Decentralized finance (“DeFi”) raises the bar on traditional financial services by starting from different core concepts. It changes what is important and what is irrelevant in the delivery of the services. By disrupting existing concepts and structures, DeFi seeks to become the new paradigm not only for financial instruments but for all manner of financial and commercial activity in digital assets. This is the start of a new paradigm. As part of the Global Blockchain Convergence (GBC), a global think tank set up in March to collaborate on ideas in the blockchain space, a group consisting of myself, Emma Channing, Lee Schneider, Lilya T. Tessler and Sunayna Tuteja, thought further education on DeFi was needed.
The DeFi movement flows from two important precursors. The first is automation through software, especially software as a service. This development occurred in many industries with financial services companies in particular constantly improving their automation capabilities. These improvements have led to the seamless integration of systems across financial services, allowing an individual at a computer terminal to use software, directly or indirectly, to accomplish every step of a financial transaction.
Several examples illustrate how traditional financial services have been automated through software, not necessarily just DeFi. The order for a securities transaction is entered into the computer and flows through various systems at different intermediaries to a marketplace for execution, after which the trade is automatically reported to appropriate intermediaries who make sure the securities or cash are reflected in the appropriate accounts. The request for a mortgage loan with accompanying documentation is entered into the computer and processed by the lender, from acceptance through to the sale of that loan to a substitute lender and its addition to a mortgage-backed security. A credit card application is filled out from the computer, sent to the card issuer and processed then the card is automatically added to one of the many payment apps to allow immediate usage. As we see, all of these processes have become increasingly automated.
The following trade flow illustrates the tighter connections that blockchain and smart contracts enable. A trader enters an order to buy an asset directly into the smart contract on the blockchain. The algorithm within the smart contract executes the order in accordance with its programming. Immediately upon completion of the trade, the smart contract automatically debits from the trader’s blockchain account the payment for the asset and credits the asset to that same account. This simplified flow is the culmination or natural progression from the more complicated trade flow required to buy an asset through traditional financial services because everything happens on the same platform rather than moving from one intermediary’s platform to another until all processing is done. Of course, more complicated scenarios are possible for the smart contract; they are just a matter of programming.
From the simple illustration, we can see what DeFi makes important and what it makes irrelevant. The computer code is important while intermediaries have become irrelevant. Automation and immutability are important while the asset type has become irrelevant. Open source software for the smart contract has become important, including the composability it brings, while physical location has become irrelevant. The result is not only smoother activities but also economic inclusion. The new paradigm of DeFi has social benefits in addition to process benefits.
The essential foundation of DeFi is that it is “decentralized”, by which we mean, no single point of failure, no single source of truth, no single authority capable of or responsible for making changes to data. This is a distinctly different approach to traditional financial services activities such as trading, lending, deposit-taking, where the activity revolves around a centralized entity, a broker, dealer, lender, custodian. All those services are available in DeFi at this time, but applies to any type of crypto asset instead of fiat. This last point is extremely important and often overlooked in the rush to claim DeFi’s role vis-a-vis traditional financial services, so it bears remembering in every discussion of DeFi: DeFi does not exclusively involve financial instruments because cryptoassets can be anything.
In the market, the term DeFi is used interchangeably to mean all types of smart contract-based platforms. The following describes the key features for a DeFi platform to conform to the definitions and principles outlined in this article by identifying what is important as compared to what is irrelevant. An analysis of these features will help determine whether a platform has achieved DeFi or is merely “emergent” or “pseudo” DeFi, the latter subject to increased regulatory oversight.
With this perspective, then, this simple “DeFi-nition” is a good start to familiarize the uninitiated: Take the traditional financial services, distill them into their component rules and procedures, and convert them into self-executing code on decentralized networks accessible to anyone with a computer and internet connection.
Moving a step further to help define DeFi, a key question is the extent to which DeFi will be regulated. The intermediaries in conventional equivalents, such as brokerage activity, payments, lending and custody, are all highly regulated. What happens, however, when code on a blockchain (a smart contract), is the intermediary? We would seem to be in the world of peer-to-peer transactions, which traditionally have not been subject to the same level of regulation. Thus, for DeFi to have a low level of regulation the following three characteristics would be arguably necessary, if not sufficient:
- The activities (transactions) should not be moderated, intermediated or validated by a single or centralized party, other than the smart contract that creates and implements the ability to do those activities.
- The smart contract also should not be moderated or controlled by a single or centralized party, but instead should leverage a multiparty or decentralized governance mechanism.
