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The story behind Decentralized Finance (DeFi)

OVIDIU POPESCU

22 November 202113 min read

Why are there 1.7 billion unbanked adults across the world, with many more who are under-banked? Why is it that we all had to bailout the very financial institutions that created the 2007-2008 global financial crisis? Why does it take so long and cost so much to transfer money to friends or family on the other side of the world? After all, it doesn’t take two days and cost substantial sums of money to send an e-mail? Have you ever stopped to consider the fact that our centralized financial system hasn’t changed substantially in the past century despite its systemic flaws?

The story behind decentralized finance is the story of the foundation of a new financial system. It’s a system based on transparency, without layers of bureaucracy and financial middlemen helping themselves to large commissions under the complicit watch of government “regulators.” It’s the story of our past and the story of our future, one in which financial services are cheaper, faster, more secure, more personalized – in a word, more democratic.

A brief history of decentralized finance

The technological underpinnings of decentralized finance date to 2008, when the first blockchain was used as the distributed ledger behind bitcoin transactions, about which we’ll have more to say in the next section.

However, the term “DeFi” itself wasn’t introduced until a decade later. It was August 2018 and Ethereum developers and entrepreneurs were brainstorming for a name to christen the constellation of open financial applications being built on their blockchain. “Open Horizon,” “Open Financial Protocols,” and “Lattice Network” were suggested, but one – “DeFi” – eventually won out, ushering forth a global, borderless, permissionless, decentralized financial revolution that continues to gain momentum today.

Even though the technology is quite new, the underlying practices and principles of DeFi are as old as humanity itself. Financial transactions free from centralized control have historical roots in the earliest barter economies and peer-to-peer exchanges, which are precursors to our contemporary monetary system. A simple definition of bartering might describe it as a system of exchange in which individuals directly trade goods or services for other goods or services without using a medium of exchange such as money. While bartering has certain advantages under specific conditions (e.g. during hyperinflation when money quickly loses value), it has a number of inherent disadvantages (e.g. both sides need to have what the other wants in order for an exchange to take place; certain goods are indivisible, etc.).

Similar to bartering (although different from representative money), commodity money provides an example of money having value even though it is not officially backed. (In this respect, commodity money bears a certain resemblance to today’s cryptocurrencies, which are largely unbacked and unregulated.) As its name suggests, commodity money derives its value from the nature of the commodity, which possesses intrinsic value or use, and includes things such as salt, tea, cocoa beans, and tobacco, among others.

Contrast the intrinsic value of commodity money to representative money, which has no intrinsic value, but represents something of value (e.g. gold or silver), or fiat money, the value of which is derived from governmental regulation that has established it as money. As we can see already with this very basic historical outline of commodity money systems, commodity-backed money, and, finally, fiat money, the history of the exchange of goods and services between human beings began in a decentralized manner, but morphed into our present centralized, regulated monetary system, with its national treasuries, mints, central banks, and commercial banks.

DeFi’s foundations

In his now famous 2008 white paper “Bitcoin: A Peer-to-Peer Electronic Cash System,” a person or group of persons writing under the pseudonym Satoshi Nakamoto described the original plan and protocol for Bitcoin. It was a watershed moment for decentralized finance, with some now suggesting that it has created two distinct historical points of reference – pre-cryptocurrency and post-cryptocurrency – for our understanding of money. As of this writing, one bitcoin is worth approximately $63,000, but it all started with a vision just thirteen years ago. Let’s travel back in time briefly and revisit the abstract of this groundbreaking paper:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they'll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone.

In its utter simplicity and purposefulness, Satoshi Nakamoto’s vision is a thing of beauty. More importantly, by creating a peer-to-peer network for transactions using “timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work,” Nakamoto tipped the scales, perhaps irrevocably, in favor of decentralizing the current monetary system. Crucially, the paper establishes the foundation of Bitcoin’s blockchain, as well as the mechanics of blockchain in general, including cryptographic hashing, proof-of-work mechanism, nodes, etc.

The story behind DeFi wouldn’t be much of a story, though, if it didn’t peek behind the curtain, if only momentarily, at some of the key infrastructure components, such as blockchain, cryptocurrency, smart contracts (a key ingredient of DeFi), oracles, stablecoins, and decentralized applications (dApps) along with a discussion of the differences between Bitcoin and Ethereum blockchains.

