So, what is DeFi anyways? A Primer.
As we begin to rapidly accept crypto as a daily household and office pantry term (even if the pantry is a background on our Zoom calls), DeFi is starting to nudge its way for a spot as well.
So what is DeFi, anyways? And why should we care? Well, let’s first rehash the basics of crypto: essentially it is a digital currency that can be used to buy goods and services, but uses an online ledger with strong cryptography to secure online transactions using blockchain technology. (We will likely cover the ever-expanding world of types of crypto in a future blog, but essentially, nearly 15,000 different cryptocurrencies are traded publicly today). Many companies have issued their own currencies, often called tokens, and these can be traded specifically for the good or service that the company provides. Think of them as you would arcade tokens or casino chips. You’ll need to exchange real currency for the cryptocurrency to access the good or service.
Now back to DeFi. Decentralized finance, or DeFi, is a system by which financial products become available on a public decentralized blockchain network. That makes them open to anyone to use, rather than going through middlemen like banks or brokerages. However, unlike a bank or brokerage account, a government-issued ID, Social Security number, or proof of address are not necessary to use DeFi. More specifically, DeFi refers to a system by which software written on blockchains makes it possible for buyers, sellers, lenders, and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction.
So how exactly does it nullify the need for a financial institution? DeFi replaces traditional financial intermediaries with software; self-executing ‘smart contracts’ secured by blockchain technology, allow innovators to reimagine everything from lending to trading, asset management, and more. Smart contracts provide the framework for the functioning of DeFi apps because they encode the terms and activities necessary for these services. For example, a smart contract code has a specific code that establishes the exact terms and conditions of a loan between individuals. If certain terms or conditions are not met, collateral could be liquidated. All of this is conducted through specific code rather than manually by a bank or other institution.
Remember your last loan or mortgage from a traditional bank? I do – and I’m glad not to re-live that experience if I have a choice. While it has gotten better with the likes of the SoFi’s of the world today, it is still a far cry from what DeFi can offer. In DeFi, individuals seeking a loan can connect to a decentralized lending and borrowing platform, deposit collateral, and draw a loan against these collateral assets in a process that can take less than five minutes. Anyone from anywhere in the world can do this at any time—as long as they have internet access. They never have to interact with a bank employee, fill out an application, negotiate terms, wait for approval, or sign complex legal documents.
The advantages are clear: cheaper (virtually no cost since self-executing), faster (think instantaneous), and a much wider reach (seamless as the internet). And while the growth chart of Defi is similar to an exponential looking graph of Shiba Inu cion (current total value locked is ~$220bn today), and the opportunity is tremendous (some estimates are upwards of ~$15tn in the next few years), there are risks and unknowns associated with it that still need to be ironed out. The DeFi system is still riddled with infrastructural mishaps, hacks and scams, and potential regulatory issues.
However, there is growing confidence that these will be appropriately addressed. DeFi is here to stay and will become a commonplace transactional vehicle for us and our kids before we know it. Best to brush up on it – either your boss or your 11-year old is going to quiz you on it any day now!