DeFi could become the next big thing in finance

DeFi, or decentralized finance, is turning into the most important nascent trend in finance. 

The ability to borrow funds, take out loans, deposit funds into a savings account, or trade complex financial products — all that without asking anyone for permission or opening an account anywhere — is quickly gaining traction. The amount of money locked into various DeFi services has recently surpassed $2 billion, according to DeFi Pulse, up from about $1 billion a month ago. But it’s not just about the money — other assets are being sucked into the DeFi ecosystem. 

Let’s take a couple steps back. DeFi, which is built on cryptocurrency platforms such as Ethereum and Cosmos, cuts out human middlemen and paperwork, and replaces them with smart contracts. These are computer programs that run on decentralized blockchains, meaning they’re near-impossible to stop or censor. If I borrowed money to someone via a smart contract, the terms built into the contract have to be obliged — no human can (typically) alter that. 

Six months ago, I wrote an article describing how simple it has become to invest, loan, and borrow money using freely available DeFi services, in my case a mobile cryptocurrency wallet called Argent.

Since then, however, the number of services in the DeFi space, as well as overall use, have skyrocketed. The simple practice of borrowing a bit of crypto and generating a return seems innocent in comparison to the massive array of opportunities available today. 

Tokenization of everything

One advancement that facilitated this change is tokenization. Tokens — essentially cryptocurrencies that run on a parent blockchain, like Ethereum — are smart contracts themselves. Tokens on Ethereum share many properties with Ethereum’s currency, which is called ether or ETH. But they can be created with properties that make them similar to certain financial products and services. The most common example are stablecoins, which are tokens whose value closely tracks the value of a real-world asset, such as a fiat currency. USDC, TUSD and DAI track the dollar. EURS tracks the euro. 

In the past year or so, an increasing number of external assets and financial products have been tokenized on Ethereum. Bitcoin, which by itself does not offer complex smart contract capabilities, is a valuable and highly liquid cryptocurrency asset. It is therefore being injected into DeFi by projects which, typically, lock actual bitcoins as collateral and produce Ethereum-based tokens which track the value of real bitcoins. Examples include WBTC and tBTC. Some 15,500 bitcoins are currently locked into BTC services, with a total value of more than $141 million. 

Stablecoins and bitcoins on Ethereum are fairly simple to understand. But smart contracts allow for far more complex products to be created. For example, you can now go to Uniswap — a completely decentralized cryptocurrency exchange — and purchase sETH, which is a token that tracks the value of an ETH short (in trading, shorting is the practice of borrowing an asset and selling it, with the idea of buying it later at a lower price). The magic of this is that to actually short ETH, you’d typically have to sign up at an exchange, transfer some money there, and perform certain actions. But the sETH token abstracts all the steps into a token that you can purchase and simply hold in a cryptocurrency wallet. Its value goes up if the value of ETH goes down, making it really simple and accessible for anyone to short ETH.

Even more complex examples are some of the products offered by a cryptocurrency exchange called FTX, which include tokens that track Bitcoin volatility, or even some that let you bet on Trump’s chances to win the 2020 election.  

There’s also a network effect at play, in which certain assets act as a foundation for other, more complex DeFi products. This is often referred to as composability — the ability to plug various DeFi services into one another to create new applications. Again, a good example for this are stablecoins, which serve as non-volatile collateral for various DeFi services.

A new bubble?

The relative ease with which new DeFi products and services can be created and offered to the market has caused a surge of interest, and some of it has the makings of a bubble. 

The most egregious example of this is the practice of yield farming. DeFi products remove a lot of the friction that’s present in finance. Also, anyone can create them and place them on the market, with no restrictions or oversight. Because of these factors, it wasn’t long until certain DeFi services started offering extravagantly high returns on lending products. Then, other DeFi services were built on top of these, further increasing these returns by doing some fairly complex and — to a typical user — arcane wizardry in the background. 

A site called DeFi Rate lists the typical lending interest rates for DeFi products. Right now, a platform called Nuo offers an 11.47 percent yearly return rate on USDC deposits, and Aave offers a 7 percent yearly return rate on DAI. If you’re not very tech-savvy and/or privy to the inner workings of these systems, you probably won’t know why one service can offer a premium over another. But a lot of users are focusing on the ones with the highest returns, which are typically associated with higher risks. 

A 10 percent annual return on an asset that tracks the value of the U.S. dollar is nice, but if you dig deeper into more obscure products, you’ll hear talk of yearly return rates going into hundreds of percents. 

DeFi service Compound caused a boom when it launched its COMP token in June. Users who provided liquidity to various Compound services would earn the COMP token as reward. Combined with borrowing and lending other products, one could employ their crypto capital to earn massive returns, which in turn caused the COMP token’s value to skyrocket. 

Massive returns on capital are almost never risk-free. Ethereum co-creator Vitalik Buterin expressed his concern about these exorbitant return rates that can currently be found in DeFi.

“Interest rates significantly higher than what you can get in traditional finance are inherently either temporary arbitrage opportunities or come with unstated risks attached,” he tweeted. 

The risk has proven to be very real several times this year, with individuals abusing DeFi products to effectively steal funds. In June, a hacker drained approximately $500,000 from DeFi service Balancer. In April, $25 million was stolen from dForce. 

For a deeper dive into the various DeFi products currently on offer, as well as some of the risks attached, check out Consensys’ latest Ethereum DeFi Report. 

Permissionless is key

In another tweet, Buterin raised an interesting point. “Realistically, many of the most valuable parts of defi are likely to be the most boring: just giving anyone in the world access to a crypto-dollar with an interest rate that matches inflation is already a huge boon to so many people.”

While DeFi stands for decentralized finance, the fact it’s permissionless is equally as important, perhaps more so in its current state. It means, essentially, that anyone can use these services, with the only barrier to entry being a little bit of technical knowledge. 

Say you’re living in a country whose sovereign fiat currency has a fast-increasing rate of inflation. Instead of saving in that currency and effectively seeing your capital dwindle, you could turn your money into a U.S. dollar-backed stablecoin and get a decent return rate on top of that. Of course, if U.S. dollars aren’t your currency of choice, you can use DeFi to invest into other fiat currencies, and stablecoins that track the value of gold and other assets, etc. 

Big potential and big risk

DeFi gives everyone in the world access to an essentially unlimited number of financial products and services. These opportunities, which range from simple savings products to complex trading platforms, are nearly frictionless, in the sense that they require very little infrastructure. The world’s 1.7 billion unbanked adults can, theoretically, access all these opportunities without asking anyone for permission. 

Also, by largely removing the middlemen (banks and related institutions), DeFi has the potential to make certain products cheaper, which could make a big difference in the long run. 

“Defi is interesting as a use case for rapidly experimenting with new financial products with considerably less friction. It’s a huge step forward for democratizing access to financial products and the design of new ones, Ethan Buchman, CEO of Informal Systems and vice president of The Interchain Foundation, told Mashable in an e-mailed statement. 

According to Buchman, there’s still a while to go before these services are useful to an average person. In fact, it’s currently mostly based on speculation and arbitrage, and a lot of it comes with considerable risk. 

“While in principle the mechanisms are much more transparent than any traditional financial product, the general volatility of cryptocurrencies, the immaturity of DeFi smart contracts (ie. the potential for bugs), and the possibility of miner interference (ie. “Miner Extractable Value”) collectively make DeFi a dangerous place to play,” he said. 

Disclosure: The author of this text owns, or has recently owned, a number of cryptocurrencies, including BTC and ETH.