Blockchain

Quite simply, DeFi is a system that makes financial products available on a public decentralized blockchain network. A blockchain is a list of records or “blocks” that are connected via cryptography. Each block contains a cryptographic hash of the previous block, a timestamp, and transaction data. Now, a timestamp is used to prove that the transaction data existed when the block was published in order to get into its hash. Since each block contains information about previous blocks, the blocks form a chain, with subsequent blocks reinforcing previous ones.

As a result, it can be comparatively more difficult to modify blockchains because the recorded data cannot be altered retroactively without modifying all subsequent blocks. In other words, decentralized blockchains are immutable, meaning that the data entered is irreversible. Generally, blockchains are overseen by a peer-to-peer network for use as a publicly distributed ledger, with nodes adhering to a protocol to communicate and validate new blocks.

Cryptocurrencies, altcoins, and stablecoins

In many respects, Bitcoin was the first DeFi application, as it allowed for sending payments around the world in a decentralized manner. The limitations of the Bitcoin blockchain were also the impetus behind creating the Ethereum blockchain with its native cryptocurrency Ether, which is a transactional token that facilitates operations on the Ethereum network.

One of the hallmarks of cryptocurrencies is the fact that they are typically not issued by any central authority. Alternative coins (altcoins) to Bitcoin include Solana, Litecoin, and Cardano, among others. And stablecoins seek to mitigate or offset the inherent volatility of many of today’s cryptocurrencies by pegging them to the US dollar or to a commodity such as gold. Cryptocurrencies, then, fall under the umbrella of DeFi and comprise a core element of a new type of finance that does not rely on central financial intermediaries.

Smart contracts

Whereas the Bitcoin blockchain can only be used to acquire, hold, or sell bitcoin, the Ethereum blockchain added an additional feature, smart contracts. Here is how Ethereum describes the technology:

A ‘smart contract’ is simply a program that runs on the Ethereum blockchain. It's a collection of code (its functions) and data (its state) that resides at a specific address on the Ethereum blockchain. Smart contracts are a type of Ethereum account. This means they have a balance and they can send transactions over the network. However they’re not controlled by a user, instead they are deployed to the network and run as programmed. User accounts can then interact with a smart contract by submitting transactions that execute a function defined on the smart contract. Smart contracts can define rules, like a regular contract, and automatically enforce them via the code. Smart contracts can not be deleted by default, and interactions with them are irreversible.

Smart contracts are often likened to a vending machine – a certain output is guaranteed with the right inputs.

ICOs

ICOs or initial coin offerings are an important part of the DeFi story, as many have launched new blockchain projects that have had a tremendous influence on Ethereum and the wider crypto ecosystems. Essentially a token sale, ICOs first became popular (read: boomed) during 2017 as a way to sell digital assets in order to raise funds for blockchain-based projects. An estimated $4.9 billion was raised through ICOs in 2017, making the period something of the Wild West of DeFi.

In the absence of any regulatory approval mechanisms, initial coin offerings were similar to crowdfunding efforts such as Kickstarter, but the money raised were in bitcoin and ethereum rather than dollars or Euros, and some of it simply disappeared (the failure rate is estimated at 47%). Still, a number of projects that were started then have become top DeFi protocols, such as Aave, a platform for decentralized crypto loans with high liquidity, or Ox, a decentralized peer-to-peer exchange of Ethereum-based tokens.

dApps

Another component of the DeFi story are decentralized applications or “dApps,” which are digital applications or programs that run on a blockchain or peer-to-peer network of computers (rather than a single computer). If you’ve ever used applications such as BitTorrent or Tor, then you’re familiar with peer-to-peer dApps.

Within the cryptosphere, dApps run on a blockchain network in a public, open source, decentralized landscape. As with cryptocurrencies, dApps exist beyond the control of a single authority. If you use Twitter’s app or Facebook’s app, you’ve relinquished control to the organization running the app. dApps are different. Rather than a single individual, company, or organization controlling the strings, dApps are community driven. Similar to cryptocurrencies, the absence of a central authority means that they are resistant to interference by governments, corporations or individuals.

