Towards the end of 2020, we witnessed an explosion in Decentralised Finance (DeFi) usage and awareness. These projects aim to decentralise the intermediary in financial transactions, moving away from the traditional rent-seeking finance model and toward stakeholder finance.
Here’s what you need to know about this fast-growing industry.
Open Innovation verse Walled Gardens
DeFi networks are destined for success. Public blockchains like Ethereum allow anyone, anywhere in the world to create trust-minimised financial services. It is an open field of innovation; all ideas can become a reality. They may fail, but their failures are additive and pave the way for better solutions. It’s almost like the three-headed hydra of finance, cut off one head and two grow in its place.
To think that the walled gardens of the current banking system will compete with the rapid process of build, launch, iterate and repeat is short-sighted. If banks wish to preserve their privileged position as intermediaries of financial activities, they will need to speed up their decision-making process to compete with an army of decentralised financial innovators.
A Financial System Native to the Internet
The core idea of the DeFi movement is that we can build a financial system native to the internet. One maintained and governed by thousands of computers distributed globally. DeFi protocols are different from our legacy financial system in that they are permissionless; anybody can use them. They are pseudonymous and don’t need you to reveal your identity. Their stakeholders govern their future trajectory, and they don’t require you to part with your funds as they are non-custodial.
This new internet of value promises to replicate and upgrade our core financial primitives of lending, borrowing, exchange and derivatives markets. Just as the internet made information accessible and cheap, DeFi will make basic financial services orders of magnitude more accessible and affordable. This process will not happen in a straight line, and many will fail in delivering this vision.
DeFi protocols are also censorship-resistant. You can’t walk into Uniswaps head office and ban their product because you don’t agree with their political stance. This censorship resistance is only possible because these protocols are decentralised and do not require a centralised entity to facilitate their service.
The theme of being censorship-resistant will become exceedingly important in the years to come. We are already witnessing authoritarian like censorship by some of the worlds largest tech services. The road of censorship is a slippery one, and centralised systems will struggle to maintain a truly free and open platform. It’s only a matter of time until this kind of behaviour moves from information censorship to financial censorship.
Ethereum Gas Fees Are a Problem, for now.
Whilst the mission that DeFi and the entrepreneurs making the space a reality is a noble one, there still remain challenges in reaching their final vision. These trust minimised peer-to-peer financial services run on public blockchains such as Ethereum.
Ethereum performs the service of processing, executing and settling requests of different services built on top of its network. This is comparable to how internet applications rely on the internet’s protocols to send and receive information. Every time you take out a loan on Aave, exchange an asset on Uniswap or make a deposit to a Compound savings account, you are required to pay a gas fee to the Ethereum network.
The Ethereum network has become exceedingly congested due to the explosion of activity created by DeFi. This congestion makes the cost of processing, executing and settling various transactions expensive. Ethereum has a scalability problem, which if left unsolved, could lead to adverse network effects.
There are numerous ways the Ethereum network and its community of developers are attempting to fix this problem. The most significant is the rollout of Ethereum 2.0, a more scalable version of the current Ethereum network, expected to launch in 2022-2023.
Tokenomics and Value Capture
This is where DeFi gets really exciting. Most DeFi projects have a token associated with the financial service that they facilitate. For example, Uniswap, a prominent decentralised exchange has UNI token. Anyone who holds UNI can participate in the network’s governance and vote on upgrades and changes to the Uniswap protocol.
As the industry matures, we expect to see the communities of these projects attempt to find suitable ways of capturing the value that their network creates. These will look more like the value accrual formulas we see in equities and other capital assets. The community can make the UNI token more valuable by issuing a dividend, burning/removing UNI tokens from the supply, paying down debt, reinvesting in further development and even performing mergers and acquisitions of other protocols.
This new DeFi movement is the financial wild west. Investing in DeFi tokens carries high risk, but somewhere in all the madness are a few lines of code that may change the world of finance as we know it.
Jason Carpenter and Michael Haynes – Managers of the Etherbridge Digital Asset Fund
Whilst we all have the option to look, to seek to understand, it’s often easier not to. Bitcoin, Ethereum and distributed ledger technology are complex systems that require significant due diligence. At Etherbridge we aim to lower the barriers of understanding this fast-growing digital economy.
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