DeFi & Crypto: A Deeper Dive into Decentralized Finance

DeFi & Crypto: A Deeper Dive into Decentralized Finance

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Investing in Bitcoin and cryptocurrency-related companies was once regarded as something of a joke, conjuring up images of teenagers posting memes on social media in their own lingo, replete with phrases like “HODL” and “To the Moon”. As the advantages of a decentralised and immutable form of money become more apparent, mainstream usage and institutional acceptance of cryptocurrency has gathered pace, with Wall Street stalwarts like the Bank of New York Mellon and BlackRock announcing plans to offer Bitcoin services in 2021.

It is all too frequently overlooked that Bitcoin is just one use-case of blockchain technology. In fact, there are wide uses for blockchain technology within the financial system: transferring money is just one of many types of financial services, which also includes lending and borrowing, decentralised exchanges, insurance, margin trading, and derivatives.

At their core, decentralised finance projects aim to create an interlocking financial system denominated in digital currencies, offering a wide array of lending and derivatives products available globally, peer-to-peer and without any middlemen.

How Does Decentralised Finance (DeFi) Work?

Blockchain is the open and distributed digital ledger technology that underpins Bitcoin. What makes this blockchain technology so valuable is its inherent malleability: it is possible to modify the programming of the blockchain software (since it is open-source) to give different blockchains different properties. There are a range of different blockchains from the Ethereum blockchain to the Bitcoin blockchain.

Functionalities of Blockchain Technology

The Bitcoin blockchain is meant to send Bitcoin tokens, alternatively, the programming language of the Ethereum blockchain, enables developers to build and run a range of distributed applications. The reason for this is that the programming language of Ethereum, Solidity, allows for the writing of advanced smart contracts.

Both of these applications of blockchain technology are separate and unique in their own way, and yet they are tethered by the same principle core function, to enable the peer-to-peer settlement of a transaction between parties without the use of third party intermediaries.

The Power of Smart Contracts

Smart contracts are essentially pieces of code that can be executed automatically in a deterministic way. The purpose of smart contracts is to remove the element of human decision-making from contracts.

The power of smart contracts can be illustrated by the following analogy which compares smart contracts with traditional contracts:

Let’s say that Maria and Dom both have 10 tokens and they agree that, if Maria sends Dom her tokens, then Dom must send Maria his tokens (so that they effectively swap tokens). In the traditional financial system, Dom and Maria would need to set up an escrow contract with a third party. When the transaction was enacted, the third party would collect the tokens from Maria and wait for the same number of tokens from Dom before sending Maria and Dom their respective swapped tokens.

By contrast, the smart contract method is fully automated and deterministic without the need for third parties so that both parties receive their coins as soon as the criteria for the transaction is fulfilled.

Smart Contracts Are Fueling the DeFi Revolution

Developers have harnessed these properties of smart contracts to initiate a range of DeFi projects. The MakerDao protocol, founded in 2015, was one of the first DeFi projects and aims to disintermediate the entire process of lending and borrowing, one of the pillars of the financial system. The protocol allows users to lock in some collateral (in the form of Ethereum’s native cryptocurrency ETH) and in return generate DAI, a stablecoin that by using certain incentives follows the price of the US dollar. The more ETH that is locked up, the more DAI can be generated. When users are ready to unlock their ETH, which serves as collateral for their DAI loan, they simply pay back the loan along with any fees. In this way, MakerDao provides a stable and decentralised alternative to the centralised system of lending and borrowing.

Other projects include Nexus Mutual which uses Ethereum and smart contracts to allow people to share risk together without the need for a centralised insurance company. Users buy tokens using ETH to purchase cover as well as participate in claims assessment, risk assessment and governance. All funds raised from token purchases belong to members. This replaces the idea of a traditional insurance company because it is wholly owned by its members.

It is important to note that these DeFi projects remain early-stage products with limited uses and performances issues.

The Ethereum Blockchain is Not Perfect But It's Getting Better

Transaction speed and costs, also known as "Gas Fees", on the Ethereum blockchain, for example, can be slow when the network is busy which can be detrimental to user experience. The fact that blockchain is an open-source platform means that Ethereum is a highly developed ecosystem with thousands of developers building new and improved DeFi applications every day.

One such improvement is layer-2 Ethereum which aims to improve Ethereum’s scalability and speed issues by handling transactions off the main Ethereum chain (layer 1). Nor is Ethereum the only blockchain to support smart contracts: the Cardano blockchain, the EOS blockchain and the Tron blockchain protocol all support smart contract functionality and have emerged as competitors to the Ethereum blockchain. It is clear, then, that the DeFi space, still very much in its infancy, is a hugely, exciting fast-growth industry with enormous unrealised potential.

Decentralized vs. Centralized Financial System Analysis

The analogy of the use of smart contracts in Dom and Maria’s transaction which was discussed earlier demonstrates some of the advantages of a decentralised financial system that runs on blockchain.

Using Smart Contracts in Lieu of Traditional Escrow Contracts

Firstly, the traditional escrow contract arrangement is wholly reliant on trust in the third party: theoretically, there is no guarantee that the third party will not steal the tokens after receiving funds from Dom and Maria. The centralised financial system relies on the reputation of intermediaries such as banks or payment processors (and the people who run them). However, given the existence of technology that bypasses the need to trust these institutions, it is questionable whether this is desirable or necessary any longer.

