In this article, I share my thoughts on Decentralised Finance (DeFi) from my learnings so far. I also write about its importance and emphasize a flaw in a major use case which when fixed can impact lives and lift billions out of poverty worldwide.
Like many, I used to think of Decentralised Finance (DeFi) as an abstract and farfetched blockchain concept. However, to appreciate the purpose of DeFi, we must go back to the basics of economics and understand the role of financial institutions in determining economic outcomes.
Financial institutions in today’s world primarily function as the engine of capital formation (aggregation) and allocation of capital to the most productive uses. This process is known as “financial intermediation”.
Optimum financial intermediation has the circular ability to create jobs and broad-based demand whilst lifting billions out of poverty. However, traditional financial systems have failed to achieve this. According to the World Bank, nearly half of the world’s population still struggles to meet basic needs. This is evident by nearly 4 billion persons worldwide, living on $5.50 per day.
To further understand the role of financial institutions in expanding economic outcomes, let’s look at the basic participants in the traditional financial system in the table below:
So basically, Traditional Finance (TradFi) is all about relying on financial institutions to aggregate capital and allocate capital efficiently to the best opportunities that not only deliver returns to capital providers but also expand the economy. As we mentioned earlier, TradFi is falling behind in achieving this, as this decision-making process is contingent on centralized authorities, geographical and economic restrictions, as well as human biases. Economist, Saifedean Ammous in his book “The Bitcoin Standard: The Decentralised Alternative to Central Banking (2018)” described the Hayekian property stating that “rational markets under a zero intelligence crowd with the right design work better than a Soviet-style management composed of maximally intelligent humans”.
DeFi is about fixing the broken design of centralised markets by relying on a set of smart contracts to self-execute optimum capital allocation decisions, as predetermined terms are fulfilled. DeFi replicates activities in traditional markets but removes power from centralised institutions and puts it in the hand of communities and individuals. Hence, financial intermediation can occur peer-to-peer on the blockchain and be executed by smart contracts, without any middlemen.
Globally accessible: DeFi is the world’s shot at a truly permissionless global financial system. Today, with an internet connection, a smartphone and a digital wallet, anyone can transact in real-time peer-to-peer and without restrictions.
Capital redistribution: Web 2 has done a fairly good job of flattening our world, mostly around the first form of human interaction - communication. Without barriers, you can interact in real-time via social media or instant messaging with anyone in the world regardless of location. The second form of human interaction is economic incentives (money and commerce), which are still being kept regionally and require centralized consent. DeFi is here to flatten it out. This means that global capital can easily flow to the most productive and attractive destinations regardless of geographical location.
Transparency: Everyone involved in DeFi transactions can see all transactions in real time, allowing for informed decision-making and honing trust while elevating community spirit as opposed to promoting any central authority. This leads to a truly open, fair, and rational market functioning. This also means that it essentially eliminates middlemen, leading to faster global transactions and lower fees.
The most common DeFi models include:
Decentralised Exchanges (DEX): They allow individuals buy and sell both spots and futures of tokens and asset. This mimics regular traditional exchanges. Examples include: Uniswap, Curve, Balancer, others.
Asset managers: This refers to protocols that operate yield generation pools, including those that create and maintain structured products, mimicking regular brokerage firms and fund managers. Examples are: Yearn Finance, Badger DAO, others.
Lending: These protocols primarily receive capital and lend to borrowers who meet pre-determined conditions. Examples include Aave, Compound, MakerDAO, among others.
I’d be honing in further on this lending use case, because lending is perhaps one of the biggest use cases of financial services globally, with global household debt towering at over $50T according to the IMF. Also, 2.5B persons worldwide lack access to any form of credit or financial services, implying that credit, especially real-world credit, presents a gap to be filled by DeFi.
However, 95% of DeFi loans are currently overcollateralized i.e. requiring a borrower to deposit more than the face value of the crypto they intend to loan, as collateral. The incentive here is mostly for speculative gains. In my opinion, this based off a shaky assumption that individuals can be or will be crypto rich, whereas global crypto penetration amongst internet natives, still stands at less than 10%.
Already this overcollateralisation amongst other challenges including DeFi’s current overly technical interface, are having a negative impact as DeFi struggles grow despite its huge potential for helping lifting billions out of poverty. According to CoinTelegraph, the Total Value Locked (TVL) in DeFi declined to $70B in August 2022 from $160B in mid-April, which is the lowest level since March 2021.
For real world adoption and explosive growth to occur, DeFi lending has to fix this collateralization challenge without posing systemic shocks to DeFi, especially as the market is still relatively early. To suffice, I acknowledge that there are some attempts at undercollateralization today thanks to Goldfinch, Jia, among others, but this is still primarily available for a vetted handful of corporates. Expansive and impactful growth will come from consumer financing for all!