DEFI in Plain English: Decentralized Finance explained.
"The things that are most difficult to think about are the things that are most familiar to us" — Martin Heidegger.
2021 was a very impactful year for the crypto space. NFTs became a huge deal. Defi also saw a more than 50% increase in transactions and total value locked (the amount of money currently deposited with Defi Companies). Most importantly, many cryptocurrencies and tokens reached their all-time high. So 2021 was indeed a good year for the Crypto space. However, I am sure many people got a bit over-excited about the news of freshly minted crypto millionaires, and this might have spurred them to make a few 'investments' in the crypto space. Hopefully, these investments were made after doing their research/due diligence. Understanding how the crypto space works is the first step when conducting your due diligence.
This article attempts to simplify the concept of Defi for the generally curious, the non-technical participants in the Defi space or even the technically minded who find it difficult to explain Defi to their friends and family. You can also check out this article simplifying NFTs here.
Decentralized finance, or Defi, refers to digital financial services performed using blockchain technology. The Word Defi has gained popularity alongside buzz-words like NFTS, blockchain, cryptocurrency, etc. But to understand how Defi works and why it has become so popular, we must first understand how the current financial system works.
The Evolution of the Global Financial Services
Financial services refer to services provided by companies in the financial sector. These services include but are not limited to banking, insurance, investment, stock trading, cross border payments, accounting services, auditing etc.
The first wave of global financial services probably started in Venice in the 11th century. The high volume of international trading in the port city of Venice led to the creation of banks to facilitate payments between merchants from different countries. To streamline the usage of various currency notes by merchants, the banks helped merchants with their accounts and created banknotes that merchants could exchange and use globally. Creating accounts and banknotes allowed the banks to offer more financial services like savings, loans, credit creation, etc. This kind of banking service (also referred to as Traditional Finance) continued for most of the 11th century to the end of the 20th century when technological advancement increased the adoption of cashless payments.
The use of credit cards and debit cards to pay for goods and services brought about a system where customers performed instant financial payments online, which in many cases replaced the exchange of currency notes. The global adoption of cashless services facilitated the emergence of a new wave of technological innovation in financial services, generally known as FinTech.
Cryptocurrencies and decentralized finance (Defi) are a subset of FinTech. Defi is the latest in the evolution of financial services.
How Traditional Finance works
Banks are the backbone of our traditional finance systems. While they are not the only kind of company that offers financial services, for simplicity, I will be using the banks to illustrate how a vast portion of our traditional financial system works.
Banks, at their core, act as a safe place to deposit your money with the assurance (trust) that you can get your money at any time. The Banks take those deposits/savings and lend them to credit seekers at higher interest rates. In essence, banks act as the middlemen or intermediaries between depositors and lenders while shouldering the risk of a default in the loan repayment.
This flow of deposits into the banks that are later used as loans is how banks make the bulk of their profits. It is also a substantial offset of modern economies because banks facilitate economic activities through loans. Bank loans are often used to develop industries and create employment that spurs economic activities. I should note that banks provide more complex financial services than just accepting deposits and lending. They also operate credit and debit card businesses, buying and selling currencies, custodial business, cash management services and investment business. Although banks are supposed to be intermediaries between depositors and lenders, they are also structured to drive economic activities.
FINTECH
Our current economic structure supports the usage of two kinds of money; paper money (banknotes) and electronic/digital money (debit card, credit card, online banking). Paper money is created by the central banks only. At the same time, electronic money is the digital representation of the banknotes in your bank account. When doing online banking or using credit/debit cards, no one is required or expected to transfer the physical money from one bank account to the other for such a transaction to work. Spending electronic money involves a complex series of account settlements between your bank, your card issuers like Master or Visa and the recipient bank (i.e. the bank account you are making the transfer to).
