What is DeFi?
DeFi (pronounced dee-fye) is short for decentralized finance. It’s an umbrella term for the part of the crypto universe that is geared toward building a new, internet-native financial system, using blockchains to replace traditional intermediaries and trust mechanisms.
I am falling asleep.
Don’t! I promise it’s interesting.
OK, I’ll give it a chance. What do you mean by “using blockchains to replace traditional intermediaries and trust mechanisms?”
Let’s back up a bit. To send or receive money in the traditional financial system you need intermediaries, like banks or stock exchanges. And in order to feel comfortable doing the transaction, all parties need to trust that those intermediaries will act fairly and honestly.
In DeFi, those middlemen are replaced by software. Instead of transacting through banks and stock exchanges, people trade directly with one another, with blockchain-based “smart contracts” doing the work of making markets, settling trades and ensuring that the entire process is fair and trustworthy.
So DeFi is crypto’s version of a stock exchange?
That’s part of it. But DeFi also includes things like lending platforms, prediction markets, options and derivatives.
Basically, crypto people are building their own version of Wall Street — one that is largely decentralized and deals exclusively in crypto, with crypto versions of many of the products offered by traditional financial firms, and without much of the red tape and regulations that govern the existing financial system.
Wild West Wall Street! OK, now I’m interested. How big is DeFi?
DeFi’s total value locked or T.V.L. — a standard way of measuring the value of crypto held in DeFi projects — is currently about $77 billion, according to DeFi Pulse. That would make DeFi something like the 38th largest bank in the United States by deposits, if it were a bank.
So not huge, but not small either.
Right. And T.V.L. isn’t the only way to measure DeFi’s growth. You could also look at trading activity on decentralized exchanges, which has grown by triple-digit percentages in the past year.
Or you could take a cue from regulators and politicians, who are increasingly looking to DeFi’s growth with concern. Michael Hsu, the acting U.S. comptroller of the currency, said in a speech at a blockchain conference in September that many DeFi products reminded him of the credit default swaps and other complex derivatives that were popular on Wall Street in the years leading up to the 2008 financial crisis.
And Senator Elizabeth Warren, the Massachusetts Democrat, singled out DeFi in a December crypto hearing, calling it “the most dangerous part of the crypto world.”
Why are people so worried about DeFi?
In short, because DeFi is mostly unregulated, with few of the consumer protections and safeguards that exist in the traditional financial system.
Can you give me an example of something that would be regulated in the traditional financial system, but isn’t regulated in DeFi?
The best example is probably stablecoins. Stablecoins are cryptocurrencies whose value is pegged to the value of a government-backed currency, like the U.S. dollar.
Stablecoins are a critical part of DeFi markets, because if you’re a crypto investor, you don’t want to constantly be changing tokens back and forth to dollars, or keeping all your assets in cryptocurrencies whose values might fluctuate wildly. You want a crypto coin that behaves like a boring, stable dollar, which you can use without needing to interact at all with the TradFi system.
TradFi?
It’s what DeFi people jokingly call traditional finance.
Clever. So, back to stablecoins. What’s dangerous about them?
Well, regulators have argued that despite the name, stablecoins aren’t actually that stable.
As my colleague, Jeanna Smialek, explained in an article on stablecoins last year, the worry stems from the fact that stablecoin issuers aren’t legally required to back their coins one-to-one with safe, cash-like assets. Investors who buy stablecoins might reasonably assume that each USD Coin or Tether (the two most popular stablecoins pegged to the U.S. dollar) is worth $1, and that they will be able to redeem their stablecoins for actual dollars whenever they want.
But there’s nothing in the law, at present, that requires stablecoin issuers to have one-to-one backing. And if they don’t have enough reserves to cover the stablecoins they’re issuing, the whole thing could collapse if enough investors decide to pull their money out all at once.
That sounds bad!
It would be, especially since stablecoins are the backbone of DeFi trading. And there are questions among investors and regulators about whether some of the leading stablecoin issuers actually have enough assets to pay out their holders, in the event of a large-scale redemption.
So stablecoins might not be stable. What else is potentially worrisome about DeFi?
The crypto firms that issue loans, credit cards and savings accounts, without many of the protections or safeguards offered by conventional banks, are also drawing concern. Regulators in the United States have begun clamping down on firms that issue these products, saying they could represent a risk to consumers.