Some of the more important blockchain dApps include Uniswap, IDEX, MakerDao, and Cryptopunks. Uniswap, for example, is a decentralized finance protocol that is used to exchange cryptocurrencies, facilitating automated transactions between cryptocurrency tokens on the Ethereum blockchain through the use of smart contracts. MakerDao is a crypto- lending platform with its own stablecoin (Dai), which aims to keep its value as close to one United States dollar as possible through an automated system of smart contracts on the Ethereum blockchain. And those of you familiar with non-fungible tokens will likely have heard of Cryptopunks, one of the first non-fungible tokens on the Ethereum blockchain. In fact, their “EIP-721” standard powers most digital art and collectibles.

Problems DeFi solves

If today’s legacy financial system were faultless, then there wouldn’t be a need for alternatives. A centralized financial system that hasn’t changed substantially in the past century is a centralized financial system that risks becoming unfit for purpose in the twenty-first century, at which point the system starts flirting with its own obsolescence.

Following the 2007-2008 global financial crisis, the current monetary system became the subject of increased scrutiny, as more and more of its systemic flaws, inefficiencies, and inequalities came to light. While our current legacy financial system continues to benefit wealthy individuals and wealthy financial institutions in some of the world’s wealthiest countries, who account for a fraction of the world’s population, it underserves or entirely neglects the needs and circumstances of vast swaths of humanity.

DeFi aims to redress these systemic (and, as some argue, in-built) faults and deficiencies, which include inefficiency, limited access, lack of transparency, centralized control, cumbersome interoperability. Rakesh Sharma distills the essence of the problem:

Modern financial infrastructure is built on a “hub and spoke” model. Key economic centers of activity, such as New York and London, function as operational hubs for the financial services industry and influence economic activity at spokes—regional centers or financial powerhouses like Mumbai or Milan that may not be as globally important as hubs but still function as nerve centers for their respective economies.

Economic prosperity or hardship radiate outward from hubs to spokes and toward the rest of the global economy. This model of interdependency is repeated in the functioning of global financial services corporations. They have headquarters in hubs and local branches, partnerships, or investments across the world. The sprawl of their operations means that the organization itself is subject to a phalanx of laws and regulations in each of its financial jurisdictions. Their reach has made such institutions systemically important to maintain the global economy’s balance and necessary to maintain or create new financial services infrastructure.

Though this model worked well in the last century, the financial crisis and, subsequently, the Great Recession, revealed the flaw in this architecture. The balance sheet problems for a couple of large financial institutions produced a domino effect of tumbling economies and the onset of the global recession.

This hegemonic center-periphery paradigm of centralized finance, then, is inherently hierarchical, Western-centric, and therefore unequal, as it disadvantages those on the geographical, political, and economic margins or periphery. In other words, one’s proximity to these financial hubs significantly determines the extent to which, and in what manner, one can participate in and reap the benefits of this system.

In both theory and practice, DeFi is addressing many of the drawbacks of the legacy financial system, including:

Inefficiency

In some cities, Amazon will physically deliver your package on the same day that you ordered it. Why is it, then, that it can take up to 3 days (or longer) in some parts of the world to transfer money between banks? As if these unjustifiable delays weren’t enough, there are also the extortionate fees that many banks charge for their “service.” US banks routinely bill their customers between $25-$50 per transfer (“additional fees may apply”) on top of already unfair exchange rates. There’s a perfectly good word for this practice: skimming.

Limited access

Just think about the statistic cited in the very first sentence of this article. Approximately 1.7 billion adults across the world are unbanked, with many more who are under-banked. Far too many people lack access to banks, and even the ones that do can find it difficult to access banking services like loans. According to a World Bank report (irony of ironies),

Because account ownership is nearly universal in high-income economies, virtually all unbanked adults live in developing economies. China and India, despite having relatively high account ownership, claim large shares of the global unbanked population because of their sheer size. Home to 225 million adults without an account, China has the world’s largest unbanked population, followed by India (190 million), Pakistan (100 million), and Indonesia (95 million). Indeed, these four economies, together with three others — Nigeria, Mexico, and Bangladesh — are home to nearly half the world’s unbanked population.

How can a financial system profess to be a global one when it excludes a significant portion of the world’s population?

