Decentralised Finance (DeFi)

As I outlined in a previous post, blockchains permit the creation of autonomous applications. When users transact with each other on the blockchain, their transactions are intermediated by autonomous computer programs – known as smart contracts – instead of human administered intermediaries such as banks, brokerages and clearing houses. When smart contracts are used for financial applications, we call this burgeoning new industry decentralised finance (DeFi).

DeFi is, in essence, simply the provision of financial services delivered by smart contracts. The tools and services that are being developed for payments, trading, financial derivatives, credit, etc are little different to what we’ve seen in finance before. However, DeFi has a number of properties that mark it apart from traditional finance.

DeFi applications can proliferate much more quickly than traditional organisation-delivered services, for two reasons.  First, because the applications are written in code that is typically open sourced, developers can constantly borrow from each other to create new variants of various applications.  Second, because there is less need for users to trust the people that created them. Once a DeFi application has been code-audited by an independent third party, users can be comfortable that its creator can’t steal their money or abuse their trust in other ways. These two factors have allowed entrepreneurs and developers that would never have attempted to build financial applications before to enter the market in increasing numbers. The natural assumption to make is that the pace of innovation and competition in finance will continue to increase in the future, to the benefit of consumers.

Since blockchains are global, a DeFi application is globally accessible from the moment it is launched. They are censorship resistant meaning they simply work for everyone no matter which part of the world they live in. Transactions are also globally immediate. They don’t take days to settle through correspondent banks or clearing houses. Instead of fearing this development regulators such as the CFTC are excited by it as they can see some of the need for their oversight is removed by this technology.  It makes sense too – with DeFi, a regulator can review code, determine that this financial service operates as intended, and approve the smart contract.  This is a lot cleaner than trying to supervise banks, many of whom have a track record of supplying misinformation to regulators.

Although those benefits are enormous, for me the key USP of DeFi is its open nature. DeFi applications and products can be combined much more easily than in traditional finance (TradFi). In fact, some of the interoperability of DeFi simply isn’t possible in TradFi. The key property of open DeFi that permits this interoperability is composability. Composability is a system design principle that deals with the inter-relationships of components. A highly composable system provides components that can be selected and assembled in various combinations to satisfy specific user requirements. As more DeFi applications spring up, it is becoming an extremely composable system within which decentralised exchange protocols, cryptoassets and wallet software can be combined in an increasing number of ways like money lego. Much like one can assemble any type of shape out of lego blocks, people will be able to create, gain exposure to or hedge against any type of financial risk imaginable.

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