What is decentralized finance?

Decentralized finance (or DeFi for short) when compared against traditional finance (TradFi) allows for permissionless and programmable financial transactions; it’s basically the internet of money.

There’s no paperwork to fill out to get an account or make a transaction, nor is there any realistic regulatory possibility of enforcement. Instead, code as implemented via smart contracts creates a protocol which dictates what is possible. A standardized set of social interactions of the community surrounding a project helps govern the rules of each protocol, usually through a proposal and voting mechanism to enact change.

This concept of programmable money emerged in 2018 and has proliferated into a Cambrian explosion of innovation. Unfortunately, this expansive growth also includes the creation of a lot of scammy or incompetent projects. But there are still plenty of good actors in the space, and as of this writing, the total amount in the DeFi ecosystem amounts to over $100B USD (https://defillama.com/chains) and the trajectory of its growth continues to accelerate exponentially.

Why is DeFi going to replace centralized finance?

DeFi is the Superior Technology

Finance as an industry worldwide has a poor reputation and deservedly so. The regulatory hurdles required to start and scale any sort of financial services firm (banks etc.) prevent all but the most well funded and well connected players from disrupting the industry. Generally startups that do get traction get acquired - see Simple, Venmo, etc.

At least in the US, bank transfers take forever, and can only take place during business hours. Wire transfers can get lost, instructions are unclear, and there’s high fees. Equities markets are dominated by high frequency traders, and there’s layers and layers of middlemen that provide esoteric services which increase the cost of operating. Whenever you want to make a transaction, there’s often regulatory / compliance overhead as well. All of this is exacerbated by most financial services firms being very inefficient and incompetent at technology; unfortunately many of us can likely empathize with this bank customer:

https://newsletter.danhon.com/archive/s11e09-a-short-conversation-with-a-bank/

The regulations certainly exist for a reason, because in the traditional space, transparency is not the default and thus must be enforced legally to ensure consumer protection. But even these regulatory requirements are often commonly skirted around by banks eager to make a profit. Most banks treat fines as literally a cost of doing business, and they make enough money that the fines don’t actually stop them from continuing their bad practices without significant public uproar. (Examples: Wells Fargo scandals, LIBOR scandals, HSBC KYC/AML scandals with Mexican drug cartels)

https://www.forbes.com/forbes/2010/0426/outfront-financial-mortgages-credit-cards-regulation-backfire.html

https://www.jstor.org/stable/2235577

However, in DeFi, transparency is the default because all transactions are observable on-chain and virtually all of the successful projects use an open governance program to determine the direction of the project. Tools such as Commonwealth.im for proposals and snapshot.org for voting on proposals are the norm, which allows for anyone to observe and participate in the governance for the protocol, thus truly democratizing the process.

Worst of all, the regulations often don’t keep up with reality. A great example is that in the wake of the subprime mortgage crisis, banks were required to keep a “healthier” balance sheet by having more cash on hand versus their loans, which in theory is certainly a good thing; but this caused a liquidity crisis as banks didn’t have enough cash on hand based on the new regulations and therefore were unable to even lend to highly qualified borrowers!

The point is that the world is moving at an ever-present pace and regulatory updates can’t keep up, nor can they protect consumers against new threats especially as the landscape changes faster and faster.

With crypto, you can be your own bank. I’ve repeatedly sent millions of dollars in value within literally less than a minute, with fees less than the cost of lunch. I’m able to trace the transactions on a blockchain explorer completely transparently, which allows me and my counterparty to know when the transaction is finished. I’m able to do this across geographic borders and to avoid onerous KYC (know your customer) checks that impinge on my privacy.

With DeFi, I’m able to access financial products that are restricted to me as an ordinary US investor (i.e. futures, options, etc.) without filling out mountains of paperwork to prove that I’m “sophisticated”. In addition, I’m able to access financial products that are at the forefront of innovation and don’t even exist in traditional finance. Speaking of which…

DeFi Innovation

There’s so much innovation happening in DeFi, it’s absolutely incredible. It’s very difficult to go into the details as each project would require its own extensive post, but just to give a flavor of what’s possible, these are existing projects with billions of USD value deposited onto their platforms which have recreated the existing financial system but through smart contracts in the space of just 4 years:

Uniswap: Decentralized trading / automated market making

Aave: Decentralized lending

dYdX: Decentralized order book exchange

Dopex: Decentralized options

JonesDAO: Automated options strategies

Alchemix: Self issuing loans

Rari: Use anything as collateral for a loan

All of these concepts would require a separate article for each so I won’t go into the nitty gritty details here, but suffice to say that there is an astounding amount of innovation happening in the space that very few people know about and can appreciate.