Lack of transparency

We hate to beat a dead horse, but there’s real merit in bringing up the 2007-2008 global financial crisis, which originated in the United States and radiated along various global “spokes” (in keeping with the earlier metaphor) to devastating effect. Despite this “once-in-a-lifetime” event, serious questions remain about the relative health of commercial financial institutions. Why not quote directly from the horse’s mouth (read: the World Bank) once again:

Lack of transparency can be costly both politically and economically. It is politically debilitating because it dilutes the ability of the democratic system to judge and correct government policy by cloaking the activities of special interests and because it creates rents by giving those with information something to trade. The economic costs of secrecy are staggering, affecting not only aggregate output but also the distribution of benefits and risks. The most significant cost is that of corruption, which adversely affects investment and economic growth.

Sure, this sounds good, but is it just lip service? Given their less than stellar record, to what extent can regulators be trusted to monitor banks and other financial institutions and thereby prevent another “crisis?”

Centralized controlled

A case can be made that the current financial system, particularly in the United States, is oligopolistic, which is to say dominated by oligopolies that inflate prices higher than competitive ones.

One way to determine whether a market is oligopolistic is through the concentration ratio, which calculates the size of companies in comparison to their industry. The media, airline industry, and, in certain markets, telecommunications industry have a high concentration ratio. Just five companies, for example, dominate US media (NBC Universal; Walt Disney; Time Warner; Viacom CBS; and News Corporation), while Apple and Google have effectively cornered the market for smartphone operating systems.

The result? Higher consumer costs and lack of competition and innovation due to the high barriers of offsetting centralized control. The same can be said of centralized finance, which is why people, armed as they are with the tools of DeFi, are taking back control of their personal data and money.

Interoperability

One of the reasons for the considerable delays when attempting to move money between banks is a result of interoperability issues as well as regulatory ones (assuming one has access to banking services in the first place).

Rather than an experience defined by incompatible systems and lengthy delays, interoperability ensures a frictionless transfer of funds between different payment systems. Frameworks for digital financial services interoperability are currently being established in a number of Africa countries with the aim of greater financial access and inclusion. As Vahid Monadjem has reported,

An emerging example of this can be seen in the West African economic Monetary Union (WAEMU), in which eight countries are building an interoperable system that will connect users with banks, mobile money providers and microfinance institutions. This project is expanding on the previous regional connectivity that was established for the card network a decade ago. By expanding it to include mobile money, the ecosystem is being made available to large sections of the population that did not previously have access to cards.

Beginning with the inherent limitations and inadequacies of the current legacy financial system, DeFi has managed to lower the entry requirements into the finance industry, all while catering to the un- and underbanked by broadening access to services.

Additionally, since DeFi operates on a permissionless blockchain, the interoperability of dApps and tokens is one of their key strengths, which explains why there has been a massive explosion in Yield Farming (lending crypto). Let’s say one dApp comes up with a new feature. Another dApp can then integrate this feature into their product without the need for permission (interoperability).

Separating DeFi fact from fiction

As we conclude our look at the story behind DeFi, it’s important to separate the many facts from the many fictions surrounding this disruptive, revolutionary approach to finance. We can dispense with many of the myths easily enough, such as the belief that all cryptocurrencies are anonymous (clearly not the case); blockchains are routinely hacked (hacks happen, but they’re far from “routine”); quantum computing will break crypto (“quantum computers being added to the mix won’t suddenly render classical modes of encryption useless or mining trivial”); or that the crypto ecosystem is prohibitively smaller than that of legacy financial institutions (comparing a century-old system with one that is only a few decades old is, well, problematic).

So will DeFi upend or even replace the legacy financial system? Well, one of its strongest selling points is that it is permissionless – no credit scores and no need to verify the identity, suitability, and risks involved with maintaining a business relationship. The rules that apply to one apply to all. It’s borderless – all you need is an internet connection. And it’s non-custodial, meaning that users have full control over their money and how it's used. However, there are legitimate concerns over certain aspects of DeFi, including security, scalability, utility, and liquidity.

Perhaps DeFI and “AltFi” will eventually co-exist in some manner, serving different needs for different users. In this respect, it’s a story with a clear beginning, but one whose ending has yet to be written.