DeFi: finance's new era

Financial innovation has completely transformed the world over the past 500 years. The Italian Renaissance was fuelled by the birth of bonds and modern banking in city-states such as Florence. These tools were later perfected by the Dutch and the British. Napoleon’s defeat, after all, had as much to do with the size of the London gilt market as it did with troop positions at Waterloo.

This relationship between financial innovation and human progress is even more salient today. In the past two decades, financial technology specialists have started to rethink finance by opening up new possibilities for the transfer and generation of wealth. Of the many innovations that have arisen in this time, few will be as meaningful as decentralised finance (DeFi). 

At its core, DeFi rests on one of the most outstanding innovations of the current financial era: the programmable blockchain. The origins of this technology stem from the launch of the bitcoin blockchain in 2009, which first provided a way to create scarcity in the digital world. “The original sin here is that digital objects and assets are not real. There’s nothing to them; their marginal costs are zero,” says Lex Sokolin, head economist and global fintech co-head at ConsenSys, a blockchain technology company. “Blockchain fixes this — they manufacture the attributes of digital scarcity for digital goods. If I give you one bitcoin, I don’t have it anymore. So, the digital world now has scarcity. It’s a physical property that has been translated into digital form.” 

Revolutionary technology

Building on this digital scarcity, developers working on the Ethereum blockchain took the next step of putting software into the system, and in doing so, created the world’s first and still largest ‘Turing-complete’ blockchain, meaning it can be used to solve any computational problem. As a result, software can be integrated into the system to cover everything from financial services protocols to games, social media and much more. “You’re putting software into that world where things can be digitally scarce. Ethereum pioneered this and is still largely the leader. The magical thing about software is that it can be applied to anything and it allows people to build very creative projects,” explains Mr Sokolin. 

David Mercer, LMAX Group

DeFi is a key offshoot of this revolution in blockchain technology — a parallel financial system that uses cryptocurrencies, and one that is entirely digital and peer-to-peer (P2P). Its applications range from exchanges to borrowing and lending protocols, as well as derivatives programs. No intermediaries are required to facilitate financial transactions between different parties because the blockchain networks on which they operate are inherently decentralised. Today, DeFi exists across a kind of multiverse of different blockchains that, for the most part, can connect with each other through third-party programs. The Ethereum network is easily the largest and most dominant DeFi blockchain in terms of developer activity and total applications, although a host of competitors are quickly catching up.

Promise of self-empowerment

To get a sense of DeFi's growth trajectory, it is worth considering the numbers. In the opening days of January 2020, DeFi’s total locked value, which measures the total assets committed to the system, was just over $600m. By mid-August 2021 that figure had reached $81bn, marginally down from the peak of $88bn registered in May of the same year, according to DeFi Pulse. But DeFi is much more than just a rapidly scaling parallel financial system. Mapping the changes it is likely to deliver to financial services specifically, and human progress more generally, is challenging because the project remains embryonic while its potential implications are vast. 

For users of DeFi, it comes with the promise of self-empowerment and autonomy. This notion cuts across several dimensions, but the efficient use of capital is one of the more functional benefits. To interact with DeFi, participants are required to have a dedicated cryptocurrency wallet. MetaMask, for instance, is the most widely used wallet and is the doorway to the Ethereum network. This eliminates the need for an intermediary, such as a bank, to store monetary value and, together with the blockchain networks on which they operate, underpins the P2P nature of the system. 

“It’s turning all of us into our own banks. It’s making us make better use of our own balance sheets. You have to step forward and, in many ways, ignore the jargon and ask ‘What assets do I have and am I utilising them efficiently?’” says David Mercer, chief executive of the LMAX Group, a financial technology company that operates institutional exchanges for foreign exchange and cryptocurrency trading. “[DeFi] allows you to effectively lend or stake your spare [cash] and earn a return on a second-by-second, minute-by-minute or hour-by-hour basis, rather than waiting for the end of month return.” 

