DeFi: towards a new financial paradigm?
One of the major challenges that Web3 wants to meet is to propose an alternative financial model. This leitmotiv is behind the name DeFi, which stands for "decentralised finance".
Before embarking on a detailed explanation of DeFi, it is important to understand the two underlying terms finance and decentralisation.
Finance is a broad concept that relates to the management of money. It takes into account expenditure, borrowing but also revenue and investment. Finance also refers to a set of instruments, tools and services used to manipulate this money.
As far as the concept of decentralisation is concerned, it refers to the idea of giving power back to the people at the end of the chain, in some cases the users. In other words, the ideological presupposition of decentralisation rejects a system that would be limited to a privileged few and that would not de facto respect the democratic ideal.
Let's take the opposite example. Platforms like Meta or Youtube are deeply centralised. Only the developers employed by these companies have the ability to make changes to the protocols. It is these same algorithms that define, or at least advise, what the user will consult. In other words, these platforms have control over their users' data. Although free, these digital giants exploit this data and sell it to advertisers. In short, if it's free, you're the product. This is precisely the pattern that decentralised finance wants to get rid of by allowing each user to regain control over their data, money and property.
To put it simply, move from the era of CeFi (centralised finance) to that of DeFi.
💡 Concepts to master
- Blockchain: The blockchain is a digital database. It acts as a decentralised gold book, where all financial transactions are recorded. DeFi is built on this technology and particularly on the Ethereum ecosystem.
- Stablecoins: Stablecoins seek to maintain a constant value of a crypto asset against a traditional asset, most often the US dollar. A stablecoin is therefore a token whose value is equivalent to that of the dollar. 1 USDC/USDT/DAI = 1 dollar (although there are sometimes small variations during intense speculative phases).
- Smart contract: a programme developed on a blockchain that executes if pre-established conditions are met.
- DAO: From the English Decentralized Autonomous Organization, a DAO is a governance structure without central authority. The members of the DAO usually hold a governance token that enables them to exercise voting rights as a stakeholder in the community. These organisations are the spearhead of DeFi.
- Exchange platforms: These are online platforms on which users can exchange fiat currency (euros, dollars, etc.) for cryptocurrency or cryptos between themselves. In DeFi, we talk about DEXs (decentralised exchange platforms). These DEXs are peer-to-peer marketplaces on which transactions are made directly between cryptocurrency traders. No market operator (such as Nasdaq, for example) is needed to certify the financial flows.
To better understand DeFi, we first need to understand what traditional finance is
Traditional finance operates on a deeply centralised system. The introduction of financial services requires validation by numerous intermediaries or a central authority. Historically, finance has been a very closed and private sector, in which the user is not informed of what the bank does with his deposits. In short, banks are based on a cumbersome administrative system that sometimes lacks transparency.
Let's take an everyday example. If you want to take out a loan, you need to fill in a lot of personal information. This involves authenticating your identity, address, tax documents and banking history. Once you have provided your banker with this file, you are awaiting approval of your loan application. However, there is no guarantee that the bank will grant you the loan. The bank is free to accept Mr X's application and refuse Mr Y's, even if both people have exactly the same credit history and the same guarantees. And all without justification. This can lead to a degree of discrimination between borrowers.
It is a central authority, over which you have no say as to whether or not you are eligible. The process involved in taking out a loan is cumbersome, both from an administrative and a financial point of view. Borrowers have to go through a number of intermediaries: bankers, lawyers, notaries and insurers. The administrative burden is considerable, since each of these players has a financial interest in the transaction. The main consequence of this system is the lengthening of the procedure. It generally takes several months for the loan to become effective.
But in concrete terms, what is DeFi, this decentralised finance ready to change the rules of the game?
In its simplest form, decentralised finance is an area of finance built on a public blockchain. DeFi consists of traditional financial services (savings, loans, insurance, etc. ) developed using this technology. Most DeFi applications are built on Ethereum, whose cryptocurrency is the ether, second only to Bitcoin. But it can be found on most competing protocols.