A Decentralised Financial system that relies on smart contracts rather than trusted intermediaries is also theoretically far less susceptible to fraud. Smart contracts on the Ethereum blockchain have the property of immutability: once transactions have been verified by network nodes through cryptography and recorded on the blockchain, they cannot be erased or altered. Immutable transactions make it impossible for any entity (for example, a government or corporation) to manipulate, replace or falsify data stored on the network.

Smart Contracts & Peer-to-Peer Settlement is Blazing Fast

A decentralised financial system is potentially much faster and more efficient than a centralised financial system, provided that the scalability teething problems discussed above can be ironed out. Looking back at the Dom and Maria analogy, Dom and Maria may well have to wait up to a few days to settle the transaction of the tokens using a traditional contract system. Indeed, both Bacs Direct Credit and Direct Debit payments work on a three-day cycle.

Payments are submitted to Bacs on the first day, processed by the banks on the second day, and simultaneously taken from the sender account and credited to the recipient account on the third day. By contrast, using smart contracts the transaction can theoretically be cleared instantaneously (depending on the speed and efficiency of the network).

Reducing The Cost of Financial Services

Another advantage of the DeFi system is that it is cheaper for consumers. The intermediaries within the financial system all charge fees to consumers for their services.

Take decentralised cryptocurrency as an example. In the centralised financial system, fiat payment networks operate on some variation of the four-party scheme, whereby parties enter into an agreement with a card scheme owner (such as Visa), which mediates payment between senders and receivers. The main beneficiaries of the system are the payment providers, (Visa, Mastercard etc.), who charge the financial institutions a fee based on gross dollar volume of account holder activity and charge the merchant a fee for using the network.

Alternatively, decentralised cryptocurrencies offer a two-party payment system utilizing an open and transparent blockchain to record and verify a peer-to-peer (P2P) transaction.

Decentralized Finance Promises a More Equitable Society With Greater Access to Financial Services

As referenced above, the benefits of utilizing decentralized cryptocurrencies go beyond its simplicity and efficiency. It is often said, bank fees are a tax on the poor, the people in society that suffer most from financial hardship take on an disproportionate level of fees when weighed against their income and assets. Thereby acting as a disincentive to the most marginalized members of society.

At its core, the promise of decentralized finance and blockchain technology is to provide a means for innovation to create a more equitable, inclusive, and egalitarian society where anyone regardless of their circumstances has access to the same financial services as those in the upper echelons of society.

How to Invest in Decentralized Finance & Blockchain Technology

The Market Capitalization of DeFi Projects Are Growing Exponentially

According to an article written by Forbes on March 3rd, 2021 titled "What’s The Big Deal About DeFi And How Do You Invest In It?"

The DeFi industry has grown rapidly in recent years, growing from $700 million in December 2019 to $13 billion by December 2020 and reportedly reaching $40 billion in March with over 20X growth in just 11 months.

In addition, investment from mainstream investors such as the American venture capital funds Andreessen Horowitz and Bain Capital Ventures have added further credibility to the nascent industry.

Alternative Approaches to Investing in DeFi & Blockchain Technology

Despite the credible risk to the core function of the their business, Bank of America actually holds the most live blockchain related patents in the space. It's not the first time we've seen institutions at risk of their business model being disrupted start to buy up patents on technologies that quite literally pose an existential threat.

Big Oil Companies in the 1960's and 1970's secured patents to potentially disruptive technologies such as energy efficient batteries and CO2 scrubbers that may have lead to a very different world than we live in today had they been allowed to potentially develop. As a defensive measure, the Big Oil companies bought up all the cutting edge patents and technologies to control and defend their influence on public policy on fossil fuels.

Despite the fact that Bank of America is one of the most iconic symbols of centralized authority in the banking system, they are either ahead of the curve or working on a sinister plan to snuff out innovation.

Argo Blockchain Invests in Pluto Digital Asset's

Inline with Argo's strategic capital investment plan, Argo has made good on their goal to invest in potentially disruptive decentralized finance and blockchain technology companies. Argo's 25% stake in Pluto Digital Asset's new venture capital fund, provides the company exposure to projects with the goal of furthering the decentralized finance (DeFi) ecosystem.

In light of the enormous growth potential within the DeFi space, this is particularly important for blockchain technology. Whilst Bitcoin – as just one aspect of the DeFi space – could theoretically fail and be replaced by a superior blockchain-based cryptocurrency or a state-backed digital stablecoin, the overall DeFi space and the inherent advantages of a financial system operating on blockchain are on stable ground. For a blockchain technology company to focus solely on Bitcoin mining would be equivalent to a football team focussing on just one player rather than the whole team.

As DeFi continues to gain mainstream institutional acceptance, the future looks bright for DeFi and the companies who operate within the space. In the words of the businessman extraordinaire and former CEO of Apple John Sculley, “The future belongs to those who see possibilities before they become obvious.”

Blockchain is the future of the financial system!

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William Ross is a Cambridge University undergraduate interested in cryptocurrency, blockchain, and all that the fintech space has to offer.


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