- Software updates provided by a founder or other operator would not mean that a platform is moderated or intermediated by that party, unless the platform and such party cannot meet the foregoing two criteria.
DeFi platforms rely entirely on computer code for all functions, including communications with various blockchains. Users interact entirely with the program, often called a smart contract, which is implemented on a permissionless public blockchain. If the code malfunctions, is hacked or otherwise has a problem, there is no recourse. As such, understanding and auditing the code becomes a hugely important due diligence exercise for the users. This is as opposed to traditional finance where users perform due diligence on intermediaries who then are responsible for the diligence and oversight of the technology.
As such, DeFi is designed for direct participation by any user. All transactions are peer-to-peer or peer-to-platform without a “middleman” and their associated fees, counterparty risk, gated access and limitations on who are acceptable customers. Wallet software or other interfaces are available to interact with the blockchain and directly with peers. Interfaces may hold assets but often are just a bridge between programs and a gateway to access counterparties. Banks, broker-dealers, lenders, money transmitters are unnecessary, but may develop DeFi products to be used by its customers in certain instances. Although decentralization typically shifts risk from intermediaries to smart contracts, risk is not eliminated, just moved from middlemen to middleware.
A key characteristic of DeFi is autonomy, whereby all features and functionality are in the code (from the simple to multi-faceted or AI-driven) such that, once activated, execution of all components occurs without interference in response to relevant inputs, including from oracles. Oracles are the reporters who exist off-platform and contribute necessary data or information required to trigger and/or execute certain functions. In conjunction with automation, there must be immutability, whereby once the processes execute (including movements of items), the results are recorded permanently on the underlying blockchain, are tamper-resistant, transparent and auditable.
Given the presence of blockchain assets, DeFi platforms allow for the mingling of asset types in ways never before achieved. This is because any type of digital asset is assigned digital uniqueness on blockchain to assure it has value. The functions and features of a digital asset determine its utilization, valuation and legal classification. This is why DeFi is not just limited to financial instruments. If an asset can be created and implemented on blockchain (which anything tangible or intangible can, with the right combination of technologies), it can move through a DeFi platform automatically and immutably.
Open source software (OSS) is available to anyone for use and updating; this includes the algorithms that run the processes. Composability refers to the ability to combine different OSS programs to create new platforms and also the ability for one platform to easily access other platforms for their liquidity and other features. DeFi platforms live on the internet and on public blockchains, empowering anyone with a computer and internet connection to access and participate in the ecosystem. There are various means to access, obtain and engage with digital assets, including airdrops.
DeFi markets and users are not constrained by physical jurisdictional guardrails, encouraging broader participation. In contrast, in traditional financial services, the markets are centralized, which means that custody of assets is centralized with regulated custodians in a particular jurisdiction. For DeFi, however this lack of physical location also poses a challenge for regulators and policy makers, legal enforcement as they continue to solve for and design appropriate controls to monitor transactions and activities that can cross borders seamlessly.
The ethos of DeFi to break down barriers and democratize financial services for the masses is anchored in the simple yet aspirational promise that anyone with a computer/smart phone and an internet connection can engage with DeFi platforms and products, and take charge of their economic freedom. Often, the entry point into DeFi can be as efficient as an airdrop, eliminating intermediaries and gatekeepers that can be blockers to participation in centralized markets. Likewise, the frictionless global access creates a big tent, inviting users who are otherwise forgotten or ignored by existing financial systems. As DeFi continues to proliferate, an added focus on user experience, education and enabling a diversity of use cases, can help unlock opportunities and make a meaningful dent in solving for global economic inclusion.
DeFi is the natural culmination of several trends as exemplified by the twin precursors of automation through software and blockchain. It has brought to the fore open source code that is composable combined with the immutability of blockchain. It has left behind the need for intermediaries, asset-specific trading venues and physical location. DeFi envisions a simpler, more efficient world where platforms are evaluated by their code and the activities it allows through algorithmic mechanisms.
While the opportunities are boundless, it is prudent that we acknowledge DeFi is not a panacea and there are still many challenges that require attention and action — questions about trust and governance, lack of regulatory frameworks, concerns over valuation, scalability and user experience, and a much higher level of individual responsibility for usage of each aspect of the DeFi platform, from the due diligence in understanding its operation or ensuring the right activity with the right assets is chosen. None of these challenges is insurmountable and several efforts currently underway seek to tackle these and other hurdles and continue to build towards an inclusive and sustainable DeFi ecosystem. From this foundation, this new paradigm should attract lots of adherents and, most importantly, users.