By essence, Bitcoin was not designed to run smart contracts on its blockchain. Bitcoin's project lies in creating a peer-to-peer payment system on which cryptocurrency is exchanged. Ethereum was built against this trend. The blockchain created by Vitalik Buterin was designed to become a "super computer". It quickly established itself as the reference blockchain for building DeFi applications thanks to the development of smart contracts. According to DeFi Llama, the Ethereum blockchain accounted for 97% of DeFi-related traffic at the start of 2021, falling to just 58% by 2022. Others have developed and taken market share, such as Tron, Binance Smart Chain, Avalanche and Solana.
DeFi protocols create financial products and services with a view to developing an open financial system. To achieve this goal, DeFi seeks to disintermediate the world of traditional finance. By way of example, DeFi's applications do not need banks or brokers ("courtiers" in French), all transactions are automated through the use of these smart contracts.
DeFi's protocols are relays in value transfers. Their aim is simple, to make peer-to-peer exchange as simple and secure as possible. However, DeFi is a branch of finance and is not intended to replace the traditional system. The idea is to offer an alternative, more transparent to users.
To give a more concrete case, DeFi loans work in the same way as traditional finance. The main difference concerns transparency, intermediaries and loan guarantees. Historically, when an individual takes out a loan to buy a house, that same property is used as collateral. In the event that this individual stopped repaying the loan, the bank could seize the house.
In DeFi, the process of depositing collateral involves depositing cryptocurrencies whose value is greater than or equal to the amount of the loan. This is known as placing cryptocurrency as collateral ("en garantie" in French). What you need to understand, however, is that these cryptos are in no way sold. You keep your cryptocurrencies; they are simply a guarantee of your solvency. If you don't repay, you can't get them back.
How will DeFi redefine financial services?
Decentralised finance rhymes with opportunity.
The innovation brought about by DeFi challenges part of traditional finance. In particular, it gives anyone with an internet connection access to financial services. In a world where 63% of the population - some 4.9 billion people - have access to the web, according to the CIA, this is no mean feat. The ideological dimension of democratisation inherent in the World Wide Web takes on its full meaning. On the other hand, the World Bank estimates that 1.7 billion people have no bank account. DeFi could therefore fill a gap left by traditional finance among unbanked populations.
DeFi is attractive in the sense that it promises to provide a system in which users free themselves from financial intermediaries who collect fees on every transaction. Here, it is the users themselves who collect the fees (and they are extremely modest).
The main innovation lies in the empowerment of users who, thanks to their governance tokens, are able to give their opinion on the community policy to be adopted. As you will have gathered, one of the things that makes DeFi so unique is the use of cryptocurrencies. Ether is the main crypto used, but a large number of protocols have developed their own governance tokens to bring their communities together and enable them to influence the future of the DAO. Of course, these cases operate on a small scale, but a DAO like that of the Aave borrowing protocol brings together a community of more than 120,000 token holders.
DeFi protocols are developed in open source, which means that developers from all over the world have the opportunity to improve the financial products and services on offer. Put simply, anyone who proposes a change to the nature of a DeFi protocol can see their proposal come into effect if the DAO has decided to vote in favour of it. This is a major shift towards a society where the user is at the centre of the financial system. The citizen is no longer a passive user of financial services, but becomes a stakeholder.
In the same sense, DeFi is intended to be non-custodial, meaning that you remain the permanent owner of your funds even if they are used in a service. In other words, no third party can take your funds without your authorisation. The best illustration to give credence to this system is the collapse of Celsius. The US platform operated on a "custody" basis (holding on behalf of customers) and arbitrarily blocked its users' funds indefinitely following the Terra/UST crash. Currently, not all customers have yet been reimbursed. In this, Celsius should be presented as a CeFi (centralised finance) company even though it operates in the crypto sector.
On the other hand, when you use a DeFi non custodial protocol, your funds can only be used if and only if the smart contract meets the conditions precedent to its execution. Put simply, your funds are never used without your consent. The development of this self-custody - synonymous with non-custodial - is part of the decentralisation of finance. Although decentralised finance appears revolutionary, there are many obstacles to its mass adoption.