Financial Technology (FinTech) are technologies that automate and digitize financial services. Most traditional financial institutions use FinTech in many aspects of their business. But some companies are pure FinTech companies using technology to disrupt the financial industry. Services like mobile payments apps, savings apps, investment apps, asset management apps, stock trading apps, crowdsources apps, insurance apps, etc., are applications that have automated and digitized financial services that traditionally took weeks and months to achieve with boatloads of paperwork, forms and interviews. FinTech companies are simplifying the services that banks have provided for decades and, at the same time, providing those services on a global scale. Fintechs companies are not trying to emulate the big traditional banks. Instead, they pick an area in traditional banking, digitize it, simplify it, reduce the barriers to entry and provide those services at scale.
The FinTech industry can offer banking services to anyone with a smartphone and an internet connection. People no longer need to go to physical banks, stay in long queues or fill out lengthy forms to make financial transactions. Fintechs also provide services for consumers without regular incomes or permanent home addresses. Let's take the classic case of M-Pesa as an example here. M-Pesa is a Kenyan Fintech Company that provides banking services to its customers using a sim card. Customers using M-Pesa only need a government-issued ID and a phone to make payments or initiate transfers via SMS; they don't even need a smartphone. The phone numbers of M-Pesa customers act as their account numbers. M-Pesa currently has more than 50 million monthly active customers, operates in 10 countries and has enabled more than 2% of Kenyan households to move out of poverty.
FinTech has democratized the financial landscape and made financial transactions more fun and borderless. I should at this junction point out that a majority of fintech applications are managed by companies that are governed by strict regulations, especially the know your customer (KYC) requirements which require that customers provide government-issued IDs and sometimes utility bills and proof of address before they can be registered on these platforms.
These regulations are extremely important for companies providing financial services because there have to be laid down rules for how companies operate with people's hard-earned money, sometimes life savings. But what happens in countries where regulations are unfair and tilted in favour of the rich and powerful. Or what happens in oppressive regimes where the government can arbitrarily shut off access to financial services? These unfair and arbitrary regulations will affect both traditional banks and most FinTech companies. Some FinTech companies have been known to restrict account activities or even shut down their customers' accounts at the request of regulators.
The point I am trying to make here is that while FinTech companies may be different from traditional banks, they are still subject to the regulations of the country they operate within. Now, how do you handle financial services bypassing arbitrary and unfair regulations? Please make way for blockchain technology.
Decentralized Finance (DEFI)
Financial services using blockchain technology are the latest evolution in the global financial sector.
Blockchain technology refers to an online, decentralized, immutable ledger or records book that records transactions or information in a permanent form. This simply means that transactions recorded on the blockchain cannot be altered. You can learn more about blockchain technology here and here.
Defi is short for decentralized finance. These financial services are run using smart contracts on the blockchain, unlike traditional financial services like banks, brokers, or other financial companies that act as middlemen or intermediaries during financial transactions — connecting depositors to lenders. Instead, financial transactions under Defi are conducted using smart contracts. For the purpose of simplicity, when I refer to Defi protocols, Defi companies or just Defi please picture an online decentralized digital bank that uses cryptocurrencies only.
I am still confused, what is DEFI and how does it work?
Sending and receiving payment using your bank account is the first, most primitive step in financial services. As stated above, there are other financial services like loans, savings plans, investments, equity, stock markets, and so much more. Today most of our financial services are completely centralized, meaning that the banks, insurance companies and other financial institutions all act as central authorities (middlemen or intermediaries) to facilitate financial transactions. These central authorities are there to make sure that transactions initiated between two or more parties work in accordance with the intentions of those parties, these central authorities guarantee a party's identity and intention, so as a customer you have to trust that when you deposit your money in your bank account, you can access it anytime you want and when you want to send money to Mr A, that money gets to Mr A's bank account.
Under Defi smart contracts are the computer codes that act as intermediaries. These codes make sure a financial transaction works the same way it was initiated to work. Smart contracts once deployed on a blockchain network cannot be changed, they are immutable. In Defi, a customer's digital wallet (an app where cryptocurrencies or other digital assets are stored) acts as their bank account, and the wallet is the only requirement a person needs to start operating with Defi protocols.
