Decentralised Finance, DeFi, Open Finance… whatever you want to call it, it’s worth a look.
It’s time for another blog with me Colin Platt where we explore some of the topics that Zeth, Shaun and I found interesting.
Hopefully you’ve been able to keep all the trends in crypto straight. This year has seen a focus on securities tokens, stable coins, new technical features, and now: “DeFi”, short for decentralised finance. What’s all the buzz about? And why should we start paying attention.
Most closely associated with the Ethereum platform itself, DeFi could loosely be characterised by projects, which seek to offer more complex financial operations than purely movement and tracking of cryptocurrencies (e.g., managing payments and contributions to the funding of a project). Some of the ideas include creating derivatives or prediction markets, lending and borrowing cryptocurrencies, and decentralised exchanges.
These projects differ from some of the projects that came before in that they seek to remove central points of control or influence from their operations. A prime example of this is Augur, a decentralised prediction market (think of it like a betting platform), which removed all ability to unilaterally ‘pause’ contracts upon its launch in September 2018 meaning that the founding team would require that users helping to run Augur would need to proactively opt-in to accept any changes they propose. While on the surface this might not seem dramatic, the inability for developers to fix bugs and push those changes to users drastically reduces their ability to not only fix intentional errors, but also diminishes their ability to enforce changes required by courts or law enforcement. Perhaps then, in Augur’s recent past, it shouldn’t be surprising that several “assassination markets”, or predictions on when famous people (including US President Donald Trump) might kick the bucket which allow backers to profit off of being right (a factor which has led some to speculate may give rise to financial motivations to ensure outcomes, such as the death of the subject in question).
In less gruesome instances, prediction markets and their more traditional cousins, derivatives have begun to gain transaction with participants trading with each other to speculate on, or hedge against price movements in things like USD, the S&P 500 index, ETH and BTC.
Of course, one of the core functionalities of finance is helping manage money over time, rather than between one place and the next (e.g., payments). You and I know this as lending, when a bank gives you a loan to buy a house, they are effectively allowing you to take money from the future and spend it today to purchase a house. MakerDAO and its corresponding stablecoin DAI, allows ETH holder to borrow against a percentage of their ETH stash and create a new token (DAI) which tracks the value of 1 USD. This is like a fancy digital home equity line of credit, in which banks allow you to borrow against the value of your home to have cash in your back account. Maker allows you to place Ether (ETH) into a smart contract called a Collateralised Debt Position (CDP) and from there issue DAI. Let’s take an example, ETH is currently worth $150, we place 10 ETH ($1,500) into a CDP, this allows us to issue a loan to ourselves for 1000 DAI which can be used onward for whatever we’d like. The money issued as DAI also have an interest rate (which goes through a complicated conversion process) and currently equates to 3.5% annually. Of course as these are loans, in theory, they eventually need to be paid back but they can be renewed provided that the CDP has enough ETH to cover the issued DAI.
Another interesting project, Uniswap, seeks to put a new twist on the decentralised exchange. Rather than simply being a platform that allows users to trade tokens using smart contracts, without a central arbiter, Uniswap seeks to incentivise market makers to continuously offer liquidity buy always posting both a bid and offer for the exchange between ETH and an ERC20 token. A market maker could, for example, place a quote for 1 ETH and 150 DAI. The way that they do this is to actually place 1 ETH and 150 DAI into a specific smart contract. Someone looking to buy DAI could place 0.5 ETH into the contract and withdraw 75 DAI. If there are more than 1 market makers they are placed next to each other and the cheapest trades first. The hope is that this feature will help bring greater liquidity to decentralised token exchanges and reduce dependence on centralised cryptocurrency exchanges, something that more traditional decentralised exchanges have struggled with.
On top of these projects, one of the interesting concepts is what I like to call “composable finance”, the ability to combine different functions into new products. Compound is one such project, they allow users to lend tokens and earn interest. Want to do that without the price risk of something like ETH? And without going through a centralised platform? Lend DAI through Compound…
I suspect that we will start to see more radical integrations between projects offering more powerful products that fit a variety of financial needs, it might not even be too far away to suggest that lending rates from such projects are used to calculate the discount rate on decentralised derivatives platforms, or finance the development of new crypto projects in a form very different from that shown by ICOs or securities tokens.
As always, there are lots of unknowns, as well as more than one or two things that have raised eyebrows at regulators and law firms alike. It will be an exciting space to watch develop, and may lead to interesting new innovations, but we’re also very likely to hear of less rosy stories as well.
As always, nothing here should be construed as financial advice, recommendation or endorsement of any project or cryptocurrency.
If you want to read about our last blog on Stable coins click here.