What is decentralized finance and why does it matter?

Authored by Makara
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Makara

Published August 20, 20218 min
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Did you know modern credit scores were invented in 1989? Twitter does. Every time someone on social media brings up the unaffordability of housing or predatory student loans, Twitter rails against the tyranny of credit scores. The idea is to point out just how unforgiving the legacy financial system has become to the average user over the last 30 years. Not only have prices for housing and education skyrocketed while wages have remained flat, humans have also been reduced to a single number that determines their worth, buying power, and opportunities. Good luck!

Fortunately, crypto provides a solution. Decentralized finance, known as DeFi, is a global, permissionless, peer-to-peer network. It offers many of the same financial services currently mediated by banks­—including holding assets, providing loans, and selling insurance—only there are no middlemen taking a cut of profits or building barriers to people’s ability to get ahead. Built on blockchains, DeFi intends to allow people in any country and with any amount of money access to the same financial services as everyone else.

Some crypto analysts have gone so far as to call DeFi the cryptocurrency sector’s reason for being. It’s definitely a more compelling use case than the speculation that has captured most of the activity (and attention) in crypto markets to date. Like Uber did to taxis or Airbnb to hotels, DeFi promises to disrupt banking and create a completely alternative financial system. And it seems to be moving that way: As of August 2021, $80.95 billion was locked up in decentralized finance contracts. How much larger and more influential that number gets depends on how many people trust and buy into the system.

How does DeFi work?

In place of banks or brokerages, DeFi uses software to automate interactions between the different parties in financial transactions. The same blockchains that house and protect cryptocurrencies can execute these contracts themselves, but apps and protocols built on top of them provide a more user-friendly experience.

Here is an example: If you need a loan, you can deposit collateral—usually a different currency in a slightly larger amount to protect against volatility—in a protocol such as Aave or Compound. You’ll receive loaned funds immediately, no credit check required. If you have money you want to loan, the process is just as easy. You can contribute funds to a lending pool on one of those same services and start earning interest or fees as it is loaned out. The extra collateral sitting in storage protects you from losing your money, as does an automated process called liquidation. If the value of the collateral drops a set amount relative to the loaned money, the algorithms controlling your transaction will forcibly close the loan. Precise rules for how this works vary between protocols, but liquidations generally act as incentives for borrowers not to put themselves in dangerous, overleveraged positions.

Other decentralized finance apps (abbreviated DeFi dApps) provide more complicated services. There’s a decentralized savings bank called PoolTogether that allows you to deposit funds and, instead of sending everyone tiny amounts of interest, distributes massive lottery-style rewards to a few investors every week. Alchemix is a self-repaying loan app. Deposit your collateral in an account and the interest it earns is automatically used to repay your laon. Decentralized insurance is still in its infancy, but a new Ethereum and Chainlink–based project called Etherisc has begun providing inexpensive crop insurance to farmers in Kenya that pays out automatically when weather data support a claim. Another, called Arbol, covers farmers, ports, energy producers, and the hospitality industry against weather-related loss of revenue.

Decentralized financial networks can also do things that traditional finance can’t, including streaming money (paying salaries by the second), providing instant loans that facilitate high-speed trades, sending money between national borders with no intermediary fees, and operating outside of normal business hours. One particularly lucrative development is the emergence of protocols, such as Yearn.Finance, that move money around the crypto ecosystem automatically—from exchanges to derivatives markets to loan providers—to take advantage of changes in prices and interest rates.

What are the potential pitfalls?

It is impossible to build an entire financial ecosystem from scratch without encountering challenges along the way. Without regulation or oversight, decentralized finance applications have been enticing to crypto “degens,” short for “degenerate gamblers,” and subject to hacks and scams. According to the Insurance Journal, $129 million was stolen through DeFi applications in 2020. One popular scam, called a rug pull, involves creators who build a project, hype up interest on Twitter or Reddit, and then rapidly drain their new trading protocol of funds, driving the price of the new coin to zero. Because the rules of decentralized finance are written in code rather than by people or an institution, even inadvertent vulnerabilities in computer instructions can leave investors unprotected—with no one to call to recover their lost funds.

Financial regulators are currently kicking the tires of DeFi infrastructure to find ways it puts investors in danger or skirts important rules (against, for example, funding terrorist organizations or providing havens for tax cheats). Even with regulation, however, the high volatility of crypto markets means most DeFi products will always be high-risk, whether they’re executed perfectly or not.

Is DeFi worth the risk?

If you’re involved in crypto, you’re accustomed to outsize risk—and the outsize opportunity that comes along with it. With DeFi, it’s almost like regular Joes get to be the people in charge of making the credit scores for once, instead of the ones oppressed by them. If you believe in financial freedom and equality, there is a lot to love about these new products. As with everything crypto-related, however, you need to go into it with wide-open eyes and a slightly stronger stomach than the average investor.