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Beyond Bitcoin: An In-depth Look at Decentralised Finance

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.

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 aspect of the financial services system, 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 is a range of different blockchains from the Ethereum blockchain to the Bitcoin blockchain.

The core functionality of the bitcoin blockchain is to send bitcoin tokens, but 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.

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.

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. Transaction speed 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.

 

Is a Decentralised Financial system better than a centralised financial system? 

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.

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.

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.

Decentralised cryptocurrencies, on the other hand, are essentially a two-party payment system, operating within an open, decentralized peer-to-peer (P2P) network and offering a more streamlined and efficient payment process with lower transaction fees.

Lastly, 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).

What are the opportunities for investing in Decentralised Finance projects? 

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. 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.

Intriguingly for its shareholders, Argo Blockchain has also been active in the decentralised finance sphere and recently took a 25% stake in Pluto Digital Asset’s new venture capital fund; Pluto invests in, incubates, and advises digital asset 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.

With the bitcoin price hitting new peaks on an almost weekly basis and DeFi beginning 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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