My take on Decentralized Finance

Welcome to the wonderous world of DeFi

This is just one of many new use-cases enabled by Decentralized Finance applications. Decentralized Finance (or DeFi for short) is a subset of the crypto/blockchain space that envisions an alternative to the traditional financial sector that we know today. Satoshi Nakamoto could be regarded as the pioneer of the Decentralized Finance movement when he invented Bitcoin, a fully peer-to-peer electronic cash system. It enabled online payments without depending on a financial institution. When Ethereum was launched, it introduced the notion of smart contracts that sparked new and powerful use-cases.

the amount of ETH locked up in MakerDAO (source: https://mkr.tools/system )

Zooming in: MakerDAO

To better understand the potential of DeFi applications, let’s look at one particular example called ‘MakerDAO’. In essence, MakerDAO is a decentralized debt system running on the Ethereum blockchain. It allows you to lock your Ether in a smart contract as collateral and take out a loan in ‘Dai’, which is a fully decentralized ‘stablecoin’ — a cryptocurrency that has its value pegged to another currency, such as the US Dollar.

Why bother using the DeFi stack today, instead of using traditional financial services?

Well, I was able to leverage digital assets that I hold and use it as collateral, without having to trust any middleman to keep it safe. I’m also able to determine the amount of risk that I’m willing to take and decide how fast or slow I want to pay off my loan, with exceptional granularity. I can literally manage everything myself, without having to deal with any type of financial institution.

The notion of leveraging your wealth without it touching hands of third parties was never possible, but is now quickly becoming available to anyone that has access to the internet and a small amount of cryptocurrency.

Why this all blows my mind(!!)

In our capitalist society, financial services are the crux of the economy. It enables us to exchange and store value, but it also enables us to take on credit. Credit enables investment, which enables growth. Most economics believe that our economies need growth in order to sustain our modern societies. (please note: the former is heavily simplified by the 24-year old author of this article, who is not an economist)

1. Misaligned incentives

I believe that the financial industry is a classic case of “the agency problem”, where a trusted third party (say, a hedge fund manager) is expected to act in the best interest of another person (say, a personal investor) but the incentives are inherently misaligned. Because of this, I prefer not to trust financial institutions to manage my funds or assets.

2. Inaccessible

A big chunk of the world population does not have access to financial services, which puts them at a crushing disadvantage in life. These demographic groups are deemed too unprofitable for financial institutions to serve, because of low income levels and illiteracy. In Decentralized Finance, anyone with access to the internet and a small amount of cryptocurrency has access to the wave of powerful applications out there. Hell, anyone could even “fork” the codebase and create a better version themselves.

3. Censorship-prone

Government-enforced financial censorship is used to combat money laundering, terrorism funding and criminal activities. Unfiortunately it is also used as a tool to censor political critics, high-risk tech companies (such as blockchain startups) and movements like WikiLeaks. Decentralized applications are robust to censorship by design, because of the network topology.

4. Highly complex

Financial institutions are known to create highly complex and intransparent (but highly profitable) derivatives with insane risk profiles (due to overleveraging risky collateral, like bad mortgages). This is exactly what caused the 2008 financial crisis. DeFi applications are fully transparent since they run on chunks of self-executing and open-source code called smart contracts. These smart contracts can be used to program business logic that prevents the formation of high-complexity or high-risk derivatives.

a visualization of the RBMS financial derivative, the nasty kind that causes the 2008 financial crisis

We won’t be be trading stocks on the stock exchange, participating in scammy investment funds or using skimpy 0.03% interest rate savings accounts. Instead, we will be using DeFi apps to manage and leverage our wealth in a way that satisfy our personal risk appetite, ethical standards and financial situations.

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Deniz

Deniz

Crypto native, in deep since '17. Passionate about coordination mechanisms and Decentralized Finance. Product Manager @ MakerDAO. wagmi culture.