DeFi (decentralized finance) is peer-to-peer financial services such as borrowing/lending, insurance, or the trading of assets being done utilizing blockchain technology without an intermediary.
DeFi, or decentralized finance, remains one of the fastest growing industries. From 2019 to 2021, the TVL, or total value locked, in DeFi protocols grew 80x from $1 billion in 2019 to $80 billion by mid-2021. Today, DeFi continues to grow, having surpassed $100 billion in TVL in 2022. DeFi, or decentralized finance, is a consortium of peer-to-peer financial services that uses blockchain technology and eliminates the need for intermediaries. DeFi aims to remove a central authority or middlemen from financial transactions such as loans, insurance, buying/selling digital assets, derivatives, or crowdfunding. With no middlemen, such as governments or companies who can block or restrict access to financial services, DeFi aims to democratize access to these services for everyone.
To understand DeFi, we have to understand the history of cryptocurrencies. Bitcoin was released in 2009 and became one of the most successful cryptocurrencies. Bitcoin essentially became decentralized digital money not controlled by a central bank or government. Bitcoin was built using blockchain technology and cryptography to create a secure, public blockchain accessible for use by anyone. This accessibility is in contrast to traditional finance, where access is limited by KYC/AML regulations for services such as having a savings account at a bank, trading stocks on a centralized stock exchange (CEX) like Robinhood, or applying for a loan.
Know Your Customer (KYC) are a set of guidelines in many countries that require the financial institution, such as a bank, to collect and periodically verify identifiable information about a person before allowing them to access the institution’s financial services. For example, if you would like to open a savings account at a bank, the bank would require you to give personal information about yourself such as your Tax ID number, driver’s license number, photo, and home address to fulfill KYC guidelines determined by the country’s government. While this information is very personal, refusal would stop you from obtaining these financial services in many countries. KYC ties directly into Anti-Money Laundering (AML) regulations, where governments use KYC to restrict individuals or entities from utilizing financial services for criminal activity. Many governments would have a list of individuals that each financial institution must refuse service. While governments have used KYC/AML regulations to stop criminal activity, they have also been accused of using these guidelines for political means. For example, many financial institutions that do business internationally are restricted from offering services to citizens of Cuba or Iran due to sanctions by the U.S. government. While there may be reasons for these sanctions, the blanket ban based only on nationality economically harms millions of people who haven’t committed any crimes.
The exclusion of hundreds of millions people from the global financial system is the impetus and one of the leading factors behind the growth of DeFi. In DeFi, there is no KYC process needed or restrictions based on nationality. While Bitcoin was revolutionary, its application was limited. One could only send money, or Bitcoin, to each other. Bitcoin lacked the functionality to do more complex financial transactions such as loans, insurance, or trading assets like stocks. To go beyond this significant limitation of Bitcoin, the Ethereum blockchain was launched in 2015.
Ethereum is a decentralized, open source blockchain with smart contract functionality. Loans, decentralized trading of assets, insurance, and many other activities not became possible for everyone. The only limitation is internet access.
DeFi is a category of decentralized applications, or dApps, that deals explicitly with peer-to-peer financial services. DeFi applications are built on top of blockchain technology using smart contracts. Smart contracts are self-executing agreements in code based on predetermined conditions. Since smart contracts execute automatically for each party when the predetermined conditions are met, they eliminate the need for intermediaries. The code is written using programming languages such as Plutus, which is the native smart contract language for Cardano. Plutus is a Turing-complete language written in Haskell, a functional programming language that considers the computations as a combination of separate mathematical functions. Haskell is a statically-typed, functional programming language that has been around since 1990. In Haskell mathematical functions map inputs to outputs, which focuses on the result of inputs, limiting unintended side effects, shared data, and mutable data. Due to provable correctness of code that Haskell offers as a programming language, it is used commercially in multiple industries such as finance, hardware design, and aerospace and defense, and other industries where entities are seeking high assurance coding. There are many programming languages used for DeFi, including the Solidity language for Ethereum and the Rust language for Polkadot and Solana.
The basic function of a decentralized exchange like the Genius DEX or centralized exchanges like Robinhood is the same, allowing users to trade assets for other assets. However, DeFi uses a distributed ledger technology, or a decentralized blockchain for transactions. No single node has control of the blockchain and all transactions added to the blockchain are immutable. User’s funds are bound by the smart contract of the dApp.
In traditional finance, entities like banks typically keep the ledgers internally. By having sole control of the ledger, the bank can change, cancel, or reverse transactions. Banks can also block those who can access their financial services and require users to identify themselves to satisfy KYC guidelines before allowing the use of their services.
In DeFi, the ledger is distributed and transactions are approved by multiple nodes. In traditional finance, the centralized nodes, or a single entity, controls the ledger. Let’s illustrate the difference below:
The distributed ledger of transactions, or blockchain, is distributed between multiple nodes. When a user interacts with a DeFi protocol on the Cardano blockchain, the potential execution of that transaction is performed based on the conditions of the smart contract. When the transaction is executed, it is recorded on the distributed ledger stored on each full node.
A great example of a smart contract coded in Plutus is the Genius DEX, where you can swap tokens or provide liquidity without the need for KYC. Technically, smart contracts allow trustless operation of a dApp. You don’t need to know the other party because the smart contract defines the conditions of your transaction. In addition, the transaction is correctly validated and executed on the Cardano blockchain, ensuring security and immutability.
DeFi has many applications that provide real utility
DeFi currently offers many financial services that are similar to traditional finance services that require KYC. Due to this reason, DeFi has started to come under regulatory scrutiny because it could eventually allow an unregulated financial system with no controls. Regulators have identified these key risks with DeFi:
Consumer protection - Many DeFi projects have mantras and disclosures of “review the code” or “DYOR” (Do your own research). Regulators believe this is not sufficient for average retail participants. While DeFi projects can be well-intentioned and publish their code, most retail investors don’t have the knowledge or skill to understand the code behind projects or test it themselves. However, a rich participant would have the skills or could hire someone with the skills to review the code and understand the risks. Regulators argue that public oversight by a central authority is necessary to even the playing field between retail participants and rich participants.
In conclusion, many regulators feel that completely unregulated markets eventually trend to corruption, fraud, cartel-like activities, and information asymmetries. The growth and robustness of the U.S. capital markets is a prime example of how well-regulated markets flourish when there are minimum standards of disclosure and conduct. The opinion of government authorities is that if DeFi really wants to flourish and experience mass adoption, it needs to integrate a regulatory framework.