To answer the question we will start at the beginning. What is DeFi? What does it consist of? What advantages and disadvantages does it have? Here we go…
DeFi is the acronym for Decentralized Finance, and it’s a movement that propose the creation a complete ecosystem of financial services that can be combined and interoperable with each other, as lego pieces, open source, transparent and decentralized, accessible by anyone on equal terms and operating without a central authority, thus allowing full control of assets and eliminating the need for current centralized financial institutions.
It may be explained in a simple paragraph, but it represents a total paradigm shift in global financial services.
Built on distributed technologies, and specifically on Blockchain networks, and interoperable through decentralized applications or DApps, it is becoming one of the main trends around Blockchain technology, since much of the crypto world is focused on this type of solution.
But what does it mean? Something as simple as not depending on a bank for a mortgage, for example. The current process of sending an application for an expertise, exchanging documentation with the bank, processing, waiting times, small print or changing conditions, etc, would give way to a model in which anyone from anywhere in the world could apply for a loan practically automatically and from their sofa at home, with transparent and unalterable conditions (thanks to the Blockchain 😉 )
At this point we should already be clear about the concept of DeFi and how important it will be in the future in the financial sector, but let’s look at its main features in more detail:
- As we have already mentioned, it’s based on Blockchain technology and Smart Contracts
- It’s generally secure, due to the use of cryptography
- It’s decentralized, and therefore does not need a financial authority.
- Just as traditional finance depends on intermediaries such as banks, and courts in case of arbitration, DeFi applications do not require intermediaries or trusted third parties. The relationship between the platforms and the users is direct, and the trusted third party for the resolution of disputes, for example, is delegated to the network itself and the Smart Contracts code.
- It is transparent. We must remember that we are talking about open source software and auditable. Furthermore, the information is written on public networks and therefore all the information is also auditable.
- No borders. Anyone can access the same services with the same conditions from anywhere. This will undoubtedly boost the economy of those countries where access to financial services is precarious, or which due to the low income of the population are not of interest to intermediaries whose only objective is to make a profit, and in short, where the population does not have access to these tools. On the other hand, it will allow any person or company to obtain financing from anywhere and with equal conditions. In this sense, we could say that this would be something like the natural evolution of crowdfunding.
- No censorship, as the data are recorded on the nodes of the Blockchain network.
- High availability of the service, since it’s intrinsic to the technology, as it is executed on decentralized public networks.
Of course, not everything is an advantage, so it also has its negatives or cons:
- Low performance. The famous trilemma of Blockchain technology comes into play in this situation, in which only 2 of the 3 vertices of the triangle can be maximised. These vertices are security, scalability and decentralization.
- As they are decentralized public networks guided by a consensus protocol, they are slower than centralized systems.
- Bad user experience. The usability and user experience (UX) in DApps still has a lot to improve. As we have commented previously, the interaction with the user is done via DApps with poor UX, so it is essential that the user has very clear the use of these interfaces if we want to to make it extensible to the general public.
- The possibility that the user makes a mistake is very high, especially if he does not have all the concepts very clear. We must remember that we are talking about immutable systems.
- Nowadays, it is a very messy ecosystem. Products and services emerge haphazardly and it can be difficult to find the most suitable DApp for our interests.
- Security, mainly in Smart Contracts.
- Lack of regulation, although this is one of its advantages or intrinsic characteristics, it is in turn an entry barrier for many users.
- Volatility of cryptocurrencies. Due to the high volatility of this type of currencies, many of the platforms have created mechanisms to guarantee economic stability, although many times they have proved not to be sufficient (let’s remember that we are in a movement in a development and expansion stage so there are still many areas to improve).
DeFi is not easy. Neither the terminology nor the use of a DApp for operations is easy to understand and operate for people without knowledge of movement and Blockchain technology. The contracts or Smart Contracts, pieces of code created or executed to achieve the functionality offered by the specific DeFi product or service, and which allow the automation of tasks under certain conditions, do not help either, since their programming language is not easy.
All this concepts implies a series of risks to consider if we want to operate within these technologies:
- Smart Contracts are a risk in themselves, as any error or vulnerability in their coding will entail loss of money. In fact, we have several DeFi projects that have already suffered security problems related to their Smart Contracts, and which have resulted in millions of dollars in losses and thefts from their platforms. That’s why a good project constantly codifies, tests, revises and audits its Smart Contracts, solving the issues as quickly as possible, and that’s why the developers are so highly valued nowadays.