No space for legacy

DeFi’s 24/7/365 operations are clearly more aligned with the digital economy that is taking root around the world than the traditional financial system. This has implications not only for individuals, but also large financial institutions. “Look at LMAX Group, we are sitting on balances in about 15 different currencies, and we are earning very little interest on all of them,” says Mr Mercer. “It might be interesting to [look at ways of deploying them on DeFi]. Those assets are actually losing money on a second-by-second basis because of inflation and seemingly endless quantitative easing. I think it’s important to all of us that we put our assets to use.” 

Generating a return and using capital efficiently in the world of DeFi relies on smart contracts. These are self-executing applications stored on a blockchain and, as a result, are verified by a large set of independent validators. Proponents argue that smart contracts are highly transparent, as the underlying code is visible to all, and boast strong security safeguards; however, questions remain over the veracity of these claims. Smart contracts also come with a high degree of flexibility, meaning they can be adapted to create new instruments and offerings to expand the suite of DeFi applications in complex and imaginative ways. 

“You can think of smart contracts as applications that run on every single node of the blockchain,” says Andrea Barbon, professor of economics at the University of St Gallen in Switzerland. “So, they are run on all the servers that are running the blockchain. It’s impossible to change the history of what has happened on a smart contract.”

To overcome the lack of an intermediary in trading and lending protocols, for example, smart contracts aggregate cryptocurrency funds into a digital “liquidity pool”. These funds — which can be contributed by any DeFi user to generate yields — are locked into and governed by the algorithm to facilitate lending, trading and a host of other financial services. Smart contracts, therefore, boast a long list of advantages. They dispense with the need for costly legacy intermediaries, they improve capital utilisation and seemingly offer high levels of transparency. 

New intermediaries needed

But they also generate their own complications and paradoxes in a system that is only a few years old. For one, they are fuelling the rise of a new generation of intermediaries looking to guarantee the integrity of the underlying code. In order to understand a smart contract, an advanced level of programming knowledge is required. 

“For technical specialists, [smart contracts] are very good because they can open the contract and they can understand it,” says Vytautas Zabulis, managing director at H-Finance, an infrastructure and compliance provider that enables institutions to work with digital assets. “So, what’s happening is that there’s a big industry that’s emerging to conduct audits, including security audits and code audits. If you have a new smart contract or even blockchain that is being launched, it will most likely have an audit.”

Supporters of DeFi correctly point out that few retail equity investors, for instance, understand the underlying mechanics of acquiring stocks. Not having a full grasp of the code of a smart contract is, they say, equivalent to this — as long as the protocol works. Even so, the rise of new intermediary auditors to generate trust in a smart contract suggests that the promise of completely cutting out the middleman will remain elusive. 

Shaky legal ground

Further uncertainties exist around legality and contract enforcement. In particular, given the multi-party nature of most smart contracts — especially in terms of decentralised exchanges, and lending and borrowing functions — typical legal norms are difficult to apply.

“English law has recognised the capacity of smart contracts to form a valid contract, providing they have offer, acceptance and intention to create legal relations,” says Christina Fleming, an associate in the commercial group at law firm Bird & Bird. “But in reality, they haven’t really been tested too much, in terms of whether the smart contract running on the protocol of a certain DeFi exchange is actually enforceable if it didn’t do what it [was supposed to] do.

“Quite often, these contracts involve several parties, and it’s not clear that they would fit neatly into the traditional offer and acceptance framework, or whether they would actually be bound by a common set of rules. We recommend that to create a valid contract, you need much more than just the code itself. That, in my view, is one of the obstacles to more mainstream adoption of these DeFi initiatives. It’s very much done on the basis that we all trust it’s working. But as soon as it doesn’t, [everyone will be left asking] where do the chips lie?”

The legality of smart contracts also touches on a further challenge that faces DeFi: regulation. For the most part, global financial regulators are yet to meaningfully intervene in the world of DeFi. The regulatory perimeter lies at the on- and off-ramps between fiat and cryptocurrency, through major exchanges such as Coinbase, that are required to meet know-your-customer and anti-money laundering standards when new customers join. Eventually, however, the regulators are expected to come knocking at the door. “I don’t think it is possible for the sector to grow and [remain] unregulated,” says Mr Zabulis. “You cannot allow an unregulated financial system to trade futures contracts, for example.” 

