The Lux List / Finance

Could DeFi be Crypto’s DeFining Moment?

Cryptocurrencies have long been derided for being a solution looking for a problem, but could decentralized finance or DeFi silence critics once and for all?

Oct 06, 2021 | By Patrick Tan
Image: Unsplash/Art Rachen

A conduit for crime and a receptacle for ransom are just some of the nefarious uses cases which critics of cryptocurrencies have highlighted as limiting their broader adoption.

And while it’s true that some of the earliest adopters of Bitcoin did indeed use the cryptocurrency to buy illegal narcotics, or in demand for unlocking corporate data that had been hacked and locked up, the nascent asset class has since moved on from its early parlour tricks.

To be sure, cryptocurrencies are still used to facilitate money laundering, criminal activities and in ransomware attacks, but for the longest time, so has the U.S. dollar and other fiat-based currencies.

In fact, a recent study by blockchain analytics firm Chainalysis reveals that by 2020, the share of all cryptocurrency activity that was used for illicit transactions had fallen to just 0.34%.

Another leading blockchain forensics firm CipherTrace, estimates cryptocurrency’s share of illicit transactions to be less than 0.5%.

But the rise of an ecosystem of financial services known as decentralized finance or “DeFi” in cryptocurrency parlance, may be challenging stereotypes that cryptocurrencies have very few uses outside of speculation and subterfuge, with some comparing the proliferation of innovation in DeFi as akin to the frenzy of invention in the early days of the internet.

A Decentralized Financial System for a Digital Age

At a time when we live more of our lives online than ever before, it seems as though the idea of digitizing currency altogether has been nothing more than an afterthought.

With tech platforms muscling in on payments and banking services and governments launching their own central bank digital currencies, DeFi offers an alternative path to decentralize power in the financial system, instead of concentrate it.

It may not be immediately apparent, but using blockchain technology to establish a vast network of computers can enable a transparent, open, and common ledger of truth without the need for a centralized authority.

DeFi has the potential to upend the financial services industry to deliver value where it had hitherto been unprofitable to do so, and thereby unlock greater value for the common good.

Image: Unsplash/Executium

While Bitcoin, being the first blockchain, may be the most well-known, it’s Ethereum, which was created some six years after Bitcoin and upon which most DeFi applications are built, that is reaching critical mass.

Whether it’s dollar-backed stablecoins or smart contracts, Ethereum has been the go-to blockchain for DeFi developers, despite the sometimes high transaction fees.

Traditional banking typically requires a massive infrastructure to help facilitate transactions between strangers, from clearing houses and compliance, to capital reserves and courts.

But that legacy financial system is clunky and captured by insiders, which is why they are able to exact their pound of flesh out of every transaction, from credit card purchases to trade finance.

In sharp contrast, transactions on the blockchain are reliable (anyone can inspect the ledger), cheap (relative to the size of the value transferred), transparent and (relatively) quick.

From trading on exchanges and issuing loans, to taking deposits through self-executing agreements known as smart contracts, many of the basic activities that we’re familiar with in traditional banking can now be banked on the blockchain.

In the process, the DeFi sector has grown with the “total value locked” or TVL in these smart contracts going from almost nothing in 2018 to US$90 billion.

And as DeFi has grown, so has Ethereum, with the value of transactions validated by the blockchain reaching a staggering US$2.5 trillion in the second quarter of this year alone, or roughly the amount processed by Visa and equivalent to one sixth of all activity on Nasdaq.

Still De-Fining

Although the crypto-faithful see a utopia in DeFi, the present reality continues to be a works-in-progress.

Smart contract exploits are common, with even the most well-intentioned developers unable to anticipate the myriad vulnerabilities and dependencies that their creations can unwittingly lead to as DeFi develops.

Transaction fees are periodically high, especially during bouts of intense speculation, undermining the raison d’être for DeFi in the first place.

And critics see cryptocurrencies as a wasteful use of energy, because they argue that blockchains can’t and don’t scale easily.

But cryptocurrencies are hardly a static invention, and Ethereum has progressively been shifting towards a far more environmentally friendly proof-of-stake mechanism, where holders of Ether can use their stakes to validate and verify blockchain transactions, instead of using the energy-hungry proof-of-work validation process that requires converting electricity into computing power to solve complex mathematical puzzles to secure the blockchain.

