, let’s jump in!
In its simplest form, decentralized finance is a part of finance built on a public blockchain. DeFi consists of traditional financial services (savings, loans, insurance, etc. ) developed using this technology. DeFi applications are mostly built on Ethereum, whose cryptocurrency is ether, the second largest behind Bitcoin. But it can be found on most competing protocols.
In essence, Bitcoin was not designed to run smart contracts on its blockchain. Bitcoin’s project is to create a peer-to-peer payment system on which a cryptocurrency is exchanged. Ethereum was built against this trend. The blockchain created by Vitalik Buterin was designed to become a “supercomputer”. It quickly became the reference blockchain for building DeFi applications thanks to the development of smart contracts. According to DeFi Llama, the Ethereum blockchain accounted for 97% of DeFi-related traffic at the beginning of 2021, it is only 58% by 2022. Others have developed and taken market share, such as Tron, Binance Smart Chain, Avalanche and Solana.
DeFi’s protocols create financial products and services with the goal of developing an open financial system. To achieve this goal, DeFi seeks to disintermediate the world of traditional finance. For example, DeFi’s applications do not need banks or brokers, all transactions are automated through the use of these smart contracts.
The DeFi protocols are relays in the transfer of values. Their goal is simple, to make peer-to-peer exchange as simple and secure as possible. However, DeFi is a branch of finance and is not intended to replace the traditional system. The idea is to offer an alternative, more transparent to users.
To give a more concrete case, the loans in DeFi work in the same way as in traditional finance. The main differences concern transparency, the absence of intermediaries and loan guarantees. Historically, when an individual borrows to buy a house, it is this same property that serves as collateral. In the event that the individual stops repaying the loan, the bank could seize the house.
In DeFi, the collateral deposit process involves depositing cryptocurrencies whose value is greater than or equal to the loan amount. This is referred to as placing cryptocurrency as collateral. What you need to understand, however, is that these cryptos are not sold in any way. You keep your cryptocurrencies, they are only a guarantee of your solvency. If you don’t pay them back, you can’t get them back.
How will DeFi redefine financial services?
Decentralized finance is about opportunity.
The innovation brought by DeFi challenges part of traditional finance. In particular, it gives access to financial services to anyone with an Internet connection. In a world where 63% of the population – some 4.9 billion people – have access to the web according to the CIA, this is not negligible. The ideological dimension of democratization inherent to the “World Wide Web” then takes all its meaning. On the other hand, the World Bank estimates that 1.7 billion people do not have a bank account. DeFi could thus fill a gap left by traditional finance among unbanked populations.
DeFi is attractive in the sense that it promises to provide a system in which users are free from financial intermediaries who collect fees on every transaction. Here, it is the users themselves who collect them (and these are extremely modest).
The first innovation is the enpowerment of the users who, thanks to their governance tokens, have the possibility to give their opinion on the community policy to adopt. As you can see, one of the points that gives DeFi its uniqueness is the use of cryptocurrencies. Ether is the main crypto used, but many protocols have developed their governance tokens in order to gather their community and allow them to influence the future of the DAO. Of course, these cases operate on a small scale, but a DAO like the Aave borrowing protocol has a community of over 120,000 token holders.
DeFi protocols are developed in open source, which means that developers from all over the world have the opportunity to improve the financial products and services offered. Simply put, anyone who proposes a change in the nature of a DeFi protocol can have their proposal implemented if the DAO has decided to vote in favour of it. This is a major shift towards a user-centric society. The citizen is no longer a passive user of financial services, but a stakeholder.
In the same sense, DeFi is non-custodial, meaning that you always remain the owner of your funds even if they are used in a service. In other words, no third party can take your funds without your authorization. The best illustration to give credit to this system is the collapse of Celsius. The US platform operated on a custody basis and arbitrarily blocked its users’ funds indefinitely following the Terra/UST crash. Currently, not all clients have been reimbursed. In this, Celsius should be presented as a CeFi (centralized finance) company even though it operates in the crypto sector.
However, when you use a non-custodial DeFi protocol, your funds can only be used if and when the smart contract meets the conditions precedent to its execution. Basically, your funds are never used without your consent. The development of this self-custody – synonymous with non-custodial – participates in the decentralization of finance. Although decentralized finance appears to be revolutionary, there are many obstacles to its mass adoption.
