Why Decentralized Finance?

One of the movements I’m most excited about is decentralized finance. Here is the description is taken directly from the Investopedia article which sums it up nicely. 

“Decentralized finance is a system by which financial products become available on a public decentralized blockchain network, making them open to anyone to use, rather than going through middlemen like banks or brokerages. Unlike a bank or brokerage account, a government-issued ID, Social Security number, or proof of address are not necessary to use DeFi.”

One of the better crypto funds I’ve come across, 1kx, estimates that 35% of the cost of the labor market is driven by establishing trust – legal, tax, accounting, auditing, KYC, etc. DeFi refers to a system by which software written on blockchains makes it possible for people who have no established relationship or confidence in each other collaborate without going through a middleman or central authority with a trustless transaction. It puts established centralized institutions such as banks, clearing houses or governments at risk and as such is one of the most disruptive ideas of our generation. 

The blockchain is enabling a shift from the “internet of information” to the “internet of value” where information and value transfer can be written into the same protocol and the incentives of users and developers are more closely linked than ever before. 

We are still in the early innings of decentralized finance; even though there is ~$75BN locked in the ecosystem, the global financial system is close to $100TN (1000x the size). DeFi only really saw the volume pick up a little over a year ago in May 2020 (the start of the “DeFi Summer”). 

Source: https://www.coingecko.com/en/defi – About $75BN in total value locked in July 2021. 

This evolution from traditional finance to decentralized finance is not going to be a smooth ride — the incumbents are centralized institutions like governments, banks that are deeply ingrained in our politics, economics, and culture. The disruption is all bottoms up and global by design and these central institutions are not going to embrace change or give up control quietly.  

Traditional or Centralized vs. Decentralized Finance

Centralized (traditional) finance gives control to a small number of organizations (banks, governments, clearing houses) which users of those organizations are supposed to trust. In many developed markets we trust these central organizations but it’s not true in many emerging markets, with good reason.

Centralized finance excludes many people in the world. Almost 2BN people in the world don’t have access to the banking system and almost 40% of Americans under 25 are underbanked.  These systems are built on outdated infrastructure and process which have very high fixed costs relative to decentralized finance and lack interoperability. Another thing that we cannot control as individuals is the leverage ratio of central banks, the supply of money (governments can print new USD causing inflation) and this gives us less control of our finances in the long term. 

DeFi, has many structural advantages – better technology, faster, cheaper and no reliance or expense needed for central institutions which operate with much higher costs — physical locations, expensive employees and rigid systems.

For example, international wires using traditional rails can have multiple intermediary banks, complex processes, unpredictability of the final transfer amounts (FX and fees) long wait times, and high transaction cost. It’s expensive, slow, and feels awful compared to crypto rails. When you first send USDC to a friend in another country using their wallet address instantly, which is fully trackable and is a fraction of the cost it’s so obvious that the incumbent technology and process is broken.

Here is some high level data on two lending platforms on traditional vs. decentralized rails; Lending club (-60% margin) vs. Maker Dao (+99% margin) and decide which is a better business  🙂 

Source: https://newsletter.banklesshq.com/p/defi-is-eating-finance
Source: https://newsletter.banklesshq.com/p/defi-is-eating-finance

Even though decentralized finance has many structural advantages and I’m very bullish on the bottoms up shift towards decentralized finance, the products and experience are still in their infancy and not appropriate for most people.

It is complicated to access, requires understanding of the underlying mechanisms (which are in turn, complicated) and you have almost no protection as a user. There is constant risk of getting hacked, logic bugs in Distributed Applications (DApps), rug pulls, user error and no FDIC insurance to save you if the sh*t hits the fan. If your wallet or the projects you’re investing in gets compromised you lose your money and there is no way to get it back. The tax code in the US also treats cryptocurrency like property which means that every time you swap currencies it’s a taxable event which is also no bueno for your taxes. The attitude of many enthusiasts in the ecosystem is one of “do your own research” not one of protection or support – proceed with caution even if you are curious.  

Intro Articles

If you’re interested in digging in further, here are a few articles that I think are worth checking out:

Podcasts


I’ll be writing a series of posts on DeFi and my experiences over the next few weeks — the next about the depths of defi and the different levels I’ve experienced personally over the last year.