Unless you have been living on a remote sheep farm in the Yorkshire dales with no broadband for the last ten years, the chances are you have heard of Bitcoin.
Regardless of your opinion on Bitcoin’s chances of becoming digital gold (or a dutch tulip bubble), it’s underlying technology blockchain (or distributed ledger technology) has given rise to a new trend that has everyone excited across the crypto and traditional finance divide… And it’s called DEFI – Or Decentralised Finance.
As central banks start to eye their own stable digital coins and financial institutions explore the transformative potential of distributed ledger technology, smart contracts and decentralised apps (dApps), the interest in this space isn’t limited to a niche of tech-savvy crypto savants anymore, the wider financial services industry is paying attention. So let’s find out more.
What is DEFI?
DEFI (pronounced deef-eye!) refers to any financial system that has been structured to operate without a centralised function.
To illustrate what DEFI is (and what it definitely is not!) Let’s use a simple example.
You want to pay your friend who is a baker for some sourdough bread, they offer you the opportunity to pay with your debit card via a iZettle, so you tap your debit card to the terminal.
The process of transferring money between you and your friend needs your bank, your friend’s bank, a payment network (like VISA or Mastercard) and the terminal/gateway provider. This is NOT DEFI. The delivery mechanisms in this case are all centralised (and there are many of them).
A decentralised version of the same transaction would see your digital wallet interacting with your friend’s digital wallet directly and the transaction then being verified on a distributed ledger that is not owned by one company or organisation.
A peer to peer payment is really the most basic example to describe DEFI, however with the use of smart contracts, DEFI projects are diversifying into evermore complicated areas of finance from lending to trading, savings to insurance… and more.
OK, I sort of get it, but…
We know, it’s a bit of a paradigm shift. Especially when people in many cases don’t even really understand what happens when their card hits the terminal.
So let’s unpick why there is a need for DEFI in the first place.
Many centralised financial systems are antiquated and slow… ever tried to send money to another country or drawn down from a stocks and shares ISA? There is no technological reason that these transactions shouldn’t occur within milliseconds, but they can take anything from 2-5 days.
But it isn’t just pace and modernity that can be the justification for DEFI, think about security. Centralised systems (especially antiquated ones) can be vulnerable to a new generation of nefarious hackers. Reputable financial institutions and their centralised systems can be vulnerable to data breaches, fraud and security issues. And it is customers who initially suffer in these security breach situations, by being locked out of their apps, their digital banking and being reissued cards.
DEFI aims to address the three pronged problem within crypto finance of Scale, Pace and Security, all whilst remaining completely decentralised.
Now whilst the proving ground for all of this is within the digital asset space, the framework is there to see how it might apply to fiat currencies and more broadly to financial services writ-large.
So, what are the advantages of DEFI?
First and foremost, interacting with a DEFI system isn’t timebound. So they are available 24 hours a day, 365 days a year. Next, they are available wherever there is an internet connection, so they aren’t flexible in terms of both time and location.
Next, they aim to be cheap, because they leverage technology to be as fast and as scalable as possible, but also because of the lack of intermediaries, developers can offer drastically lower fees and charges.
Finally and arguably most importantly, it offers an avenue to address ‘the unbanked’. A segment of any population that due to isolation, lack of funds, lack of credit history or (in some cases) political or socio-economic oppression cannot participate in the existing financial system.
DEFI aims to be fast, secure, cheap, available, connected and egalitarian. Sounds great!
Let’s look at a few of the best DEFI’s in the space.
Who is doing what?
To explore the world of DEFI projects, let’s take a look at three separate categories. First – the enabler, second – the lender and third – the interest rate protocol.
The Enabler – Algorand
Algorand is a platform to build DEFI projects on. Their aim is to remove the technical barriers which have impeded blockchain and decentralised ledger projects to date.
Their objectives are to facilitate bringing new financial assets on chain, building new tools & services and expanding the methods for transaction and exchange of value.
With a Turing award winner as their founder and employees who moved from IBM, Google & Mozilla with their Ivy league & MIT credentials in tow, they are a serious outfit that wants to enable enterprise to embrace decentralised finance.
The Lender – AAVE
AAVE have taken a financial instrument called Flash Loans to market, which is the first uncollateralised loan option in the DEFI space.
Designed for developers, AAVE’s loans allow a developer to borrow any available amount of digital assets without putting up any collateral, as long as the liquidity is returned to the protocol within one block transaction.
This high technical knowledge transaction is an example of how the mechanism of lending and the stipulations that guarantee the safety of the funds in the reserve pool (and the complexity of the necessary contracts) can be disrupted with DEFI.
The Interest Rate Protocol – Compound
Compound Labs are an open-source software development company that builds products and services for DEFI.
The compound protocol means that any individual who holds cryptocurrencies can earn interest in the same way that someone with pounds sterling in their savings account can.
This algorithmic, autonomous interest rate protocol can be utilised by platforms or wallets to incentivise the secure storage of digital assets by their customers. However, this could be applied to any central bank issued stable coins that are created in the future.
Compound aims to maintain, manage and audit a publicly verifiable and secure interest rate protocol that leverages smart contracts to provide safe and stable earnings on digital assets.
…so, as you can see, it’s pretty tech heavy stuff.
But as with fintech’s, the ‘bet’ is that technologists can develop better systems, processes, methodologies and delivery mechanisms outside of the large (and in some cases slow) financial services organisations, and then help these same established financial services providers disrupt their business models, by incorporating the best of what has already been developed, tested and proven.
What is the future of DEFI?
DEFI projects are being spun up in an environment aligned with crypto-currencies and digital assets and as such have limited regulation applied to them.
But just like any new technology, the maturation of these projects and the inevitable failure of some, will create a safer and less risky space to innovate, whilst ensuring the correct KYC/AML procedures are in place and the adequate legal and regulatory frameworks are adhered to.
At the point where fintech and DEFI map and merge (which should happen, as they are both just trying to find better ways to apply technology to finance), we will have a true inflection point where nascent financial technology is just part of a new financial system…
One which hopefully realises the dream of being fast, secure, cheap, available, connected and egalitarian.
At Waracle, we work with established enterprise organisations across the UK financial services sector and as such we like to keep abreast of how the world of finance is being impacted by technology. If you want to read more about our fintech insights, click here.