What are the challenges for DeFi ?
The first is financial. Building on Ethereum has many advantages, but one of its drawbacks is the high price of transaction fees. In the event of network congestion, users may have to pay particularly high transaction fees. Developers are thinking about how to reduce this problem, and one way to do this is to develop overlays for the Ethereum blockchain. This is called layer 2.
This is the whole issue of scalability. How can the network on which decentralized finance applications are built adapt to user demand, while maintaining a secure, instantaneous and inexpensive network?
DeFi can also be used by malicious individuals. According to a Chainalysis report dedicated to the use of cryptos for criminal purposes, wallets marked as “illicit” sent 17% of their funds via DeFi protocols in 2021. That’s a 1964% increase from 2020 levels. Some decentralized finance apps (like Tornado Cash) are also a way for unscrupulous organizations to launder money. This drastically damages the image of decentralized finance, especially vis-à-vis established financial institutions.
Speaking of security, we can’t talk about DeFi without bringing up the immaturity of the technology. The industry has already seen numerous hacks that have resulted in the loss of hundreds of millions of dollars. The decentralized finance ecosystem is young and has loopholes that hackers are quick to exploit. According to Chainalysis, nearly $2 billion has been stolen from the crypto sphere, 97% of which through DeFi applications. The flaws stem from vulnerabilities in certain smart contracts, which allow hackers to divert large amounts of liquidity.
The flaws have resulted in a distorted image of what decentralized finance really is. This is reflected in the reluctance of banks to enter the sector, which is one of the most important obstacles to the development of DeFi. However, the DeFi system of exchange and transactions works very well. More and more progress is being made, which is leading to an increase in the number of users. The only catch is the bridge from the DeFi ecosystem to traditional finance, from cryptocurrencies to fiat currencies. Indeed, when it comes to taking out this money injected into DeFi’s protocols, banks are particularly suspicious. As part of Anti Money Laundering policies, they report any suspicious transactions to the relevant authority – TRACFIN in France (Traitement du renseignement et action contre les circuits financiers clandestins).
This is why education is a challenge on the sidelines of DeFi. While some of the services offered by DeFi’s protocols are innovative, if citizens are not enlightened and acculturated to this new internet, decentralized finance may never be widely adopted. DeFi is in its infancy and education is needed to understand how the protocols work in order to optimize their use.
A concrete example of DeFi : Aave by The Big Whale community.
At an Ethereum conference, we had the opportunity to meet a person who had borrowed money in DeFi to finance the work on his house. The banks had always refused him his loan, because they did not consider him capable of repaying it.
Clarification: the individual in question is disabled and this particularly complicated his application. But with DeFi, there is no discrimination, as it works with smart contracts and no human factor. This implies only one thing, the borrower must be able to place cryptocurrencies as collateral for their loan. To put it simply, the origin, skin color, socio-professional status or health of users does not enter into the borrowing process. It is only necessary to have a guarantee in cryptocurrency.
This is why this person decided to turn to decentralized finance. He used the Aave protocol on which he placed his ethers as collateral in order to borrow the equivalent amount in stablecoin dollars. This allowed him to finance his work quickly and avoid lengthy administrative procedures. He then transferred his stablecoins into euros to pay for his work. DeFi seems like a magical solution to traditional finance, but is it really?
No, because it might be more complex in other cases. Indeed, the taxman who discovers a payment in euros from a crypto exchange platform does not usually admit that this inflow of money comes from a credit line, but rather from a capital gain recorded on the crypto markets. Indeed, it is likely that the tax authorities will interpret it as a way of cashing in returns on investment and impose a tax (30% of the capital gain, or 30% of the amount cashed in if the taxpayer is unable to justify his operations).
Moral of the story: it is possible to borrow in DeFi by anyone who wants to do so, but the process of transferring cryptocurrency into euro or dollar is complicated by the tax authorities (or even the bank if they don’t want their customers to deal with cryptos). That’s why the majority of DeFi users use it to make a return on their cryptos, without cashing in their profits.
Everything remains to be done, but the future promises to be exciting.
