What Is DeFi and Why Is It Important?

DeFi – short for Decentralized Finance – is a new and rapidly growing industry attracting more and more capital, both in terms of retail investments as well as an increasing amount of institutional money. The total value of money tied up in DeFi protocols – also known as the total value locked, or TVL – increased from roughly $22 billion in January 2021 to over $240 billion as of December this year.

But what exactly is DeFi? And why should institutional investors – such as family offices and asset managers – pay attention to it?

DeFi Explained

DeFi broadly refers to a financial ecosystem based on the blockchain technology. This technology allows the transaction and building of financial services that do not rely on third party intermediaries, such as banks, brokerages or exchanges. Instead, DeFi utilizes smart contracts; these contracts are software code on the blockchain designed to carry out a specific set of instructions.

DeFi brings innovation and a different perspective to the financial industry through the potential enabled by the blockchain technology. Part of the narrative is to operate without a centralized intermediary such as a bank, and instead operate with direct, peer-to-peer relationships – or peer-to-peers relationships- with users interacting through these smart contracts. Most financial services used in traditional finance today are now available through DeFi, from trading to lending and borrowing, to the DeFi equivalent of savings accounts with interest, as well as insurance.

As mentioned, DeFi applications run on a public blockchain, with Ethereum being the first and still leading network on which DeFi apps are built. Click here to read more on the upcoming Ethereum 2.0.

Dimitri Vardakas, co-founder and managing partner at DeFi Consulting Group oberves: “DeFi is an ecosystem of hundreds of decentralized applications, smart contracts, developed on programmable blockchains such as Ethereum. One of the greatest attributes of those applications is that they can easily be connected to interact with each others to build more advanced and complex use cases.”

However, as new blockchain networks emerge, Defi apps have expanded beyond the Ethereum chain to others, such as Polygon (which is an Ethereum Layer 2), Avalanche, Fantom, Solana and Terra Luna.

How is Decentralized Finance Different from Traditional Finance?

1. DeFi is Permissionless – The only requirement to access DeFi services is having a crypto wallet and an internet connection. Protocols can be used anonymously, with no personal login information, KYC or minimum amount of funds required.
2. Transparency – whereas financial institutions often operate with closed books, defi protocols are built on transparency, meaning anyone can look at the data and transactions. Ethereum and the DeFi applications built on it are also engineered with open-source code, meaning anyone can view, audit or build upon the code.
3. Privacy – transaction activity on defi protocols is usually conducted pseudonymously, whereas in traditional finance transactions are tightly linked to your identity.
4. Efficiency – transactions are settled within minutes or seconds instead of days, defi markets are always open and costs can be lower as there are no intermediaries in play.
5. Interoperability: DeFi apps on the same blockchain can communicate and interact with each other – developers have the flexibility of building on top of existing protocols, customizing interfaces, and integrating third-party applications. For this reason, people often use the analogy of ‘Lego building blocks’ to describe the interoperability and composability of DeFi networks. Because of the applications’ open-source nature, anyone can view the code and use it as a building block for new apps.

Key DeFi Use Cases

DeFi aims to not only replicate but go beyond all of the functions offered by traditional finance. However, in the interest of simplicity, we will break down the functions into three main categories: Lending and borrowing, trading and derivatives.

1. Lending and Borrowing: If you own cryptocurrencies, instead of simply keeping it stored in a wallet, you can lend it to a DeFi protocol, such as Aave or Compound in return for interest and/or rewards. Similarly, you can borrow digital assets as well. This is done through pool-based borrowing, where lenders provide funds, or liquidity, to a pool that borrowers can borrow from.

1. Trading:Decentralized exchanges (DEXs) remove the intermediary so people can trade through pools of digital assets. This is done through Automated Market Makers (AMM) – An AMM is a type of decentralized exchange protocol that relies on a mathematical formula to price assets. Instead of using order books – as is the case for traditional exchanges – assets are priced according to an algorithm.

1. Derivatives: Derivatives platforms such as Synthetix and dYdX, allow its users to go beyond spot trading. For example, users can make leveraged trades in which they bet more than they have, or even create “synthetic assets” that mimic traditional stocks and commodities.

Beyond simply replicating the financial services possible in traditional finance, the capabilities brought about by blockchain technology now also allow for the building of new types of financial transactions, one example being flash loans. Flash loans are a form of lending that doesn’t require any collateral or the provision of personal information. The basic premise is that the loan that is taken out is to be paid back within the same transaction, meaning within minutes or seconds depending on the blockchain used. This is only possible through blockchain technology and requires certain technical skills to execute, which is why it hasn’t reached mainstream adoption yet.

Why Should Institutional Investors Pay Attention to DeFi?

Institutional investors are rapidly recognizing the opportunities presented by the digital assets space – according to a NASDAQ article, a recent survey found that a full 62% of institutional investors not already exposed to digital assets plan to invest within the next year and many have already done so. DeFi represents the next step, beyond just holding digital assets.

Traditional financial institutions are increasingly experimenting with DeFi and blockchain technology, one notable example being the 10-month pilot launched by Banque de France and Société Générale. The pilot explored the use of blockchain technology and digital assets in a series of bond transactions and included some of the country’s largest banks as well as the public debt office. To read more on the pilot click here.

Professional investors are tasked with generating consistently increasing returns and outperforming the market. Not only have notable crypto assets, such as Bitcoin and Ether significantly outperformed traditional investments over the last few years, DeFi now presents an extremely fast-growing field for investors to keep an eye on as a way to put their crypto assets to work, potentially generating value that goes beyond that of the underlying asset. The interest rates (yields) offered on DeFi protocols are often also higher than those provided through the traditional financial system.

However, it is important to be aware of the risks associated with DeFi, most notably the technical risks, hacking risks, financial or asset risks and the ongoing regulatory uncertainty.

1. Technical Risks:The technical risks associated with DeFi refer to problems in the hardware, software, and protocols that inform a DeFi product or service. Among others, they include risks such as high network fees, failed transactions and liquidation issues. Technical risks are of paramount importance as they can compromise the functionality of the entire platform.

2. Hacking Risks:DeFi protocols are subject to cybersecurity risks, as hackers can exploit vulnerabilities in the smart contracts or other aspects of a DeFi service for their own gain. Importantly, because of its decentralized nature, there is no central, regulatory authority responsible for giving back any stolen funds.

3. Financial/Asset Risks: DeFi protocols operate with cryptocurrencies, meaning users are exposed to the risks associated with the cryptocurrency used, one example being the high volatility inherent to many digital assets.

4. Regulatory Uncertainty: DeFi is still a very new space, with most services being offered by entities that operate outside of the regulatory environment present in traditional finance. The lack of intermediaries, the anonymity of peer-to-peer transactions, and its global nature present potentially amplified compliance risks for participants in the space.

While some DeFi protocols are more advanced than others in terms of their ability to cater to institutions, there are a number of protocols working on solutions designed specifically with the needs of professional investors in mind. Examples include Aave Arc and 1Inch Pro.

The space is experiencing extremely fast growth both in terms of the emergence of new protocols as well as the flow of investment. While DeFi is still in its infancy and there are associated risks to consider, it is an industry with big potential, receiving increasing institutional interest.

DeFi is effectively changing the world of finance as we know it and with more and more institutional solutions emerging, professional investors are taking note.

At DeFi Consulting Group, we provide consulting services to family offices and other institutional investors to help them understand and gain access to Crypto and Decentralized Finance. Reach out to our team for guidance on how to effectively approach this space.