What does DeFi mean? Your ultimate guide
What is decentralised finance? What does it hope to achieve and why has the value of Ether going through the roof in recent weeks?
What does DeFi mean? Well, it stands for decentralised finance. By all accounts, DeFi is becoming one of the next big things in the cryptocurrency industry.
Let’s begin by delving into DeFi’s meaning, as well as what it hopes to achieve. Although banks and financial institutions are at the beating heart of the world’s economy, some critics argue that they have often exacerbated or even caused recessions. Bitcoin (BTC) was created in the immediate aftermath of the 2008–2009 financial crisis, and decentralised finance is designed to take middlemen out of the process, so everyone can access the services they need.
DeFi is a response to the fact that, according to the World Bank, 1.7 billion people globally are unbanked. Given that two-thirds of them own a mobile phone, advocates of decentralised finance are hoping to reach this audience and champion inclusion.
But perhaps the simplest way of illustrating DeFi’s potential is to describe it like this. Think of every financial service that you’ve used in your life – from savings accounts and loans to insurance and mortgages. Decentralised finance has the goal of providing a modern, fairer alternative to all of these services that can be accessed over the internet. These tools are often available in the form of decentralised apps, or ‘DApps‘.
Advocates of DeFi also point to how it could make transactions much less expensive for all of us. One sticking point, when sending payments around the world, is the brutal currency conversion fee that goes along with it. Not to mention the high commission rates charged by remittance services. Even if centralised entities continue to operate, the competition that’s offered by decentralised finance platforms could mean they’ll be forced to offer a fairer deal to their customers.
Now is a good time to consider what DeFi means because of how decentralised finance has witnessed an unprecedented explosion in popularity in the last year.
According to DeFi Pulse, the total value locked in decentralised finance protocols has soared since the fall of 2020. In mid-November 2020, the figure stood at $12.5bn (£9.3bn, €11bn). A year later, it was $107bn – that’s a whopping 756% increase. Not bad at all for such a burgeoning industry.
The scale and scope of the decentralised finance industry does pale into comparison with the sheer size of the traditional banking sector, which is worth trillions of dollars. However, it’s a start, and the developers behind DeFi DApps are banking on raising awareness and showing people that there are alternatives out there.
Many DeFi applications are built on the Ethereum blockchain, primarily because of how this network boasts smart contract capabilities. As you might expect, this has resulted in substantial gains for Ether (ETH) – especially over the past month or so. In the space of a fortnight in July 2020, ETH soared from $228 to $400, an increase of 75% that dwarfed BTC’s performance back then. In 2021, it rode the wave of the autumn crypto boom, reaching beyond $4,600.
The demand for DeFi products has also put Ethereum under increased pressure to launch the second iteration of its blockchain, known as ETH 2.0. This upgrade is expected to dramatically improve the network’s scalability, meaning that it will be better placed to handle a greater number of transactions as decentralised finance protocols grow. The first phase launched in late 2020 and work will continue well into 2022.
What are the most popular DeFi platforms?
You may be wondering: If decentralised finance is meant to eliminate the middle men, how do these platforms come to exist? Surely someone must be responsible for creating the infrastructure and ensuring it all works?
The answer is yes – to an extent.
One of the most popular DeFi protocols is known as Maker. It allows people to post their cryptocurrency as collateral in exchange for a loan. The platform is supported by a foundation, but, over time, the plan is for this organisation to be dissolved so future business decisions are made by the community who use the protocol. This is achieved through a governance token that people can purchase, effectively giving them voting rights and a stake in the protocol’s future.
Other popular platforms such as Compound also offer lending. Typically, this works by encouraging people who want to save their BTC and earn interest to lend to others on a peer-to-peer basis. Decentralised exchanges such as Curve and Balancer have also been gaining momentum.
Are there any downsides to decentralised finance?
The sheer speed with which DeFi has taken the crypto industry by storm also took some people by surprise. As a result, there are fears that a bubble could be forming – and that this could result in a sudden and sharp crash in the value of ETH. Cynics have been drawing parallels with how ETH was sucked into the initial coin offering (ICO) boom back in 2017 and 2018.
Another challenge lies in how much the whole world of DeFi is still incredibly complicated, meaning it might struggle to attract significant levels of adoption from everyday consumers. Usability and simplicity remain two crucial factors that many protocols are yet to conquer.
Lastly, there are also points of failure within DeFi’s infrastructure. One of the most significant examples of this came back in March 2020, when ETH was subject to a sudden flash crash.
When a borrower is looking to take out a loan using their crypto as collateral, they usually have to over-collateralise, meaning that they’ll post 50% more digital assets than the value of the cash they wish to borrow – this makes sense, as it means that the borrower won’t have to sell their crypto to access the cash (something that could result in them missing out on future price gains).
When ETH crashed sharply and suddenly, many borrowers saw their positions liquidated, and ended up losing their crypto altogether. This actually sparked a major class-action lawsuit against the Maker Foundation, which has been accused of misrepresenting the risks that investors face.
Needless to say, there are those who are extremely enthusiastic about what DeFi can achieve in the years to come. But – at least for now – it’s not something that banks on Wall Street or in the City of London need to worry about. Why? Because DeFi is a very small fish in the Atlantic Ocean.