The second cryptocurrency wave is restarting the whole enterprise of decentralized electronic cash from scratch. The first task has been to design a more user-friendly form of electronic cash: a stablecoin. To create a stablecoin, the very features that make bitcoin or dogecoin a bad currency but a great gamble — the thrilling price jumps and dangerous collapses — have to be removed.
But the second wave goes beyond a decentralized stablecoin. It envisions an entirely new decentralized financial system — one with banks, lending, credit, and more. This effort is sometimes called open finance, decentralized finance, or defi.
A bewildering number of decentralized financial tools have been created in just a few short years.Will these remain niche products used only be acolytes, like the Segway? Or will these tools catch on and go mainstream?
Anchoring the defi ecosystem is a protocol called Maker DAO. It serves as a mechanism for creating stablecoins. Users can convert volatile cryptocurrency tokens into Dai, a stablecoin that closely follows the U.S. dollar. Unlike other stablecoins such as Tether or USDC, both of which rely on reserves held at a traditional bank in order to stabilize their value, Dai is entirely isolated from the traditional financial system.
Maker DAO and most other defi applications are implemented on the Ethereum blockchain. Ethereum can be thought of as a global computer run by thousands of anonymous validators. Whereas traditional financial networks require people to seek permission from the network owner in order to participate, the Ethereum network is open to anyone. This property is referred to as being censorship resistant. It is difficult for people to be censored from using applications on the Ethereum network.
In addition to Maker DAO, there are a number of other defi tools that have been implemented on Ethereum. Uniswap is an exchange where people can trade tokens. Dharma and Compound are lending platforms, like Lending Club. Individuals deposit their cryptocurrency tokens or Dai stablecoins, which get lent out at interest to borrowers. According to Loanscan.io, there is currently $120 million in defi loans outstanding.
What drives defi development? As Ethereum creator Vitalik Buterin puts it, the financial world is “insanely inefficient” and ripe for attack. Whereas traditional finance is stuck in the dark ages of bank counters and ATMs, decentralized-finance supporters believe that Ethereum’s programmability will lead to the creation of faster and better financial products.
Those working on defi applications also believe that traditional finance has left people behind. They aspire to connect both the unbanked and the de-banked.
Lastly, defi advocates are profoundly skeptical of traditional financial architecture, which requires customers to place large amounts of trust in “siloed” providers. The renegades want to provide transparent tools that save people from what they see as the tyranny of large centralized financial giants.
Each of these ambitions is admirable. But will defi live up to the hype?
As an example of “insanely inefficient,” Buterin mentions how hard it is to move money between accounts, especially internationally. But Buterin is attacking a stale version of the traditional financial system. As I’ve pointed out before, central banks around the globe have been aggressively rolling out real-time retail payment systems over the last decade. These systems allow people to make instant and free 24/7 domestic payments.
As for international payments, remittance provider Transferwise has been able to plug into these new instant retail payments systems in order to provide customers with 10-second remittances. Over the last two years, SWIFT has shifted 20 percent of all cross-border payments up to five-minute settlement or less, and expects this to become the standard within a few years.
Sure, certain jurisdictions (like the U.S.) are behind the pack. But they’ll catch up. The point that I am trying to make is that defi developers need to be careful that they are not misunderstanding their competitor. Old-fashioned finance is a much more efficient machine than Buterin makes it out to be.