The smart contracts of a Defi protocol can interact with cryptocurrencies and digital assets like NFTs in a programmable way. When using Defi, the smart contracts will read your wallet and implement the financial transaction when all the set requirements are met. A smart contract is able to do this because when you connect your wallet to a Defi application, the smart contract of that Defi application sees your wallet's history and identifies the assets contained in your wallet. Those assets allow you perform complex financial services using Defi. You can take loans through these Defi protocols by depositing a certain percentage of your crypto assets as collateral, the smart contract reads your wallet and automatically determines how much you can get as a loan from the protocol, and when you fail to repay the loan at the due date, your collateral is automatically liquidated by the smart contract.
Now, you may be wondering how these Defi protocols can provide loans to users (customers) when it doesn't have traditional depositors depositing their money for safekeeping. Technically, there are also depositors in Defi protocols called liquidity providers (LP). Liquidity providers are people who deposit or, in Defi terms, stake their cryptocurrencies in Defi protocols in order to provide liquidity (i.e. the cash flow for the protocol to offer financial services).
Liquidity is the backbone of Defi, the same way deposits are the backbones of banks and other companies in the financial sector. The difference between liquidity providers and depositors in banks is that profits generated from financial transactions (interest rates from loans and transaction fees) are shared between the Defi protocol and the liquidity providers. The liquidity providers are awarded a percentage (based on the total value of liquidity provided) of the total profits generated by the Defi protocol. While banks, on the other hand, offer depositors a tiny interest rate for their deposits or savings and in turn use those deposits to do businesses that generates insane profits for the bank.
In Defi, the liquidity providers are critical stakeholders in how the profits generated are distributed because the smart contract determines the profit-sharing formula based on the amount of liquidity provided and the amount of profit generated.
Another difference between Defi and other FinTech applications is the trustless protocols that govern Defi. In Defi, a wallet is your identity because it contains your digital assets and transaction history. In Defi, there is no need for strict KYC (government ID or proof of address) because the Defi protocols do not require this to issue a loan. The only requirement for the issuance of a loan is digital collateral (in the form of cryptocurrencies or NFTs) that is double the value of the loan obtained. This collateral is locked in the Defi protocol until the loan is repaid or the collateral is liquidated. This is what Defi all boils down to — trustless protocols enabling peer to peer financial transactions without the necessity of a profit-making intermediary. Instead of intermediaries, we have open-source code in the form of smart contracts that govern the mode of financial transactions.
Risks associated with DEFI
1. Smart Contract risks: As it is with all computer programming (codes), it is very possible to find bugs in smart contracts. Bugs are mistakes in a code that makes it easy for a hacker to manipulate computer software and in the case of Defi, such manipulation may lead to the theft of funds from the Defi protocols. This is more like the bank robberies of the digital world. But this risk can be mitigated when smart contracts are audited. Smart contracts auditing refers to a situation where ethical hackers (the good guys) are hired to hack a smart contract code looking for bugs or weak points in order to fix or strengthen them. Think of this as a stress test.
2. Complex User Interface and User Experience: Defi can be incredibly complicated to use. There are too many things to understand before using a Defi protocol, and these applications are usually complex to navigate. I have been a crypto native since 2017 and sometimes I get confused with the way some Defi application works. Any slight mistake can lead to the permanent loss of your funds. Defi is not going to be banking the unbanked anytime soon.
3. Unregulated Space: Because of the unregulated nature of Defi, a lot of fraudulent players operate within the system. From online influencers that are clueless about the kind of companies, they advertise for to people writing smart contracts that can steal funds from your wallet. The Defi space is still very much like the wild west. Therefore, you must do a ton of learning before investing any money in this space. Though it may seem that the crypto industry is inherently anti-regulation, that is not the case. There has been a push for fair and transparent regulations that will help onboard more people.
Conclusion
Though the Defi space offers many great opportunities to participate and make money, the way it is currently structured is still highly technical. There is no room for mistakes when facilitating a transaction because a little error can lead to a loss of funds. I will advise anyone interested in this space to learn how cryptocurrencies and finance work.
We still have a long way for Defi to become mainstream like FinTech 1.0.
However, I am confident that Defi is here to stay and will make many people wealthy.