Ethereum has also managed to achieve something that has proved otherwise elusive for other blockchains — consensus for and further development.

Given the decentralized nature of the cryptocurrency ecosystem, even something as seemingly innocuous as increasing the block size can lead into heated debates and lead to fractious hard forks, as happened for Bitcoin in its early development.

But while Ethereum and other challenger blockchains can solve the tech stack, many programmers are still coming to terms with the economic incentives behind the systems they help build.

Cryptocurrencies hold value because they rely on a decentralized consensus as to that value and the shared expectation of their utility.

But unlike fiat currencies, there is no state with a monopoly on force, or a central bank as a lender of last resort to prevent runs on the value of cryptocurrencies, and without these, the code alone won’t always save the DeFi platform.

Take for instance the collapse of the automatically-managed quasi-stablecoin Titan, which saw investors lose billions as the smart contracts which managed Titan’s stablecoin peg acted exactly as they were programmed to do — what the developers had got right was the software, but what they hadn’t considered was the economics.

Nonetheless, each addition to DeFi increases the odds that something meaningfully and powerfully disruptive will result.

And with just half of the US$90 billion in TVL held in the five most popular DeFi applications, with the rest scattered throughout the hundreds of others which are rapidly gathering assets, the odds of decentralized innovation are good.

cryptocurrency markets
Image: Unsplash/Behnam Norouzi

From automated market markers, arbitrage systems, hedge funds, self-stabilizing currency pegs and even tokenized stocks, there appears to be no boundary of financial (and regulatory) technology that isn’t being challenged.

And DeFi’s coming of age is arriving at a time when trust in centralized authorities has plummeted, while our lives become increasingly digitized.

DeFining Circumstances

With trust in government and centralized institutions falling progressively, and the decentralization of news sources exacerbating that decline, DeFi may at least serve as one way in which decentralization adds value, as opposed to undermining it.

To be sure, it would be far cheaper to build a centralized financial settlement system around an entity that everyone trusts, such as a central bank, than to get a diffuse group with individual interests, to verify transactions.

But as history has demonstrated, government infrastructure ossifies over time and privately-run networks tend towards monopoly, encouraging anticompetitive behaviour and rent-seeking.

The U.S. Federal Reserve for instance has been in no rush to adopt an instant-payments system, despite the widespread benefit such an initiative could deliver.

Meanwhile card network operators like Mastercard and Visa extract gross profit margins of as much as 80% through their control of the payment rails.

And despite the “disruption” narrative that Big Tech CEOs feed audiences on stage, behind the scenes, companies like Apple change how software works on its mobile devices, essentially being able to deprive companies like Facebook from tracking Apple device users at the drop of a hat.

Facebook itself alters its content-delivery algorithms opaquely and YouTube “demonetizes” content creators in what often appears to be a whim.

And all the while, each of these tech behemoths take the lion’s share of the profits associated with their networks, which is why expecting them to provide a solution for financial services that would distribute influence, power and profits to users, would be naïve.

Decentralization then offers an alternative — interoperable, transparent and for the most part, efficient systems, that by distributing control over software, provide a natural protection against the concentration of power.

Distributed consensus and the ability for many decentralized participants in a network leverages Game Theory to create a “trustless” system, where none would otherwise exist.

Decentralized exchanges or Dexes have risen in response to the inherent vulnerability of centralized exchanges to cyberattacks, theft, and most recently, regulatory crackdowns.

Rather than depositing cryptoassets to an exchange like Coinbase Global, which could be sued by the U.S. Securities and Exchange Commission, a trade can be executed using a smart contract and performed in one indivisible, and more importantly, immutable transaction, eliminating the need for intermediaries such as escrow services and central clearing houses.

Uniswap, one of the world’s most popular Dexes, regularly transacts over US$1 billion in cryptoassets on a daily basis, but there are countless others, many of which are clones of Uniswap and use its core code, all of which is open source.

And that is another beauty of decentralization — the open-source ethos.

Open Sesame

Because the blockchain is transparent and can be infinitely inspected, all code, including smart contract code, lives on the blockchain, enabling developers to basically copy wholesale the previous code, make some minor improvements and then recast as an entirely new Dex or other service.

