The brilliance of DeFi and how it is reshaping the world of finance
If you’re new to cryptos, then DeFi or ‘decentralised finance’ is a term you will want to become familiar with.
This is the coming wave that will swarm the world of finance and upend some of our most cherished assumptions about how to transact, earn interest and borrow money.
All of this can be done using DeFi platforms with no middlemen involved. That reduces costs, speeds up transaction times and allows you to transact with someone you don’t know or trust and still transact safely.
That’s the brilliance of DeFi.
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A recent article by billionaire Mark Cuban extolled the beautiful simplicity of DeFi and why he has started investing in this space:
“The first question you have to always ask about any DeFi is the same question you need to ask about any business you may create a financial relationship with – ‘What business are they in?’
“Yes, every single DeFI project, is at its core, just another business. They may or may not know what business they are in, but they are just another business that happens to be using a blockchain and smart contracts to host and programme their business processes.”
As this guide from Coindesk illustrates, most applications that call themselves DeFi are built on the Ethereum network, which is the second-largest cryptocurrency platform after bitcoin.
At the core of DeFi are smart contracts, which are contracts that execute without human intervention if certain conditions are met. For example: “Pay Joe R2 000 on Tuesday at 10am provided the Vodacom Bulls remain top of the Pro14 Rainbow Cup.”
All of these conditions can be coded into a smart contract and executed without any human intermediary.
Crypto interest accounts: DeFi smart contracts are now widely used for lending and earning interest of up to 20% a year, such as that offered by Ovex.
Collateralised lending: At any one of several decentralised exchanges you can take out a loan in minutes, using crypto as collateral. The person you are borrowing from does not know your name, where you live or how much you earn per year. That’s the difference between DeFi and traditional banking, and why DeFi has come from virtually zero a year ago to $60 billion in assets currently under ‘lock up’. Most of these decentralised exchanges are built on the Ethereum network, and the collateral required is called ether – the currency of the Ethereum network. The conditions of the loan, hard-wired into computer code, spell out the terms of repayment and events that would trigger a liquidation of the loan (usually when the value of ether declines by a certain percentage).
Decentralised exchanges such as Aave, Compound and Uniswap provide a platform for borrowers and lenders to transact with each other without having to know or trust each other. A loan of R1 million can be taken out in minutes, and the ability to ‘stake’ (invest) R1 million at interest rates that are the envy of the traditional banking world can likewise be done in minutes.
Stablecoins are another outgrowth of DeFi. These are crypto-like coins backed 1:1 with fiat currencies such as the US dollar or rand. These stablecoins can be shipped anywhere in the world in seconds without Reserve Bank approval (as things stand now, though that may change in the future).
Staking: One of the innovative ways DeFi applications are able to generate ‘interest’ using cryptos is through a process known as ‘staking’ – this is where you put your cryptos to work in the blockchain and get rewarded with more crypto. You retain full ownership of the crypto and can withdraw it at any time.
Liquidity providers: As Cuban points out in this article, this is the brilliance of DeFi. In traditional financial businesses, the owners need to have the financial depth to take on the risks of pricing volatility and loan defaults. Not so with decentralised exchanges, which are able to pass that risk on to liquidity providers (LPs) who earn a fee based on the percentage liquidity they provide.
Why DeFi is a revolutionary force
Cuban explains why DeFi – and the business model on which it is built – is so revolutionary:
“Basically, traditional, centralised businesses raise capital first. Start a business and then hope they make enough revenue to return enough capital to their investors and/or founders to make them happy.
“In the crypto/DeFi world, organisations don’t require near as much capital to start and operate. Rather than raising money in a traditional sense, they can sell tokens to raise capital, they can reward liquidity providers instead of having to raise liquidity for financial transactions, they can reward stakers who support validators, they can operate on a blockchain where most of the capex/infrastructure and much of the critical security is provided by miners or validators. They can build communities that replace layers and layers of bureaucracy.
“And what I’m about to say is what makes the crypto world so dramatically different and why it’s a model for future technology businesses and possibly all businesses …
‘Profits are useless in a decentralised business environment’
“Profits are of no use. There is no company I have mentioned that thinks they have to make profits to put in their owners’ pockets.
‘There is no reason to financially engineer and manipulate EPS [earnings per share]. This isn’t to say that they don’t have to cover the costs they have. They do. But their mission is not to maximise profits because, in almost every crypto-based organisation, they are decentralised. Every token is created equal. No matter who owns it. And every token owner gets to participate in the community.
“Yes, bigger owners get more votes, but there are not multiple classes of tokens. There aren’t VCs [venture capitalists] or founders whose tokens get priority treatment as with stocks (at least [not] that I know of), decentralised and automated completely changes the game.”
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