Deconstructing DeFi – revolution or evolution?

Decentralisation is the buzzword in fintech at the moment – whether that’s sharing data more widely, such as with open banking, or directly using decentralised systems, as with the blockchain. Decentralised finance (DeFi) is one of the latest developments, aimed at democratising access to finance by removing the middlemen that control the flow of capital. There are a few standouts making waves already: Aave allows users to borrow and lend several different digital assets in a peer-to-peer, automated system; Avalanche focuses on facilitating non-fungible token (NFT) trading; and platforms like Fantom and Radix are providing the glue which holds the system together with their work on smart contracts.

Amid all the hype, though, there is a need to be clear about exactly what DeFi is, and what change it can bring to our financial system.

Loosening the purse strings

At DeFi’s heart is removing barriers, such as intermediaries and institutions, within finance to make it easier to access and use financial services. It does this by facilitating direct transactions between participants, mediated by smart contract programs that use open-source software and are built and maintained by a community of developers.

Crucially, DeFi also reduces, and in some cases could even remove, the fees that accompany the process barriers within traditional centralised finance (CeFi), and puts control into the hands of the consumer as funds are stored in digital wallets rather than in bank accounts. In theory, it is a separate system from the CeFi model – but there are contradictions aplenty and many instances of overlap.

In the majority of cases, to access DeFi, you must first cross a ‘CeFi bridge’, relying on the old methods to use the new. Stablecoins – cryptocurrencies that are backed by an entity, like a central bank, or are pegged to fiat currency like the dollar – encapsulate DeFi’s struggles to be wholly new as they are an example of the need for bridging.

The DeFi promise

Removing the intermediaries – which have been involved in finance since the very beginning of money as a concept – is DeFi’s big promise to those who promote it, and is its central aspect as the existing system is built on the idea that intermediaries are required to deliver services. Remove the intermediaries and you can remove the fees for holding money, and you can also make finance more accessible with fewer barriers to funding and limits on movement of assets.

The most successful use case so far is P2P lending, which has been able to dramatically reduce fees by taking it out of the banking structure and reduce the threshold for access to funds. The process is similar to a traditional loan, but there is no need to pay for a lender’s services. Instead, a borrower enters their loan needs in a decentralised finance application (dApp), and an algorithm matches them with peers that meet their needs. Once the lender’s terms have been agreed, the borrower receives their loan and the transaction is recorded on the blockchain.

The DeFi reality

But it’s difficult to see many truly successful pure-DeFi use cases emerging. John Oliver said that cryptocurrency is “everything you don’t understand about money combined with everything you don’t understand about computers” and the same can be said of DeFi. Consumer understanding of how DeFi works is limited, compounded by the fact it’s built on cryptocurrency, which only slightly more people understand.

And despite all the theoretical use cases, most people still choose to put their trust in intermediaries for vital financial products like mortgages or insurance, despite disruptors attempting to make inroads for an execution-only service. This might be down to a lack of awareness, but it’s more likely a lack of trust. Banks take on the burden of keeping money safe – with a DeFi wallet, it’s far less clear where this responsibility sits and how strong protections are.

Centralisation brings with it a degree of certainty that DeFi rivals just don’t have, coupled with the current lack of regulation, although this may well change in the coming years. Governments and central banks across the world have been considering the future of cryptocurrencies in the mainstream economy for a while now, although we are yet to see decisive action or wide-ranging regulatory regimes.

It’s also worth stating that for many, cryptocurrencies are seen as assets rather than currency in the normal sense, meaning that it’s unclear how fluctuating values could affect a lending system that relies on them. And in the successful example of P2P lending, we don’t know how rapidly rising interest rates currently hitting all aspects of financial services will affect its trajectory.

Towards a clearer-eyed view of DeFi

The noise out there can make it seem like DeFi is the financial system’s next saviour, but the reality is that it’s one of many tools that is going to continue to help us create greater speed, efficiency, and value for the end user. And if the tech continues to push incumbents to provide a better level of service and innovate themselves, that’s a huge success.

Blockchain is a 20-year play and, if you follow it to its logical conclusion, you’re looking at overhauling a financial services business model that almost every government today relies on, and millions are employed by. In an entirely theoretical disintermediated world, these institutions would not exist, and that’s something no leader will allow to happen. So, instead of all the noise and hype that portrays DeFi as a panacea, we should focus on the tangible ways it’s making a difference – even if it’s using traditional finance bridges to make it happen.