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What Is Decentralised Finance and Why Does It Matter for Anyone Interested in Cryptocurrencies?

Disrupting traditional finance

This article was contributed to us by Arthur Cheong, Founding Partner of DeFiance Capital, one of the largest DeFi-focused venture capital funds in Asia.

With a fast-growing user base estimated at more than 3 million and nearly US$145 billion in total value locked, Decentralised Finance (DeFi) has emerged as a disruptive force in personal finance. Thanks to its ability to provide financial services that are more accessible, efficient, and at a lower cost than those provided by traditional financial institutions, many believe it has the potential to be the next great driver of financial inclusion.

However, DeFi remains somewhat of a black box for people on the outside looking in. The goal of this article is to shed light on what exactly DeFi is, what you can do with it, and why it’s important to the future of personal finance.

Understanding Decentralised Finance And Its Appeal

Decentralised finance (DeFi) can be defined as an open, cryptocurrency-based financial system without the need for traditional intermediaries like banks, brokers, and insurance companies. It is collection of financial services, such as lending and borrowing, that require only an Internet connection and a cryptocurrency wallet to access. Users can, for example, borrow against the value of their cryptocurrency holdings without needing approval from a bank.

DeFi differs from traditional finance in a number of ways. The first is that all DeFi transactions are conducted with cryptocurrency, with ether (ETH) and USD “stablecoins” (stable-value cryptocurrencies backed 1:1 by fiat currency) as the primary currencies. The second is transparency. DeFi transactions are visible to the public, meaning that there are no intermediaries hiding behind information siloes. The third is that anyone can participate. Activities such as liquidity provision are now no longer only the domain of large financial institutions.

DeFi has gained popularity in response to the high fees and low yields associated with traditional financial services. The barriers to entry are low and the opportunities for generating returns are high, an effect which has given new life to financial inclusion efforts. Beyond that, DeFi is also increasing access to liquidity, decreasing our reliance on centralised entities, and helping to reduce the inherent discrimination in the financial sector.

As with any new financial technology or service, however, there are risks. DeFi services can be prone to scams and hacks, resulting in the potential for financial loss. The volatility of cryptocurrencies must also be factored in, especially when transacting with non-stablecoin cryptocurrencies. It goes without saying that only reputable services should be utilised and proper due diligence should be conducted prior to any investment decision.

How Decentralised Finance Works

To understand how DeFi works, there are three core components that need to be explained. First, the blockchain networks, such as Ethereum, Solana, and Avalanche, that provide the transparent and immutable record of all transactions. Second, the “smart contracts”, software hosted on blockchain networks, that enable the financial services. Third, the “oracles”, data sources, that feed information to the smart contracts. Together, these components allow DeFi services to work without intermediaries.

Now that we have the tech stuff out of the way, let’s look at how DeFi works from the perspective of users. There is one primary concept that makes DeFi tick: liquidity pooling.

Liquidity is critical to any financial system. In traditional finance, however, liquidity tends to be siloed or provided by large financial institutions. DeFi services, on the contrary, source their liquidity by incentivising contributions from investors both large and small. These contributions result in “liquidity pools” that are then used to facilitate financial activity such as borrowing, swapping, and trading.

In exchange for their contributions, liquidity providers are able to generate a return, either through interest earned or a share of the fees generated by trading activity within the pools. Investors also receive liquidity provider (LP) tokens that represent their position in each pool and can themselves be swapped.

To demonstrate liquidity pooling, let’s say you want to swap some ETH for USDC. To create the necessary liquidity pool, investors are incentivised to contribute equal amounts of ETH and USDC. Then you come along with your ETH and exchange it to USDC by adding ETH to the pool and taking the corresponding amount of USDC out. The small fee for conducting this swap is split by all liquidity providers according to their share.

Here’s how the DeFi ecosystem functions with liquidity providers, borrowers and traders acting without intermediaries using DeFi services and blockchain networks:

What You Can Do With DeFi

DeFi has emulated many traditional financial services, but also has a few of its own.

Here are some of the things you can do with DeFi:

  • Liquidity Provision – You can provide your cryptocurrency holdings as liquidity on platforms such as Aave (in exchange for interest) and SushiSwap (in exchange for a share of the fees generated by activity in the pool).
  • Borrowing – Also on Aave, you can borrow against the value of the liquidity you provide.
  • Investing – Services like Set Protocol, Balancer, and Synthetix allow you to invest in crypto index funds and other synthetic assets.
  • Swapping and trading – You can leverage decentralised exchanges – or DEXs – like SushiSwap to swap and trade cryptocurrencies.
  • Staking – Some blockchain networks, such as Solana and Ethereum 2.0, allow you to participate in the confirmation of transactions in exchange for a reward, while DeFi services such as Aave incentivise you to provide liquidity that mitigates shortfall events.
  • Aave and yearn have decentralised their governance mechanisms by issuing special tokens that give you the right to vote on changes, additions, and other issues pertaining to the future of the services.
  • Gaming – Blockchain-based games such as Axie Infinity create open economic systems where users can earn cryptocurrency that can then be exchanged using DeFi protocols.

Looking Forward

The DeFi space is moving quickly. New services are being introduced every day that are pushing the boundaries of what’s possible. When we look to the future, we are keeping our eyes on five areas:

Improved security – In response to recent security concerns, existing services need to become more mature and robust to better secure user assets, while new services will need to learn from past mistakes. In the same vein, we are also likely to see the emergence of better consumer protection and financial instruments such as decentralised smart contract insurance.

Commitment to user experience – Crypto-based services have not historically been known for their usability. DeFi services are better, but we hope to see a continued commitment to improving the user experience, particularly with respect to the onboarding of new users. DeFi doesn’t just need to be open and accessible, it needs to be easy to use.

Decentralisation of everything – DeFi services don’t just aim to decentralise financial services, they aim to decentralise the whole value chain. This includes everything from software development and policymaking to oracles and future direction.

Better integration – Another important area to watch for is better integration between blockchains and between services. For DeFi to be truly open, services need to be able to conduct transactions across blockchains. Termed “interoperability”, such integration could play a major role in the next phase of DeFi expansion.

Traditional entrants – It is also likely that we will see more traditional financial institutions begin dabbling in DeFi, either through investment or intrapreneurship. Given the number of opportunities available, it is only a matter of time before banks, insurance companies, and brokers stake their position in the space.

DeFiance Capital is one of the largest venture capital funds in Asia focusing exclusively on decentralised finance (DeFi), and an early investor in successful DeFi projects, including Mintable, Synthetix, Axie Infinity, SushiSwap and Aave. The company is founded by Arthur Cheong who started his investment journey at 19 years old and is one of the earliest investors in the DeFi space in Singapore. His career experience spans across crypto assets, oil trading, and start-ups sector. The team at DeFiance comprises investment analysts with backgrounds in economic research, investment banking, deal making, markets and data analytics.