My take on Decentralized Finance
This month, I took out the biggest loan of my life.
Yes, I’ve borrowed money before; as a kid I borrowed money from my parents all the time and as a student I once was a debtor to the Dutch government. This time feels different though. This loan wasn’t provided by a bank, investor or government. It wasn’t my dad either! I used a decentralized application, running on a public blockchain platform, to literally borrow money from myself. Say what?!
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.
At this point in time, the Decentralized Finance ecosystem is flourishing with teams working on various ingenious applications that enable borrowing, lending and trading of assets, but also creating derivatives around assets. There are even companies paying out interest on crypto holdings today!
The DeFi space has been around for years, but it grew increasingly fascinating to me in the past year. What’s been particularly interesting to observe is the way that these applications and its mechanisms have been surviving the grinding & crushing 1.5 year long bear market the entire cryptocurrency space is going through and got us all by surprise.
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.
This 1:1 value peg of Dai can only uphold if debtors don’t default on their loans, which is very similar to how the success of traditional financial institutions depends on the quality of their financial risk modeling practices. A bank has expert teams and complex models to determine risk of each loan they provide. These methods are often very complex and opaque.
How do we solve this in a decentralized manner? The simplified answer is collateralization. As a user of MakerDAO, in order to take out a loan in US Dollar as ‘Dai’, you are required to lock at least 150% of the equivalent value in ETH. The collateral is locked in a smart contract, where it will be managed by the MakerDAO application. As soon as the value of your collateral drops below 150% of your loan (for example, because the value of Ether dropped), your collateral is automatically liquidated (sold to the market) in order to repay your loan. In practice, a lot of novel mechanims have been implemented to maintain stability in the system. (eg. WETH/PETH ratio, the 13% liquidation penalty, keepers on the network, price feed oracles and the absolutely mind-blowing governance risk framework featuring the MKR token). The stability of the Dai value in USD is a solid indicator of the MakerDAO system health. If this doesn’t convince you, look up the security audits, check the open-source code yourself or consider that the >2M ETH held in the MakerDAO smart contract hasn’t been hacked after all this time.
Although MakerDAO currently only accepts ETH as collateral, the development roadmap states that support for other cryptocurrencies will be added later this year. The creators of the MakerDAO project envision that in the near future, users will be able to use all kinds of assets as collateral for loans. Interesting examples would be security tokens (essentially, company stocks on the blockchain), tokenized real estate assets and tokenized commodities (such as gold or coffee beans).
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)
However, I despise the current state of the financial sector and regard it as broken. Here’s what I hate about it:
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.
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.
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.
The cryptocurrency bear market has been mentally demanding for us all, but watching the developments in the crypto space—most notably the DeFi space—is humbling to say the least. We’re truly living in interesting times.
Although the user experience of these Defi applications are quite rough at this point in time — it feels absolutely nerve-wrecking to send a large amount of ETH to a CDP contract — I do believe that my generation will be massively adopting Decentralized Finance applications because of the benefits stated above. We’re growing increasingly tired of financial institutions making a mess, so we’re keen to switching to an alternative enabled by distributed tech.
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.
Thanks for reading! Please do share any comments, remarks or questions that you might have. Also feel free to call me out on things you don’t agree with — we’re all learning, I guess.
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New to blockchain technology? I wrote a six-part series on its potential effects on society, featuring hand-drawn animations by my friend Niels Sinke. Take a look!