What are the challenges for DeFi?
The first is financial. Building on Ethereum has many advantages, but one of its disadvantages is the high cost of transaction fees. In the event of network congestion, users may have to pay particularly high transaction fees. Developers are thinking about how to reduce this problem, and one way of doing this is by developing overlays for the Ethereum blockchain. We're talking about layer 2.
This is the whole issue of scalability we're talking about. How the network on which decentralised finance applications are built adapts to user demand, all while maintaining a secure, instantaneous and inexpensive network.
DeFi can also be used by malicious individuals. According to a Chainalysis report dedicated to the use of cryptos for criminal purposes, wallets marked as "illicit" sent 17% of their funds via DeFi protocols in 2021. That's a 1964% increase on 2020 levels. Some decentralised finance applications (such as Tornado Cash) are also a way for unscrupulous organisations to launder money. This drastically damages the image of decentralised finance, particularly in relation to established financial institutions.
Speaking of security, we can't talk about DeFi without raising the immaturity of the technology. The industry has already seen numerous hacks resulting in the loss of hundreds of millions of dollars. The ecosystem of decentralised finance is young, and is riddled with loopholes that hackers are quick to exploit. According to Chainalysis, nearly two billion dollars have been stolen in the crypto universe, 97% of which via DeFi applications. The flaws stem from vulnerabilities in certain smart contracts, which allow hackers to divert large amounts of liquidity.
The flaws have resulted in a distorted image of what decentralised finance really is. This is reflected in the reluctance of banks towards the sector, which is one of the biggest obstacles to the development of DeFi. However, the DeFi exchange and transaction system works very well. More and more progress is being made, leading to an increase in the number of users. The only snag concerns the gateway from the DeFi ecosystem to traditional finance, from cryptocurrencies to fiat currencies. Indeed, when it comes to taking out this money injected into DeFi's protocols, banks are particularly suspicious. As part of their Anti Money Laundering policies, they report any suspicious transactions to the relevant authority - TRACFIN in France (Traitement du renseignement et action contre les circuits financiers clandestins).
This is why education is a challenge on the fringes of DeFi. Although some of the services offered by DeFi protocols are innovative, if citizens are not enlightened and acculturated to this new internet, decentralised finance may never be massively adopted. DeFi is still in its infancy and we need to educate ourselves to understand how the protocols work in order to optimise their use.
A concrete example of DeFi to get the full picture: Aave by The Big Whale community.
At an Ethereum conference, we had the opportunity to meet someone who had borrowed money in DeFi to finance work on his house. The banks had always refused him his loan because they didn't think he was capable of repaying it.
Please note: the individual in question is disabled and this made his application particularly complicated. But with DeFi, there is no discrimination, because it works with smart contracts and no human factor. This implies just one thing, the borrower must be able to place cryptocurrencies as collateral for their loan. To put it simply, the origin, skin colour, socio-professional status or health of users does not enter into the borrowing process. All that is required is a guarantee in cryptocurrency.
This is why this person decided to turn to decentralised finance. He used the Aave protocol on which he placed his ethers as collateral in order to borrow the equivalent sum in stablecoin dollars. This enabled him to finance his work quickly, avoiding lengthy administrative procedures. He then transferred his stablecoins into euros to pay for the work. DeFi seems like a magic solution to traditional finance, but is it really?
No, because it could be more complex in other cases. Indeed, the taxman who discovers a payment in euros from a crypto exchange platform generally does not accept that this inflow of money comes from a credit line, but rather from a capital gain recorded on the crypto markets. This is because the tax authorities are likely to interpret it as a means of cashing in returns on investment and impose taxation (30% of the capital gain, or 30% of the amount cashed in if the taxpayer is unable to justify his transactions).
The moral of the story: it is possible to borrow in DeFi by anyone who wishes to do so, but the process of transferring cryptocurrency into euros or dollars is complicated by the tax authorities (or even the bank if it does not want its customers to touch cryptos). That's why the majority of DeFi users use it to make a return on their cryptos, without cashing in their profits.
So everything remains to be done, but the future promises to be exciting.