What is DeFi?
DeFi is the term given to a new form of financial intermediation that reduces the reliance on central intermediaries. Applications or protocols that are built to facilitate this new form of intermediation are referred to as decentralized applications (DApps) and are built on public blockchain infrastructure. DeFi projects are typically open source, interoperable, internet-based protocol stacks that leverage smart contracts built on public blockchains, such as Ethereum, to facilitate financial services.
Smart contracts that operate on public blockchains, are a critical component of DeFi. Smart contracts are code stored on a blockchain platform that autonomously perform a set of predetermined actions, generally pursuant to terms of an agreement, without the need for an intermediary. Once deployed these smart contracts are immutable and the source code and transactions facilitated by the smart contract are recorded on the blockchain for anyone to view.
For example, a smart contract could be programmed to exchange a certain amount of currency for another, between two counterparties. If the smart contract code verifies that the required currency from each counterparty has been provided, it will execute the transaction, thus eliminating the need for third parties to facilitate the transaction. A group of smart contracts can interact to facilitate a number of different functions and often times an application will rely on multiple smart contracts that are linked together.
Most DeFi services mimic existing services found in today’s tiered financial system but this was not always possible. Historically cryptocurrencies were too volatile to facilitate financial transactions, other than for speculative trading. The answer to this problem came in the form of “stablecoins” – assets that utilize either complex algorithms (as with DAI) or legal relationships with a trusted centralized entity (as with USDC) to peg their market value to an external reference (such as a fiat currency). Stablecoins, given their ability to replicate the features of traditional money and compatibility with DeFi applications, are able to act as a foundational component for facilitating more sophisticated products, similar to the way in which the existing financial system operates.
Why is it important?
If you apply this decentralized peer-to-peer model on a global basis to the various forms of financial transactions that require an intermediary today (for example, collateralized lending, interest-bearing deposits or investment portfolio management), the potential impacts to the existing global financial system and its intermediaries become significant.
DeFi empowers individuals to retain more control over their assets compared to the traditional financial system, and allows individuals the financial freedom to choose how to invest their assets without the need to rely on an intermediary. This does not mean that individuals will no longer need financial guidance or that traditional financial institutions will become obsolete, but the way individuals and institutions interact within the financial system and make financial decisions could look very different in the future.
DeFi will also impact business-to-business interactions. As institutions begin to plug into the blockchain ecosystem, and tokenization of financial assets such as derivatives and securities continues to mature, there is potential for smart contract-based decentralized applications to begin acting as intermediaries between institutions. An example of this would be if, instead of clearing trades through the Depository Trust & Clearing Corporation (DTCC), institutions were able to instantaneously trade tokenized securities in an open marketplace facilitated by smart contracts on the internet.
Another area of disruption will be the tokenization of real-world assets on public blockchains. This will unlock liquidity for firms by allowing historically illiquid assets, such as commercial real estate, to be represented as tradable fractionalized tokens on a public blockchain. These tokens can then be posted as collateral or included in investment pools on DeFi protocols. This will also apply to existing supply chains, as it will allow for a more open smart contract-driven marketplace, where entities transact using privacy-preserving technology on a public blockchain and prices are dictated by market conditions.
What are the opportunities?
DeFi is still in the early stages of innovation and institutions will have a prominent role to play in developing the ecosystem. There are financial opportunities, including new services and products, as well as operational efficiencies that can be gained by leveraging the existing DeFi ecosystem and infrastructure. As this new financial ecosystem continues to evolve it will create significant growth opportunities for institutions that are able to adapt and embrace these changes.