- The runtime environment is a risk in itself, since developers have no control over it and if a vulnerability is detected and not solved in time, it can be used by attackers with serious consequences.
- Although DeFi applications run on Blockchain networks (mainly Bitcoin and Ethereum), this does not mean that they are completely decentralized, since to prevent something worse (such as loss of money), DeFi protocols and applications generally have some point of centralization in order to have a certain control, i.e, although they operate as decentralized entities, most of them have an “Emergency Shutdown”, which allows them to stop operation to prevent investors from suffering serious losses due to an issue in the protocol, and although this sounds nice, and seems a possible solution to the problems, it is also a risk, since these same functions can be exploited by malicious agents.
- The large number of projects that are emerging suggest that what happened with the ICOs in their day is beginning to happen with the DeFi nowadays, and it is that many projects are being born that are simply copies, only changing some things and launching a service with the unique purpose of getting the money out of the users. Since the idea of these protocols is total transparency, if it is not possible to access some specific type of information, we may think that the project is hiding something strange…
At this point we have seen what DeFi is and what it is based on, its characteristics and risks, so let’s go to our initial question… is it really the last refuge for savers?
It is clear that decentralized finance is becoming a magnet for savings.
Information such as that published in recent days indicating the growing interest of “the world’s millionaires” to invest in cryptocurrencies, only democratize access to these protocols. If it was a process that had already been taking place in recent years, it has accelerated in recent months.
Reports from the main decentralized protocols support this claim, since one of the best known protocols for the exchange of cryptocurrencies and ERC tokens20 (Uniswap, which we’ll see in more detail in a future article) is handling volumes of the order of 1.5 billion dollars per month on a sustained and continuous basis in recent months, and a few months ago announced that it had raised more than 10 million dollars in Series A funds, with investments from various well known funds.
Although today DeFi is more interesting for investors than for savers, the proliferation of projects that explain in a simple way the use of cryptocurrencies and how to make investments with them is bringing the movement closer to savers.
In addition, another important step is taking place at regulatory level, and it is that regulations in different countries are being aligned to allow banks to manage cryptocurrencies, with the encouragement that it can provide for individual savers. In fact, some private initiatives have already emerged for the outsourcing of the cryptocurrency custody service in which various banks have expressed interest. On the other hand, the United Kingdom has just indicated that it will regulate Stablecoins (which we’ll also talk about in future articles) with the aim of leading the new financial services, at the same time as investigating the central banks’ digital currencies (CBDC or Central Bank Digital Currency) as an alternative to the FIAT currency.
In Spain, for example, the latest studies show that despite the current pandemic, households with a high average income have significant average monthly savings, which leads us to another problem, what to do with the money saved?
Stock markets are still interesting in the long term, but in the short term they are unpredictable, as we are seeing every day, so they don’t generate confidence in the savers.
Traditional bank deposits are no longer an option, as they have long offered zero profitability (when they have no cost) or even disappearing from the portfolios of the entities. The current zero or negative interest rates in most of the more advanced economies make it difficult to find a place for these savings, so we must look for alternatives to traditional financial products, and in this searching, DeFi appears as an alternative.
For about a year now, several decentralized finance protocols have been offering daily deposits in crypto assets linked to Stablecoins with interest rates above 2% in many cases.
In this way, these protocols are becoming established as viable alternatives for those people who want to obtain a return on their savings but who are not investors.
As a summary, the alternative proposed by DeFi to the current financial system, replacing it with a more open one on equal terms for all users, is not only fashionable but also fully viable, and although we must be careful with the projects we invest in and be clear about the concepts, it can provide a higher return than that currently offered by traditional financial systems for equivalent products.
Everything seems to presage that we are living the beginning of a new global financial order, and if it succeeds, DeFi will place in hands of people the power that centralized institutions have today, evolving to a user-centric model so fashionable these days.
In future articles we will go deeper with DeFi protocols and concepts that every investor should understand, such as yield farming or liquidity mining, as well as examples of companies that are already working in this area.