With all of this amazing innovation though, why hasn’t DeFi taken off sooner?

Immature Markets

The DeFi space is extremely immature but the pace of innovation is breakneck, so the educational materials haven’t caught up with all of the protocols being invented. It’s hard for the common layperson to tell the difference between what is a legitimate innovation versus a scam, and because there are significant financial incentives for unethical promoting / advertising of projects, it takes awhile for the quality projects to distinguish themselves with a track record to allow for everyday Jane and Joe to be able to trust the product. \

User interfaces are often unintuitive with no instructions on how things work, and documentation is often lagging behind so users need to go to Discord and Telegram to chat directly with project staff to get the latest instructions for understanding the functionality.

There’s also a dearth of reputable educational resources in the space to help guide people who are starting off and point out the good projects, although that’s starting to change now, with some good resources that come to mind including blocmates.com and rabbithole.gg.

Finally, there’s also a very strong counterculture of impropriety / flippancy towards the existing system which often acts as a deterrent to those more familiar with the seriousness of the traditional financial system. Although I personally can understand and even identify with the DeFi attitude, I can also fully understand why the average person may be uncomfortable with trusting some of these protocols with their hard earned money.

Risk of Loss of Funds

Finally, the fact that crypto is a bearer instrument creates a significant risk factor in usage for those who are unfamiliar with the process for safe custody of the assets. Basically, if you don’t know how to secure your coins, you can lose them and thus your money - this is probably the biggest blocker in terms of adoption.

But I see significant evidence that the younger generations (read Gen X and younger) are effectively crypto-native which is why I believe the trend is inevitable. They’re born into a world where the existing financial system is being weaponized (for good but potentially unsustainable reasons).

The Path to Going Mainstream

I believe a combination of three factors will make DeFi go mainstream:

  1. Increased inflation due to both central bank policy (the inability to raise interest rates which are at all-time lows) alongside the continued issuance of additional fiat to pay for national debt.

  2. Increasing financial censorship

  3. Superior value delivery

Inflation

DeFi allows a path out of the inflationary policies of fiat by creating a totally new monetary system that even has the potential to be deflationary (see Ethereum’s upcoming upgrade to v2.0 which anticipates a slow decline in the amount of available ETH due to a token burning mechanism). This new experiment presents a radically different set of economic incentives than the existing system and will be a fascinating progression in the evolution of money.

Increasing Financial Censorship

In the democratic world, we have the luxury of assuming that people have fundamental unalienable rights to certain freedoms, but in our modern capitalist society, if you don’t have the freedom to transact, you won’t have the ability to exercise any of your other freedoms.

There have recently been two major incidents that have gotten very respected people to take a second look at cryptocurrencies and DeFi in general as more than just a scam or fad:

  1. In Canada, Justin Trudeau used financial sanctions to shut down the truckers protest.
  2. Globally, Western countries used financial sanctions against Russian aggression in Ukraine.

These two articles summarize the situation better than I ever could:

https://world.hey.com/dhh/i-was-wrong-we-need-crypto-587ccb03

https://twitter.com/punk6529/status/1494444624630403083

As a result, as financial censorship sees more and more widespread use (and often for good reasons, such as in the Ukraine-Russia conflict), I believe people will start waking up to the dangers of the current financial system in terms of its ability to “cancel” a participant, and as a result start to seek alternative monetary systems.

Superior Value

The regulatory overhead of operating in the traditional financial space has eliminated virtually any form of risk taking or experimentation, but with the advent of programmable money, DeFi finally allows for a breath of fresh air when it comes to innovation and it shows in the extremely creative and groundbreaking inventions that have been happening in the space.

Virtually all of a bank’s functions can be replaced at much less cost and more availability; services are 24/7 and require no bureaucracy, thus saving a lot of resources previously spent on compliance and customer service.

Protocols are composable so that new protocols can be built on top of existing ones, which leads to much more collaboration and innovation, translating to value delivered to the customer.

DeFi also allows the users of a protocol to share in the benefits; when a protocol collects fee revenue and has a governance token that distributes a portion of the fee revenue to token holders, token holders can participate in the financial rewards. This concept is very similar to that of owning equity in a publicly listed company, but with further transparency since the “dividend payout” is known in advance.

As people learn about the benefits of DeFi, bad actors start getting flushed out of the system, and trustworthy educational materials start building a brand and reputation for teaching people how to use these new products, adoption will only continue to increase.