What is Decentralized Finance?

Photo: David Mark. Source: Pixabay.

When I first tried to understand the practical implications of digital currencies, it made my head spin. The most basic discussion quickly descended into a babble of protocols, yield farming, rug-pulling, and new token exchanges. I tried to ask, “What’s the point?” Eventually, the fog started to lift.

Decentralized Finance, or DeFi, is a way for people to borrow, lend, insure, and do all kinds of other transactions directly and anonymously across the Web. It’s a way for people to make and fulfill promises without resorting to financial intermediaries like banks, brokerages, or insurance companies. Any crypto token includes a blockchain – the decentralized record of ownership that goes back to when the token was created. There’s no reason why this indelible record couldn’t include other factors besides ownership.

DeFi expands the blockchain resource to facilitate anonymous financial transactions. Consider how insurance works. You have no idea if your home will be hit by lightning in the next storm. But an insurance company that underwrites millions of homes can predict, fairly well, how many homes will be hit by lightning in the next year. So they charge everyone a premium that covers that risk plus a markup for their operations and a profit margin. But imagine if the operations and profit margin could be eliminated? Insurance would be a lot cheaper, and more people could afford it.

Photo: Blitzmaerker. Source: Pixabay

Now think of the same thing happening in banking. Analysts used to joke about 6-3-3 bankers, who lent money at 6%, paid depositors 3%, and were able to go golfing by 3 pm. But if you didn’t need to pay your banker an extra three percent (for their operations and green fees), maybe the depositor could earn 4.49% and the borrower could pay 4.51%, with a tiny slice going to maintain the computer code that settles the transactions.

The potential is tremendous. Borrowing can be cheaper while lending becomes more profitable. Insurance gets more affordable while insurance is more attractive. Suddenly traditional banks and insurance companies look about as efficient as 12-column ledger books compared with an Excel spreadsheet. But how could this work?

The reason people borrow from banks is that banks have depositors’ money. The reason depositors put their money in the bank is they trust the bank. The same goes for insurance: people pay premiums to insurance companies because they trust that the insurance company will pay a claim if their house burns down. Financial intermediaries profit from the trust they build among their customers. If my neighbor insures my house, I can’t be sure they’ll have the money to pay my claim. And they might not know what premium to charge to underwrite the risk.

But underwriting is just math: risk analysis, classification, inspection, actuarial tables, commitment. And having enough cash to pay a claim can be verified online – especially when the cash is a cryptocurrency with a distributed ledger verifying who owns what and how much. Imagine all our money is in a pool, and the software registers who lends and who borrows and who insures and who is insured. It’s just software. And the software doesn’t need to take vacations or pay greens fees.

This is the promise of DeFi – the benefits of modern finance without the overhead of the financiers. The peril of DeFi is that we just exchange one set of intermediaries for another. Because software needs to be maintained, and “trustworthy” isn’t the first word that comes to mind when we consider today’s software giants.

DeFi proponents tell us that this is the “D” in DeFi – decentralized, no one in charge, using open-source code and ledgers that are distributed across the system. And consider Bitcoin: the system hasn’t been hacked despite many, many attempts. (And as Bitcoin’s market value increases, there are hundreds of billions of reasons to try.) Could DeFi reduce the risk of fraud and abuse in our financial system?

In my view, that’s not likely. There are no foolproof systems – just reviews and checking and working with counterparties we trust. It may be that Bitcoin, blockchain, and DeFi revolutionize the financial world by making financial transactions as efficient as buying a book online. But revolutions take time. And they typically cost more than we think.

Painting: Archibald Willard. Source: Wikipedia