– July 24, 2019
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Decentralized finance, or defi for short, is a relatively new development in the cryptocurrency movement. The original cryptocurrency wave began all the way back in 2009 with the debut of bitcoin. Copycats soon emerged, including Litecoin, Dogecoin, Sexcoin, and thousands of others. This multitude of coins were all marketed to the public as decentralized forms of electronic cash. But very few people use cryptocurrencies to make payments. If these coins did succeed, it was as a new type of gambling technology.

The second cryptocurrency wave is restarting the whole enterprise of decentralized electronic cash from scratch. The first task has been to design a more user-friendly form of electronic cash: a stablecoin. To create a stablecoin, the very features that make bitcoin or dogecoin a bad currency but a great gamble — the thrilling price jumps and dangerous collapses — have to be removed.

But the second wave goes beyond a decentralized stablecoin. It envisions an entirely new decentralized financial system — one with banks, lending, credit, and more. This effort is sometimes called open finance, decentralized finance, or defi.

A bewildering number of decentralized financial tools have been created in just a few short years. Will these remain niche products used only be acolytes, like the Segway? Or will these tools catch on and go mainstream?

Anchoring the defi ecosystem is a protocol called Maker DAO. It serves as a mechanism for creating stablecoins. Users can convert volatile cryptocurrency tokens into Dai, a stablecoin that closely follows the U.S. dollar. Unlike other stablecoins such as Tether or USDC, both of which rely on reserves held at a traditional bank in order to stabilize their value, Dai is entirely isolated from the traditional financial system.

Maker DAO and most other defi applications are implemented on the Ethereum blockchain. Ethereum can be thought of as a global computer run by thousands of anonymous validators. Whereas traditional financial networks require people to seek permission from the network owner in order to participate, the Ethereum network is open to anyone. This property is referred to as being censorship resistant. It is difficult for people to be censored from using applications on the Ethereum network.

In addition to Maker DAO, there are a number of other defi tools that have been implemented on Ethereum. Uniswap is an exchange where people can trade tokens. Dharma and Compound are lending platforms, like Lending Club. Individuals deposit their cryptocurrency tokens or Dai stablecoins, which get lent out at interest to borrowers. According to Loanscan.io, there is currently $120 million in defi loans outstanding.

What drives defi development? As Ethereum creator Vitalik Buterin puts it, the financial world is “insanely inefficient” and ripe for attack. Whereas traditional finance is stuck in the dark ages of bank counters and ATMs, decentralized-finance supporters believe that Ethereum’s programmability will lead to the creation of faster and better financial products.

Those working on defi applications also believe that traditional finance has left people behind. They aspire to connect both the unbanked and the de-banked.

Lastly, defi advocates are profoundly skeptical of traditional financial architecture, which requires customers to place large amounts of trust in “siloed” providers. The renegades want to provide transparent tools that save people from what they see as the tyranny of large centralized financial giants.

Each of these ambitions is admirable. But will defi live up to the hype?

As an example of “insanely inefficient,” Buterin mentions how hard it is to move money between accounts, especially internationally. But Buterin is attacking a stale version of the traditional financial system. As I’ve pointed out before, central banks around the globe have been aggressively rolling out real-time retail payment systems over the last decade. These systems allow people to make instant and free 24/7 domestic payments.

As for international payments, remittance provider Transferwise has been able to plug into these new instant retail payments systems in order to provide customers with 10-second remittances. Over the last two years, SWIFT has shifted 20 percent of all cross-border payments up to five-minute settlement or less, and expects this to become the standard within a few years.

Sure, certain jurisdictions (like the U.S.) are behind the pack. But they’ll catch up. The point that I am trying to make is that defi developers need to be careful that they are not misunderstanding their competitor. Old-fashioned finance is a much more efficient machine than Buterin makes it out to be.

What about programmability? Etherum provides a programming language that developers can use to make decentralized financial tools. I think this is a pretty neat feature. Money has been pretty dumb for a long time. What if developers could give it life so it might do new and useful things?

But so-called “programmable money” isn’t unique to Ethereum. The Open Banking revolution that has started in the UK and Europe and is spreading elsewhere is set to introduce programmability into the traditional banking layer. Banks are being required to provide fintech companies with direct access to banking services and customer information. This access comes via application programming interfaces, or APIs. Developers will be able to build their own unique financial apps right on top of banks.

What about connecting the poor and unbanked? For many people, cash is the only monetary instrument available to them. Even when banks are an option, notes and coins are simpler and more accessible.

Developers of decentralized-finance applications will have to try to replicate this simplicity. Unfortunately, most defi applications remain daunting to use. Tools like Maker DAO and dYdX aren’t built with Fulani herdsmen or San bushmen in mind. Rather, they’ve been designed by those with relatively sophisticated financial backgrounds for those with sophisticated financial backgrounds — the very sorts of people who are likely to already have bank accounts. Never mind the fact that some of the poor unbanked don’t have smartphones or mobile internet access.

Finally, let’s turn to the idea of providing people with “trustless” tools — tools that don’t rely on third parties.

Since Ethereum is an open system that operates automatically, it’s hard to prevent people from using it. But regular banks and networks like Visa regularly cut off certain types of customers. For now, the previously banked make up a niche market. But who knows, if geopolitics heat up and entire nations are severed from the global banking system, open defi tools could go mainstream.

Until then, decentralized finance could become the choice of the “conscious financial consumer.” Choosing defi over regular finance would be like choosing non-GMO products over GMO, or fair-trade coffee over regular coffee, or ethical investing over regular investing. But I suspect that for the vast majority, so-called trustlessness won’t be much of a factor in their financial decisions — a regular bank or fintech will do the job just fine.

What defi really needs is something entirely new. Something that regular finance can’t replicate. Something so useful that regular consumers will desert their bank to use it. This killer tool hasn’t been created. For now, defi seems mostly a copy of what already exists. But I wish it the best of luck.

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J.P. Koning

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J.P. Koning is a financial writer and blogger with interests in monetary economics, economic history, finance, and fintech. He has worked as an equity researcher at a Canadian brokerage firm and a financial writer and publisher at a large Canadian bank. More recently, he has written several papers for R3, a distributed ledger company, on the topics of central bank cryptocurrency and cross border payments. He founded the popular blog Moneyness in 2012. He designs economics and financial wallcharts at Financial Graph & Art.

Koning earned his B.A. in Economics from McGill University.

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