Decentralized finance (DeFi) has taken the world by storm over the last year, illustrating mushrooming growth and a strong increase in value across the markets. Before we dive into what is DeFi and why is it growing, let’s take a walk down memory lane in order to understand the true origins of DeFi.
What Is DeFi?
The devastating mortgage crisis of 2008 has created everlasting changes to the economy that are still echoing today. The fallout was due to the nature of mortgages being asset-backed securities and the asset plummeting in value.
In the case of mortgages, loans were issued with housing being the underlying collateral, which went on to lose a significant amount of its value.
During the 2008 financial crisis, the packaging of securities backed by poorly-performing housing assets with healthy assets resulted in an overvaluation of the housing market, and a “bubble” that exploded.
In an interesting progression of the narrative, the buzzword of cryptocurrency in 2020 and 2021 has been “DeFi”. DeFi is an industry consisting of applications and blockchain-enabled systems that deal with finance in a trustless and transparent manner.
Directly addressing the millions who were burnt and affected by the crisis of 2008, DeFi promises to conduct finance in a way where centralized, profiteering entities are either left out of the equation or made more transparent using the same technology powering Bitcoin and smart contracts.
Understanding DeFi’s Core Principles
But what makes DeFi more reliable, trustworthy, and worth a look compared to its centralized alternatives?
Basically, DeFi leverages on the over-collaterization of assets to issue loans, while systematically reducing credit risk through a series of automatically triggering mechanisms that safeguard asset value in the event of a default.
Although one may point out that the securities that caused the financial crisis of 2008 were seen as over-collateralized, there are a few differentiating factors that make DeFi a much better proposition.
1. Market liquidity of the underlying collateral in most DeFi solutions
In contrast to property, the underlying collateral used in most DeFi solutions are stablecoins or crypto assets. For instance, DAI, a USD stablecoin, is issued using over-collateralization of ETH at a 150% ratio, and automatic liquidation mechanisms prevent the issued DAI from going below the value of the ETH that is backing it.
TUSD and GUSD are stablecoins backed by underlying cash reserves at a 1:1 ratio, with regular audits to ensure that the cash reserves are held in escrow accounts. These assets are meant for use in trade and have strong liquidity as compared to illiquid property assets.
2. Automatic liquidation mechanisms
DeFi, by nature of being on the blockchain, has access to liquidation mechanisms that trigger automatically to protect its collateral, assets, and functionality.
Traditional finance requires an intermediary or human intervention, creating high risk and cascading consequences should there not be a timely or appropriate response.
In the event of a crypto-related black swan event, such as high volatility or change in the market value of the underlying collateral, the decentralized network can automatically follow and execute a set of predetermined rules as agreed upon by stakeholders.
3. The behaviour, execution and assets in DeFi are publicly visible and transparent
The 2008 financial crisis was exacerbated by corruption — with rating agencies, regulatory authorities and financial institutions working to hide problems from the public. DeFi solutions are executed on the blockchain in a fully transparent manner, with predictable behaviour.
The code governing most DeFi applications is publicly visible on the blockchain, allowing independent auditing of its code to ensure that the assets involved will behave in an exact and agreed-upon manner. This allows individuals to make an informed decision on whether to engage with a certain DeFi application, rather than rely on centralized entities with an agenda to behave in their best interests.
Although loans are not new or innovative in the traditional financial ecosystem, they serve as a powerful foundation for more complicated products and solutions — many businesses, institutions and consumers alike understand and are able to benefit from simple collateralized loans.
Its clear that increased education about blockchain-based products has led to a massive increase in DeFi usage, with an estimated one billion dollars locked in the DeFi ecosystem as of early 2020.
The concept is simple: the lenders are often a pool of consumer investors who are interested in depositing their assets with a DeFi service in order to earn interest in the asset. At present, the market is offering up to 9% interest on various assets, with credit risk shared between a large pool of lenders who are depositing together — effectively acting as a form of crowdfunding.
The Future of DeFi
Although it is unknown as of now whether the growth in DeFi is sustainable, the increased market for these DeFi products is a bullish sentiment for the future of cryptocurrencies, and with an increasing number of institutional entities looking forwards DeFi for inspiration, we believe that there is huge potential for cryptocurrencies to explore DeFi as a mainstay of the industry.