While the ease of availability of open source code helps in innovation, it also leads to plenty of blatant copies, many of which add incremental improvements, if at all.

Yet that is a feature and now a flaw of DeFi.

Because anyone can create a copy of an existing DeFi platform, there is a pressure on stakeholders to improve, to innovate and competition can help to ensure the best outcome for users.

Image: Unsplash/Executium

By decentralizing cloned services, DeFi also helps in preserving its own longevity, by distributing service provision and helping to ensure that there is no single point of failure or weakness that is vulnerable to exploit.

Banks and traditional financial institutions on the other hand have little incentive to improve processes or service provision given their entrenched positions at the chokepoints of the global financial system, nor any motivation to share their expertise or distribute their services to ensure systemic resilience.

If nothing else, and as demonstrated by the 2008 Financial Crisis, financial service providers would rather concentrate their significance, because that all but guarantees that they will be bailed out in times of trouble.

All of Life is a Speculation

For now though, the vast majority of DeFi applications are used for speculation, whether in non-fungible tokens or NFTs, or in the prices of other cryptocurrencies.

Two of the biggest lending protocols on the Ethereum blockchain, Aave and Compound, offer flash loans that enable a borrower to request and repay funds, plus a small platform fee, within the same block.

Because the Ethereum blockchain adds a fresh block every 13 seconds or so, it’s possible for a borrower to request the loan to bet on the upswing (or downswing) in the price of another cryptocurrency, say Bitcoin, and repay the loan and the fees, all in the same block, provided the trade goes in the direction forecast.

Because the entire transaction is cancelled so that no funds were ever borrowed if the borrower fails to repay, the lender takes no risk at all, something which is only possible because the loan is never crystallized until the block is settled.

cryptocurrency coins
Image: Unsplash/Executium

Traders have used these so-called “flash loans” to arbitrage between different trading platforms or price dislocations and especially during times of intense and heated speculation, typically rallies.

Speculation notwithstanding, DeFi services are for the most part efficient and provide creative solutions to genuine financial problems.

From decentralized exchanges with automated market makers, to flash loans, which make seamless arbitrage possible, DeFi services help enhance the efficiency of financial plumbing.

But if DeFi is to go beyond speculation, it will ultimately need to bridge a gap with the real world and extend into the realm of conventional finance.

If mortgage-backed securities or sovereign bonds are to become incorporated into the DeFi ecosystem, regulators and their centralized institutions would need to somehow become involved.

But the odds of a happy marriage between the two conflicting stakeholders are driven by diametrically opposite motivations and is unlikely at best and impossible at worst.

Even the attempt to include a vague, but seemingly modest provision to regulate the digital asset industry through an infrastructure bill in the United States was met with howls of outrage from the denizens of DeFi.

Regulators already view DeFi with scathing and suspicion, with many seeing it as a conduit for crime and a tool to launder the proceeds of illicit activities.

Since the likelihood of DeFi merging with the world of legacy finance through regulation is slim, new pathways will need to be forged in a world that is increasingly digital and where consensus can be obtained through decentralization.

Legacy payment rails providers are recognizing the impact of cryptocurrencies and for their own corporate profits, have deigned it too lucrative to ignore any longer.

As more users demand payment in cryptocurrencies, companies like Visa and Mastercard have indicated their willingness to facilitate such transactions, especially in circumstances where merchants may still need fiat currency rails for payment received.

But the value of any currency derives from how many users are willing to accept it in exchange for goods and services, and such a shift can occur even without the acquiescence of authorities.

El Salvador became the first country in the world to declare that Bitcoin would become legal tender, but in many other parts of the world, the cryptocurrency has been as-good-as for some time now, and needed no such formal proclamation.

From the impoverished streets of Caracas to the plazas of Nairobi, everything from Bitcoin to mobile phone minutes have been used as currency, none of which have ever required the approval of governments or central banks.

And for as long as DeFi continues to add value and evolve to serve genuine financial service needs, the criticism that cryptocurrencies serve no purpose other than speculation will sound increasingly ignorant and ill-informed.

For more finance reads, click here.

Back to top