Regulating the new system

For its part, the UK’s Financial Conduct Authority is considering expanding its regulatory reach around the use and promotion of cryptocurrencies, while the Financial Times reported a June 2021 video call between leading DeFi applications, such as Uniswap, and a suite of US regulatory agencies, in order for the public agencies to better understand the system. A lack of regulatory clarity is frequently cited as one of the main stumbling blocks facing the development of DeFi. 

“The main risks [facing DeFi] include the lack of responsibility and accountability for the actions of participants and, in the event of an error in one of the protocols, the risk of vulnerability across the entire system increases significantly,” says Vladimir Potapov, chief executive officer of VTB Capital Investments. “As the importance of DeFi increases in world finance, the need to regulate the system as a whole, or to allocate a regulated part of the system, will become increasingly important.”

Vytautas Zabulis, H-Finance

In mid-August 2021, DeFi caught the attention of global regulators for all the wrong reasons. More than $610m in cryptocurrencies were hacked from a DeFi platform known as the Poly Network, which provides bridging services between different blockchains. It was the biggest incident of its kind in the system’s history. Although the hacker returned most of the funds and received a monetary reward for discovering a bug in the Poly Network platform, according to various media reports, much remains unclear about the nature of the incident. 

For critics and supporters of DeFi, however, it was notable for different reasons. Long-time cynics quickly pointed to the inherent vulnerability of the system and its ‘Wild West’ nature. Supporters, meanwhile, noted how easy it was to track the bulk of the stolen funds through the network. Yet, even as this argument was playing out in the days following the hack, cryptocurrency prices were booming. Some of the largest cryptocurrencies by market capitalisation, including bitcoin, ether, XRP and ada, enjoyed strong gains over and beyond the period in which the hack took place. 

“The [cryptocurrency] markets did not react negatively to this hack at all, probably because [the Poly Network] is relatively unknown. In addition, the DeFi community understood that it would be very hard to get away with the stolen money,” says Mr Zabulis. 

Nevertheless, the hack has widened the split between DeFi’s proponents and its critics. Few topics in contemporary finance generate the kind of division that is sowed by the project, because it fundamentally alters, or at least questions, nearly every tenet of the existing financial system.

Luminaries of the incumbent system, from bank CEOs and central bankers to legacy media titles, frequently weigh in against both DeFi and the cryptocurrencies that exist within it. Many of these criticisms are valid: DeFi remains a highly risky and volatile project for many users, issues of governance and regulation need to be settled, and security problems continue to flare up, to name but a few of its most pressing problems.

For supporters of DeFi, however, bigger issues are at play. “It’s a global, horizontal layer for all financial products and all financial services,” says Mr Sokolin. “It’s also built in such a way as to preserve human dignity, because that’s what privacy and control over your own data, and the ability to choose which protocols you interact with, is: dignity.

“What DeFi does is it privileges the young and gives them social capital and their own system, which depending on your value judgement of the prior system, is important. And I think it’s a platform shift that has been missing in finance and is finally here.”

Whatever position one adopts towards DeFi, the project is here to stay. It forms part of a wider digital revolution taking place across the online world: the growth of Web3. Built on decentralised blockchains such as Ethereum, this new digital universe works in a completely different way to the existing internet (Web2) in that it avoids the monetisation of personal data.  

In a sign of the momentum that is building up in this new digital world, an Ethereum-based online game called Axie Infinity surpassed $1bn in sales in August 2021. The coming months and years are likely to deliver more milestones of this kind across the entire spectrum of Web3, including DeFi. 

The development of modern banking, the bond market, joint stock companies and the equity exchanges had the effect of supercharging western European and then US growth in recent centuries. How DeFi might shape the world around us remains unclear, given that it is just a few years old. What is certain, however, is that lasting and significant change is on the way. 

“DeFi is one of the most interesting things to happen to finance in the past 10,000 years. [Its] open architecture is pushing a lot of developers and a lot of smart people to work on new applications. So, there is a really strong creative force that is, for sure, going to breed innovation and ultimately change financial services,” says Mr Barbon.