DeFi’s two fundamental characteristics — permissionlessness and transparency — translate into multiple powerful use cases.
Lower entry barriers, reduce switching costs, and provide optionality
The permissionless nature of Ethereum-based applications makes it possible to
The ability to freely and seamlessly “fork” (i.e. copy and adapt) an ecosystem reduces the barrier to entry for entrepreneurs to zero. End users are the main beneficiaries of this innovation environment: because all applications share the same database (the Ethereum blockchain), it is easy to move funds between platforms. This forces projects to compete ruthlessly on fees and user experience.
A relevant example here is the rise of “exchange aggregator” applications: by using public APIs, these aggregators tap into multiple liquidity venues, splitting orders across platforms to provide the best possible exchange rate to the end user. In just a few months, these aggregators have accelerated DeFi’s progress towards best price execution, a standard that previously required formal regulation for early electronic trading venues.
Contrast DeFi’s competitive market with the personal banking that exists today, where it can take three days to open and close an account; or compare DeFi to brokerage, where transferring securities between platforms can take up to six business days and multiple calls. Coupled with other onerous terms, these “switching costs” discourage consumers from taking their business elsewhere, even with the pain of inferior service. In fact, to the detriment of individual consumers, traditional finance is moving in the exact opposite direction, with the number of banking licenses declining at an annual rate of 3.6% since 1990, limiting consumer choice.
Transparent accounting and rigorous risk assessment
The auditability of capital reserves in DeFi means that rigorous risk assessment and risk management can be achieved. For decentralized money markets and credit facilities (which allow users to obtain peer-to-peer, secured loans), users can check the quality of the collateral portfolio and the degree of leverage in the system at any given time.
This is in stark contrast to the opaque nature of the current financial system. It was only after the global financial crisis of 2007-2008 that analysts and regulators began to realize that the US loan-to-deposit ratio had reached 3.5, twice that of the next most leveraged banking system, Russia.
Coordinate incentive mechanisms to solve the principal-agent problem
Using trustless, programmable escrow accounts (often called “smart contracts”
”) allows DeFi protocols to be secured at the protocol level.
For example, in the MakerDAO system (a decentralized credit facility), MKR token holders earn interest paid by borrowers. However, in the event of (system) insolvency or (borrower) default, they will become the primary backstop: MKR will automatically be minted and sold to the market to cover losses (repay bad debts). This procedural enforcement creates a very strict accountability system that forces MKR holders to set reasonable collateral and liquidation risk parameters, as lax risk management practices put MKR holders at risk of MKR dilution.
In contrast, in traditional finance, when management makes mistakes, shareholders suffer direct losses. The recent collapse of hedge fund Archego is a recent example: Credit Suisse
Credit Suisse lost about $4.7 billion in dealings with Archegos, causing massive losses to the bank’s investors, and although several of its executives left the bank, they were not personally responsible for those losses. In DeFi, direct accountability will translate into better risk management.
Modern infrastructure, improved market efficiency and robustness
Ideally, in the Internet age, capital should flow as seamlessly as information. In particular, settlement should be instant, transaction costs should be minimal, and services should be available 24 hours a day, 7 days a week, and 365 days a year. Our global financial system operates only from 9 to 5 (except weekends and holidays), which is inefficient.
There’s clear latent demand for a modern settlement infrastructure, as evidenced by Ethereum settling $1.5 trillion in trades last quarter, up from $31 billion in Q1 2019. We’ve also seen recently the potential for market disruptions due to a lack of instant settlement: online brokerage Robinhood was briefly forced to suspend buy orders for GameStop (GME) as it struggled to meet capital demands, itself a byproduct of T+2 settlement (an industry standard where trades typically take two days to clear).
Effective markets also require robust infrastructure. The distributed nature of blockchains makes them incredibly resilient: in the six years since Ethereum launched, the network (and the applications built on it) have had 100% uptime. The same cannot be said for their centralized counterparts. Even where they are centralized, established, and/or regulated, these centralized entities (whether exchanges or payment networks) can exhibit unreliability, especially during periods of high volatility.
The impact on users is very real. Take the example of Robinhood’s sudden suspension of GME stock trading in March 2020, which caused some users to suffer losses and sue Robinhood for this.
Global access, unified market
In essence, international markets have larger liquidity pools that can significantly reduce transaction costs for all market participants.
Today, decentralized exchanges (DEXs) can offer better exchange rates for certain assets than isolated centralized exchanges or service providers. In the stock market, like American Depositary Receipts
Financial instruments such as Australian Dollars (ADRs) provide a bridge to the foreign exchange market, but often suffer from huge premiums and thin liquidity.
When markets are globally accessible, it can also lead to more financial equity. Currently, some developing countries are often excluded from financial services due to the high cost of establishing local businesses relative to demand, lack of infrastructure, etc. But decentralized financial services can serve marginalized populations, providing services such as insurance, international payments, dollar-denominated savings accounts and credit.
Real-time data
In a transparent shared database (i.e., a distributed ledger in the blockchain
One benefit of building financial services on top of blockchain is that all relevant transaction data is publicly available in real time. For example, in the Uniswap protocol, the returns generated by liquidity providers (LPs) can be tracked at a granularity of one second. Investors can use this data to decide how to allocate funds, thereby providing more efficient price discovery and resource allocation, while regulators can monitor real-time transaction data to identify illicit user activity.
This is very different from traditional capital markets, where investors are kept in the dark until companies release their quarterly earnings reports. The situation is even worse in private markets, where companies often fudge their own bookkeeping metrics (if they decide to publish them at all). It’s hard to imagine investors making rational decisions when faced with out-of-date data! Regulators also struggle with the current system, where they may have to wait years to discover wrongdoing, often too late, with the collapse of Greensill Capital and Wirecard’s accounting fraud being two recent case studies.
Eliminate counterparty/credit risk and reduce compliance costs
DeFi platforms are “self-custodial” by definition: users never place their assets in custody with a centralized operator. While DeFi may seem daunting to some at first, the self-custodial nature of DeFi helps eliminate counterparty and credit risk, which in traditional finance is associated with one party in a financial transaction defaulting or failing to fulfill its obligations in a transaction or loan. Analysts estimate that the total value of cryptocurrency lost through centralized exchanges (CEXs) since 2011 is over $7 billion, due to everything from hacker attacks to operators intentionally absconding with user funds. DeFi is a paradigm shift that turns “don’t be evil” into “can’t be evil.”
Self-custody is also beneficial to DeFi application operators, who can avoid unnecessary responsibilities and compliance management costs: for example, the US FinCen (Financial Crimes Enforcement Agency)
Cryptocurrency guidance published by the Federal Reserve Bank of New York (FBI) requires companies that custody user funds to obtain a money transmitter license, often a difficult process, while DeFi apps that interact with self-hosted wallets can operate without a license.
Challenges of mainstream adoption
As with any evolving new technology, DeFi faces challenges. This is not unlike the early days of the internet, when connections were slow, hardware was expensive, and even the smartest innovators were hampered by the inability to support images or videos, which are now widely used in online social activities.