Regulators are also looking into decentralized exchanges, or DEXs, which allow users to swap crypto tokens with the help of market-making algorithms.
And then there are all the hacks and scams …
Oh, great.
Yeah. DeFi, like crypto in general, is a big target for fraud. More than $10 billion was lost to hacks and scams in DeFi projects in 2021 alone, according to a report from the blockchain analytics firm Elliptic.
There typically isn’t much recourse for victims of DeFi scams. And unlike deposits in a regular bank, which are insured by the F.D.I.C., crypto tokens usually can’t be replaced or recovered once they’re gone.
So, let me get this straight. One of the fastest-growing areas of crypto is a Wild West version of Wall Street where there are no investor protections, where the things that are called “stablecoins” might not be stable, and where your money could be irreversibly stolen at any time?
That’s an unflatteringly phrased but largely accurate summary!
Why would anyone sign up for this?
Four reasons.
First, many people like DeFi because it’s so new and unregulated. Building an entirely new financial system from scratch is the kind of intellectual challenge that doesn’t come around every day, and lots of people are attracted to the sector’s wide open, blank slate potential. Plus, if you’re a clever trader or an experienced financial engineer, you could do all kinds of things in DeFi that you couldn’t do in the traditional financial system, and potentially make a lot of money very quickly.
Second, many DeFi fans argue that blockchains are technologically superior to the existing banking system, much of which runs on ancient databases and outdated code. (Most bank transactions, for example, still rely on programs written in COBOL, a programming language that dates back to the 1960s.) Crypto, they say, is the first form of money that is actually devised for the internet, and as it grows, it will need a new, internet-native financial system to support it.
Third, if you’ve bought into the crypto/web3 vision of a decentralized economy, DeFi is the financial architecture that makes all of the things you’re excited about possible. There’s no way, in the traditional financial system, for a DAO to create a membership token out of thin air and use it to raise millions of dollars. You can’t call up JPMorgan Chase or Goldman Sachs and ask them to give you a quote for Smooth Love Potion, priced in Dogecoin. (Well, you could, but they might have you committed.) But with DeFi platforms, you can find people who are willing to trade almost any crypto asset for almost any other crypto asset, with no central entity’s approval needed.
And fourth, there’s a more idealistic cohort of DeFi fans who see all of this heading in a much more utopian direction.
Decentralizing finance, these people say, could help fix what’s wrong with our current financial system, in part by eroding the power of big Wall Street banks over our economy and markets.
How would that work?
These optimists contend that because DeFi replaces human intermediaries and trust mechanisms with public blockchains and open-source software, it’s cheaper (fewer fees), more efficient (faster transaction times) and more transparent (less opportunity for corruption) than the traditional financial system.
They say it democratizes investing, placing tools in people’s hands that only professional investors had access to before. And because you can participate in crypto anonymously and without a bank’s approval, they say, DeFi is a way to provide financial services to people who aren’t well-served by the conventional banking sector, and avoid many of the discriminatory practices that have kept minorities from accessing financial services in the past.
Ultimately, the optimists say, DeFi will become safer and more robust over time, as more people use it and some of the early problems are ironed out. And just as they believe that web3 will replace greedy tech platforms with user-owned collectives, they believe that DeFi will replace today’s banks and brokerages with a better, fairer system.
That sounds great, but I’m still worried. Didn’t we learn our lesson in 2008 about the dangers of unregulated finance? Could DeFi bring about the next financial crisis?
Right now, it’s unlikely that DeFi could produce any disasters on the scale of the 2008 financial crisis. It’s still a relatively small piece of the crypto world (which is a relatively small piece of the overall economy), and many of the people pouring money into DeFi are the kind of deep-pocketed investors who could absorb even big losses.
But the possibility that DeFi could grow big enough to present a systemic risk isn’t lost on regulators, who are scrambling to make the Wild West of crypto a little less wild.
Go deeper:
“Finance 3.0: DeFi, Dapps, and the Promise of Decentralized Disruption” Kevin Werbach, a professor at the Wharton School of the University of Pennsylvania, makes the case that DeFi will revolutionize the world of finance by “eliminating costly and controlling intermediaries from financial transactions.”
“Anyone Seen Tether’s Billions?” Bloomberg’s report on the mysterious dollar reserves of Tether, the stablecoin at the heart of the DeFi economy, helps explain why regulators are worried.
“The Defiant” This independent media company’s daily DeFi newsletter is an industry must-read.
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