Market Overview

Dare to DeFi?

“DeFi” is the buzzword of the year in financial circles. But what does it mean – and what does it mean for you?

DeFi is shortened version of decentralized finance and is defined as “the ecosystem of financial applications being built with blockchain technology,” according to cryptocurrency news source CoinMarketCap. The term “DeFi” was coined in an online chat among crypto-famous luminaries in August 2018 who “were discussing what to call the movement of open financial applications being built on Ethereum,” according to Camilla Russo, the article’s author. “Other options considered were Open Horizon, Lattice Network and Open Financial Protocols.” But it was hard to beat the winning entry which, after all, is pronounced “defy”.

That kind of oppositional stance is endemic in the crypto community, so how did it end up being discussed by Wall Street’s graying establishmentarians?

“Banking has always meant bankers, the people who arrange everything from savings accounts to synthetic collateralized debt obligations. But what if computer code could take their place?”, Olga Kharif asks on behalf of Bloomberg.

The building blocks of DeFi are more than a decade old, and the goal of decentralizing finance has been aided immensely by crypto experimentation.

“A DeFi world could be one where money flows more efficiently and more fairly, its proponents say, pointing to platforms where users are boasting of hefty returns,” Kharif posits.

Nuts and bolts

You might have to spend an hour on YouTube tutorials to really get the following, but here are the bullet points:

• Blockchain is the technology that enables cryptocurrencies, but it does that by creating a shared database that never requires auditing because all transactions are witnessed and agreed to by all subscribers to that database. There can never be a disagreement on a properly operating blockchain.
• Decentralized applications – dapps – are the widgets that enable those transactions to be performed, whether they be sales of securities, or direct loans, or what have you.
• Dapps function because they are programmed with so-called smart contracts, which are just self-executing contracts that automatically and unfailingly release one item of value in exchange for another as long as specific conditions are met.
• DeFi uses specially designed cryptocurrency tokens to enable the sale of – for example – Bitcoin Core, which lives on one blockchain, with Ethereum, which lives on another, via a smart contract executed on a dapp, which functions as a neutral exchange.

Given that infrastructure, it’s easy to see how trading cryptocurrencies can be – indeed, has already been – made easier by DeFi. But not everybody is into crypto. Still, it’s certainly not uncommon to be trading in stocks, and there are millions of amateur traders who dabble in foreign exchange and commodity futures. And that’s where DeFi’s future lies.

Use cases

By the end of the year, you could be able to use DeFi dapps to trade anything you might trade electronically. They might provide you with margin lending. They might enable to you to leverage your equity 10 times or 100 times rather than the three times which current U.S. trading rules set as the ceiling. They might even extend you consumer loans or, for that matter, mortgages.

Of course, regulators are going to have something to say about all that. There are reasons why exchanges are regulated, and particularly why some of those regulations apply to trading on margin. Those overseeing banks will likewise look askance at any development which gets around their 26-page list of the actionable provisions of U.S. lending laws.

In the meantime, though, there has been some convergence between the industry side and the compliance side. For example, Coinbase – the leading U.S.-based crypto trading platform – is not only licensed by both the federal and New York State governments as a securities exchange, it’s also a public company with its own shares trading on the Nasdaq.

As for lending, the confluence is just as visible. The advent of cryptocurrency occurred in 2008, coincident with – but unrelated to – the financial crisis. That crisis, though, led Washington to pass the Jumpstart Our Business Startups Act of 2012, which extended all kinds of private placement and crowdfunding opportunities.

And crypto, by its very existence, flies in the face of the prerogatives of the Federal Reserve and the world’s other central banks. And yet, there’s no law that says all money has to have the picture of a dead president on it, so the Fed has had to reach a détente with the crypto space. So has every other monetary authority. Why, some have even found ways of working with it and establishing a reasonable regulatory system which crypto proponents can live with.

Laying down the law

America, though, is still a long way from that kind of accommodation. We’re not even sure how to regulate it here. It’s not really currency – at least, not yet – so it can’t be treated like forex. It’s not a commodity, so it can’t be treated like futures contracts unless it’s specifically structured like futures. Nor is it equity, although that’s how the Securities and Exchange Commission has at times viewed it, as we reported earlier this year in the case of XRP and its related corporate entity, Ripple Labs.

Crypto is an entirely new asset class, and our leaders would be well served to figure that out before the rest of the world’s economies do. And that has everything to do with the decentralized nature of its financial impact – the “De” nature of its “Fi”.

So be careful

While the prospect of sidestepping government regulations is tempting, there is a significant downside. If anything goes wrong, you would have no legal protection. If you get hacked or scammed, it’s on you. There’s no way to recover a penny. That’s why we live by the rules of the road which made the U.S. financial system the envy of the world. We accept the tradeoff: You can’t have both total freedom and total protection, so we need to give up a little of the former, however reluctantly, to have any of the latter.

DeFi is likely to affect you in very real ways, but exactly how has yet to be determined. Those who follow it closely will tell you that the foundation has barely been laid, and there’s no telling what the structure is going to look like once it’s substantively built out.

While DeFi might mean you never have to see a banker again, it’s likely to increase the number of options you have as an investor, regardless of asset class. We expect you’ll find, even when DeFi is completely ubiquitous, you’ll still need the advice of a trusted financial expert.