Decentralised Finance (DeFi) replicates many of the functions of the traditional financial system. It has seen tremendous growth over the last year, making it one of the most important applications of Distributed Ledger Technology (DLT).
Is DeFi indeed a “digital” version of traditional finance, or is its design fundamentally different? In this post, we argue that DLT has led to a rethink of how financial services are delivered in a decentralised setting.
DeFi is a collection of smart contracts, cryptoassets, Decentralised Applications (dApps) and Decentralised Autonomous Organisations (DAO), mostly built on the Ethereum network, that offer many of the functions of the traditional banking and financial system, such as borrowing, lending, exchanging and investing. To understand its tremendous growth, it is enough to consider that the total value of assets locked in DeFi projects is now more than $50 billion, whereas in the beginning of 2020 it was around $600 million.1 However, the most interesting development is that DeFi projects are not just a replication of traditional financial services in the digital world. They are redesigned in order to incorporate the main characteristics of DLT, such as decentralisation, trustlessness and permissionless access. In this post, we discuss how these characteristics have shaped the design of DeFi projects.
Distributed Ledger Technology (DLT)
DLT refers to a collection of protocols and procedures that allow the updating, access and validation of a database by nodes in a network, in a decentralised and distributed way. In broad terms, this means that instead of having a unique copy of the database, maintained by a central node or authority, there are many nodes in a network, which maintain and update multiple copies that are simultaneously synchronised. A blockchain is a special case of a DLT, with the added characteristic that the database is updated by appending the new block of transactions at the end of the long chain of blocks.
Below we list the most important design characteristics of DLT and public blockchains.
Shared Ownership and Permissionless Access
Nobody controls the database in a permissionless DLT project, as it is maintained and updated by the nodes of the network. Moreover, anyone can participate, as long as they follow the rules. This means that permissionless DLT projects are inherently open. At the same time, users are typically pseudonymous, which means that part of their identity is hidden, although transactions are public.
DLT creates digital scarcity of the native cryptocurrency, using cryptography and game theory. This means that a bitcoin, for example, cannot be replicated endlessly. Digital scarcity effectively allows for cryptoassets to effectively and directly represent value without external legal contracts, thereby themselves become valuable bearer assets, as their supply is no longer infinite.
A user can prove ownership/control of a cryptoasset, using cryptography, without relying on a trusted intermediary to verify their identity. This means that transactions are completed in a trustless environment, where a user does not need to trust their counterparty in order to do business with them. Getting rid of trusted intermediaries and middlemen implies that no single entity needs to control the network, nor can they generate monopoly power by taking advantage of the fact that users cannot switch networks easily.
Transparency and Privacy
DLT has built-in transparency and privacy. A user has better control of the information that is generated through their activities, as they can directly grant and revoke use and control rights to other users. At the same time, because the distributed ledger is public, there is transparency on how transactions are handled. For example, an attack that falsifies transactions can be detected immediately. In a centralised database, like that of a bank, this may not be possible, unless the bank discloses it.
Smart contracts are programs that encode a set of rules on how transactions are processed. They can be invoked automatically, without human intervention. They enable distributed ledgers to build a lot of functionality into transactions, that was not possible before, while removing the need for constant human intervention. Moreover, because they are auditable, anyone can inspect the code and understand in principle how they work.
A DLT project is governed by everyone who is willing to participate. In formal on-chain governance, proposals for the future direction of the project are put forward and then users vote, using the governance token of the project. Tokens can facilitate innovative forms of governance, which can go beyond the traditional governance of firms, which consist of shareholders, a CEO and a board of directors. On the other hand, the pseudonymity of the users provides some limitations: they can implement a one-token-one-vote system, but not a one-person-one-vote system, which may create problems of concentration of power to a few people with many tokens.2
Decentralised Finance (DeFi)
The most prominent DeFi projects are in lending (Compound, Maker, Aave), decentralised exchanges (Uniswap, SushiSwap, Curve Finance), derivatives (Synthetix) and digital assets (Vesper, Badger DAO). All these projects share several characteristics, which are inherited from DLT.
The lifeblood of any financial system is the assets that are traded, and we cannot trade an asset which is in infinite supply, as these types of assets cannot retain value. Digital scarcity, enabled by DLT, generates valuable, finite cryptoassets and it is what makes DeFi projects possible.
The decentralised and trustless nature of DLT means that DeFi projects create protocols that are non-custodial. That is, instead of a user depositing their assets with a custodial bank that they trust and then trade, transactions are completed in a trustless environment, where assets are not deposited. Instead, they are locked and released using smart contracts.
The permissionless nature of DLT implies that everyone can participate in DeFi projects, either as a user or as a participant. For example, a user can lend money to other users or stake liquidity in a decentralised exchange, in order to facilitate exchanges and receive fees. A participant can earn tokens from the beginning of the project, for example by contributing code. They reap the rewards of a successful project by selling their tokens, if they appreciate in price. Moreover, by voting on proposals they can participate in its governance and shape its future direction.
In contrast, a bank or a country can place a user in a blacklist and refuse to do business with them, or even seize their assets, precisely because their assets are in custody with a bank. Similarly, a country can restrict the types of interactions that a user can have with financial institutions of other countries. Investors can participate in a fundraise either at the VC stage, which is not open to retail investors, or at the IPO stage, which is after the firm has evolved considerably.
DeFi is inherently borderless, although this may change with regulation. At the same time, because DeFi projects do not need to be controlled by anyone, there is more economic scope composability, as building on top of software which is not centrally controlled, can be less risky from an interdependence and control perspective. Different protocols or DAOs can be combined with each other, which has positive externalities. A user can compose their own bespoke financial services and benefit from greater choice, rather than being sold a specific bundle by their bank.
Finally, the transparent nature of permissionless DLT means that the DeFi projects are generally auditable, and the code is open source, so anyone can inspect it for code errors or malicious intentions. Generally speaking, the more developers there are checking a piece of code, the lower the risk of code errors or malicious intentions. Since the protocols employ smart contracts, there can be more certainty about what procedures will be followed in a given situation, when compared to trying to predict how individuals will behave in every scenario.
DeFi holds a great promise of revolutionising and democratising access to financial services. However, it is important to note that the technology is still very new, and there are significant risks, both from investing and participating. There have been incidents where money is lost in projects, because the code was not implemented and inspected correctly, or because of attacks. Moreover, there are still significant bottlenecks to overcome, because the infrastructure is still incomplete. For example, there are limitations on how many transactions can be processed on the Ethereum network, which can then lead to high transaction fees.
1 See https://defipulse.com for the current list of the biggest DeFi projects in terms of value locked. A historic account of the value locked in DeFi is given at https://arxiv.org/abs/2101.08778.
2 For more details, see the post “On-Chain Blockchain Governance” at https://www.coinscrum.com/on-chain-blockchain-governance/.