Have you heard of DEFI? If not read on
Forgive the corny headline. I couldn’t resist it. My 84-year-old mother has become quite deaf over the last 12 months. I, for one, will not be calling her a DEFI though!
No, DEFI is the acronym for decentralised finance, not an insult aimed at deaf people. Who on earth dreams up these acronyms?
So what is decentralised finance? Well if you haven’t yet heard the phrase, you will be hearing about it a lot in the future.
Decentralised finance, also known as DeFi, is a fast-growing sector of the cryptocurrency industry. Cryptocurrency is not run by governments in other words it is decentralised. While cryptocurrency coins create a decentralised store of value separate from any government-backed fiat currency, DeFi creates decentralised financial instruments separate from traditional centralised institutions such as banks.
Cryptocurrency is a digital currency in which transactions are verified and records maintained by a decentralised system using cryptography, or encryption, rather than by a centralised authority.
The English Oxford Living Dictionary defines cryptocurrency as ”A digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. ‘Decentralised cryptocurrencies such as bitcoin now provide an outlet for personal wealth that is beyond restriction and confiscation.’
Cryptography or encryption is the use of secret codes between the buyer and the seller. It is highly secure.
Although still small when compared to the global economy, DeFi has seen rapid growth in 2020. In early 2019, there was only $275m of crypto collateral locked in the DeFi economy. By February 2020, that number had grown to $1b, and it has continued to grow impressively throughout the year, hitting $2.5b in early July, $3b by mid-July, and $4b on 25 July.
This growth shows that there is significant interest in DeFi from within the crypto community, but it’s still a small enough sector that many outside the industry may not have heard of DeFi yet. So let’s look at what DeFi is, and why it’s so exciting.
In order to be considered DeFi, a financial platform must have one or more decentralised functions. These often take the form of using distributed ledger technology (DLT), otherwise known as the blockchain, rather than storing records in a centralised fashion; decentralised governance of the platform in the hands of the token holders rather than a ruling board; the use of decentralised information feeds and algorithms to determine things such as interest rates and currency values. An algorithm is a process or set of rules to be followed in calculations or other problem-solving operations, especially by a computer.
Most DeFi platforms take the form of decentralised apps, known as DApps. These DApps use a series of smart contracts to automate financial transactions, making them faster, more efficient, and often more affordable than their centralised counterparts. Likewise, because DApps are governed by computer code, which is inherently neutral, there is no issue of bias.
Much of the interest around DeFi has to do with giving people more control over their money, and more interesting ways to use it. The centralised financial industry has long excluded people of modest means, reserving the best instruments for those with more funds, and thus further increasing the wealth gap. Many DeFi projects aim to make investment and trading more accessible, with lower minimum investments and platforms which are easy to use from any smartphone with an Internet connection, regardless of geographical location. DeFi is interesting and exciting, but it’s also risky. While anyone can get involved with DeFi, it’s not advisable to invest heavily in the industry unless you can afford heavy losses. The industry has suffered several high-profile hacks and attacks in 2019 and 2020, resulting in major losses.
DeFi, most of it built on the Ethereum blockchain network, is the next step in the revolution in disruptive financial technology that began 11 years ago with bitcoin. One area in which these decentralised applications (DApps) have taken off is cryptocurrency trading on decentralised exchanges (dexs) such as Uniswap. These are entirely peer-to-peer, without any company or other institution providing the platform.
Other DeFi services now in use allow you to:
- Borrow and lend cryptocurrencies to earn interest using platforms such as Compound or Aave.
- Bet on the outcome of events using Augur.
- Create and exchange derivatives of real-world assets such as currencies or precious metals on Synthetix.
- Take part in a no-loss lottery on PoolTogether, where everyone gets their money back and one lucky participant wins all the interest that has accrued in a shared pot.
- Buy cryptocurrencies known as stablecoins, which are pegged to the value of a particular currency or commodity. For example, DAI and USDC are both pegged to the US dollar.
DeFi is sometimes known as “Lego money” because you can stack DApps together to maximise your returns. For example, you could buy a stablecoin such as DAI and then lend it on Compound to earn interest, all using your smartphone.
Though many of today’s DApps are niche, future applications could have a big impact on day-to-day life. For example, you will probably be able to purchase a piece of land or house on a DeFi platform under a mortgage agreement whereby you repay the price over a period of years.
The deeds would be put up in a tokenised form on a blockchain ledger as collateral and, in the event that you defaulted on your repayments, the deeds would automatically shift to the lender. Because no lawyers or banks would be required, it could make the whole process of buying and selling houses cheaper.
Centralised finance is subject to several rules and regulations. This is a double edged sword. Many of these regulations hamper what users can do with their money, but they also provide protection. Regulations create a legal framework for prosecuting anyone who illegally misuses their customers’ funds and a framework for restoring lost assets to victims of financial crimes. Unfortunately, just as hackers are able to exploit loopholes in smart contracts to steal funds, traditional financial institutions are adept at working the laws to make as much money as possible from their users, without committing any actual crimes.
For DeFi to succeed, the industry will need to self-police, work with legislators to encourage the development of sensible laws that offer a good balance of freedom and consumer protection, and provide good educational resources to help newcomers navigate the financial landscape safely and effectively.
With education, it’s far easier to make a good decision on how to use your money, based on things like your risk tolerance, the amount of money you have to work with, and your end goals (such as the down payment on a house, or building a retirement nest egg).
DeFi is no different from the centralised financial industry in this regard. Users need access to quality education in order to make smart decisions about their digital assets. This education should be easy to find and easy to understand. It must be presented in a variety of formats to accommodate different learning styles. 2020 is looking to be a big year for DeFi, but it still has a long way to go. Now is a good time to start learning about this exciting new industry, so that you can follow along with its growth.
So the lesson is to tread carefully in this newly emerging sector of decentralised finance. The opportunities are huge but equally, at this early stage, the risks are high too. In the future, DeFi will become mainstream and extremely secure. It will lower costs and speed up transactions with high security. If you are interested in exploring DeFi you will need to educate yourself and become familiar with the sector. Only then should you enter it but only cautiously. As it isn’t yet as well regulated as centralised finance it would be wise to be cautious. You know it makes sense*.
* The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs’ practice. Levels and bases of tax relief are subject to change.