There’s been a lot of hype, buzz, skepticism, confusion, and excitement around decentralized finance aka “DeFi,” the ecosystem of blockchain-enabled products and services that replace traditional financial intermediaries with freely accessible, autonomous, and transparent software.
While it’s still early days for DeFi (just a couple years in), its associated economy is already large and consequential: Ethereum, the backend infrastructure for DeFi, settled about $1.5 trillion in transactions last quarter, or 50% of Visa’s payment volume; decentralized money markets are issuing billions of dollars worth of loans every month; and individuals and businesses are using platforms like the Uniswap protocol to trade volumes roughly 30% the size of Coinbase’s. [Disclosure: I work for Uniswap Labs, which helped invent the protocol.]
Since there’s so much interest in this trend from entrepreneurs, corporate leaders, policymakers, and institutions big and small, I will try to explain the features and benefits of DeFi, outline some challenges ahead, and consider the road to mainstream acceptance and adoption.
But first, what made it all possible?
DeFi builds on three major waves of blockchain innovation across the last decade, each of which began with deep skepticism and has since progressed to acceptance and adoption.
The first era was defined by Bitcoin (invented in 2009), which gave us the distributed ledger, or blockchain, designed to facilitate peer-to-peer transfers of a non-sovereign digital asset. The second wave was defined by Ethereum, which drew from the same underlying distributed, censorship-resistant architecture: however, unlike Bitcoin, Ethereum’s native programming language (Solidity) can be used to create any conceivable application, transforming it into a globally accessible supercomputer. The third wave was the initial coin offering boom of 2017, which financed a range of projects, some of which have started delivering on their promise of a decentralized financial ecosystem.
DeFi is the fourth wave, and it builds on a combination of these innovations.
With DeFi, anyone in the world can lend, borrow, send, or trade blockchain-based assets using easily downloadable wallets without having to use a bank or broker. If they wish, they can explore even more advanced financial activities — leveraged trading, structured products, synthetic assets, insurance underwriting, market making — while always retaining complete control over their assets.
DeFi protocols abide by key criteria — in particular, permissionless-ness and transparency — reflecting values found in Ethereum, the open-source decentralized software platform that forms the infrastructure for most decentralized applications.
“Permissionless” speaks to both end consumers and developers: DeFi applications can serve anyone in the world with an internet connection, regardless of ethnicity, gender, age, wealth, or political affiliation. Additionally, any set of developers can confidently build upon these platforms, knowing that no central authority has the ability to revoke access in the future.
“Transparent” refers to the inherently auditable nature of DeFi platforms: Because the software is always source-available or open source, all underlying code is perpetually available for review, and all associated capital is open for audit. The transactions are all recorded on a blockchain, which enables easy review of particular transactions or building businesses exploring the data for investment (or even investigative) purposes.
DeFi’s two foundational qualities — permissionless-ness and transparency — translate to multiple, powerful use cases.
The permissionless nature of Ethereum-based applications — with the ability to freely and seamlessly “fork” (or copy and adapt) codebases — collapses barriers to entry for entrepreneurs down to zero. End consumers are the primary beneficiaries of this innovative environment: Because all applications share the same database (the Ethereum blockchain), moving capital between platforms is trivial. This forces projects to ruthlessly compete on fees and user experience.
A relevant example here is the rise of “exchange aggregator” applications: Using public APIs, these aggregators tap into multiple liquidity venues, splitting orders across platforms to provide end users with the best possible exchange rate. In just a matter of months, such aggregators have accelerated DeFi’s journey to best execution, a standard which required formal regulation for early electronic markets to converge upon.
Contrast DeFi’s competitive markets with consumer banking as it exists today, where opening and closing accounts can take three days. Or compare DeFi to the brokerage business, where transferring securities between different platforms takes up to six business days and numerous phone calls. Coupled with other onerous terms, these are the “switching costs” that discourage consumers from taking their business elsewhere, even with the pain of inferior services. Indeed, to the detriment of retail consumers, traditional finance is moving in the diametrically opposite direction, with the number of bank charters declining at an annual rate of 3.6% since 1990, limiting consumer choices.