Think it - Decentralised Finance (DeFi)

Hottest term nowadays in finance is DeFi. DeFi is quite different from FinTech. FinTech is the provision of traditional financial services through the use of communication technologies. Although it aimed to replace the brick and mortar banks and other financial institutions, somehow it could not replace the banks. On the other hand the DeFi (Decentralised Finance) altogether aims to eliminate the intermediation role of banks. It is based on blockchain technology and uses peer to peer independent record keepers known as Distributed Ledgers.

One primary characteristic of DeFi is its peer-to-peer nature and resulting ability to create alternatives to traditional and centralised financial market infrastructures, products or services. In DeFi, financial products and services are created using smart contracts, which operate in a stack of technologies that interact with each other. The DeFi technology stack consists of four “layers” as well as a grouping of external, off-chain inputs that connect to multiple layers.

1. The “settlement layer” - where transactions are recorded, and participants and smart contracts have addresses that can hold crypto-assets and interact with other participants and smart contracts.

2. The “asset” layer – crypto-assets (coins and tokens) that participants and smart contracts create and transfer on a blockchain.

3. The “smart contract” layer – smart contracts (and auxiliary software) used to provide functionality to DeFi products and services.

4. The “application” layer – front-end user interfaces, APIs, and other code that allow participants to interact with the smart contracts. Today, these applications are primarily hosted off-chain.

5. Key off-chain inputs that make up a “DeFi supply chain” of information, services and assets that can affect the application, smart contract or asset layer.

It is important to recognize that DeFi does not exist wholly independent of traditional financial markets and entities and centralised crypto-asset markets and entities and there are important interlinkages.

Take the case of lending, in a traditional finance lender providing funds to borrowers in return for interest and is an activity that is typically facilitated by a centralised third party, most commonly a bank, which will utilize customer deposits to lend to others. Whereas in DeFi instead of being deposited with a central party, users deposit crypto-assets to a smart contract on a distributed ledger which automatically manages the ratio of liquidity between supplied and borrowed assets, a ratio which in turn will also determine the interest rates paid by borrowers and received by lenders. Credit assessments typically are not required for borrower loan approvals. Instead,

DeFi arrangements may rely on over-collateralization (i.e., tokens supplied by the borrower will be worth more than the amount borrowed).

Another key product and service in DeFi involves various trading protocols, which can involve both the deposit of crypto-assets into the protocol as well as trading activities through use of the protocol. Crypto-asset trading protocols in DeFi are often called decentralised exchanges or “DEXs.”

The reasons for the recent growth in DeFi are multifaceted, and there are multiple underlying incentive mechanisms that have helped fuel participation. The estimated Total Value Locked in DeFi is USD 197b.

At its core, DeFi seeks to eliminate traditional intermediaries like banks between parties to transactions. Although it is argued that disintermediation allows for faster, cheaper and more efficient execution of transactions, it also eliminates market participants that have traditionally acted as gatekeepers, performing central roles of

ensuring investor protection and market integrity. The DeFi market and its participants in many respects have operated to date either outside the scope of existing regulatory frameworks or, in some jurisdictions, in non-compliance with applicable regulations.

Retail investors in DeFi projects typically form part of an online community or otherwise are brought into DeFi through influencers, social media, and other forms of digital engagement and promotional activities, which can be a prominent avenue to gain more traction. Misinformation and inappropriate advertising using these promotional channels present well-understood risks to investors. Many DeFi products and systems fail to provide important disclosures. Although blockchain data and smart contract code is transparent for all to see, understanding this data and code requires technical capability and knowledge. Without basic regulatory safeguards, including those that are the purpose of traditional financial services regulation, such as requirements for the disclosure of material information about a

product, service or the individuals and underlying entities, investors may not necessarily receive sufficient information to make informed investment decisions. Some DeFi products and systems may require certain technical or other expertise that not all investors have and, as a result, may be unsuitable for some investors.

There may be hidden informational or technological advantages sophisticated participants have over retail investors that make for an uneven playing field. Even absent fraud or misconduct, investors may lose some, if not all, of their investment due to these asymmetries.

Blockchain technology and DeFi are nascent and developing. Although innovations may hold promise for certain applications, at present, DeFi naturally faces several early-stage challenges that may not be readily apparent to retail users. These can be grouped into 1)Comprehensibility 2)Scalability 3)Supportability 4)Reliability.

There are no shortcuts to success.