Bernstein DeFi report Feb 2021
by Parker · 67 things on Twos
- Decentralized Finance (DeFi): Is a Crypto-driven Revolution on the Horizon?
- Even if you don't believe in Bitcoin's rise, DeFi represents different uses of the underlying blockchain technology, which has a lot broader potential
- Crypto is more institutionally accepted this time around (vs. 2017), with major financial institutions and public companies investing in crypto in some way
- DeFi (Decentralized Finance):
- DeFi is an ecosystem of mostly decentralized protocols that aim to provide many
types of financial services in a decentralized, non-governed way
- DeFi refers to the overall ecosystem of decentralized apps ("Dapps" being the colloquial for those "in the know") that aim to provide many types of financial services in a decentralized, permission-less and/or non-governed way
- DeFi is an open framework using the same base technology (the Ethereum blockchain) that
many parties contribute to
- DeFi developers and participants broadly want to recreate existing traditional financial services (lending/borrowing, exchanges, insurance, etc.) in a
- At the time of writing, there is an estimated $35B (USD) locked in DeFi applications, compared to only $1B just one year ago.decentralized way on the blockchain.
- DeFi theoretically offers a number of products (Dapps) that focus more on remaking financial services beyond just short-term trading
- Admittedly, there is still significant speculation in many subcategories of DeFi, but we think that financials and tech investors should at least be aware of this space's existence and have elementary knowledge of its potential
- DeFi Dapps currently offer a variety of financial services, including lending/borrowing and financial exchanges
- DeFi advantages/value:
- Cost reduction: DeFi essentially aims to cut out the financial institution middleman
- Speed: While speed varies by coin, cryptocurrency transfers (as done through DeFi) are broadly much faster than traditional services
- Transparency: By design, Dapps are much more transparent than traditional financial institutions. DeFi protocols are built on the public Ethereum blockchain and open for anyone to audit, and the governance is decentralized and more democratic
- Accessibility: DeFi is accessible to anyone with an internet connection, even where financial institutions and their services are not
- Ethereum:
- Ethereum is the open source blockchain platform that Dapps are built on
- Ethereum cannot be unilaterally shut down and serves as the base for Dapps and smart contracts
- Ethereum can also be used to create decentralized autonomous organizations (DAO) or issue other cryptocurrencies
- DAO is a non-governed organization that runs on code and smart contracts, operating independently and transparently, mostly without manual human involvement; at times, rulings and decisions about governance can be done democratically through DAO token ownership voting
- Dapps (decentralized apps):
- Dapps (decentralized apps) are applications built on the Ethereum blockchain, comprising the general DeFi ecosystem
- A dapp interacts with a blockchain, like for example, storing user data onto blockchain
- Dapps advantages/value:
- Open-source and transparent: Unlike traditional apps, the source code for Dapps is generally open for anyone to examine and audit
- Constantly available: Dapps should be available as long as Ethereum stays up. Dapps cannot be unilaterally taken down by their creators, in the way that standard apps can
- Decentralized and immutable: Once information is on the blockchain, it cannot be changed (a pro or a con, depending on the person). No centralized authority or person can intervene with the application
- Incentivizing: Dapps issue their own coins to incentivize those who validate records on their blockchain networks. These coins have value and can be traded, although the ideal is to use them for governance voting (they are more often used for speculation and are farmed)
- Smart contracts:
- Smart contracts are self-executing, programmable contracts between two counterparties (usually buyer and seller). The code and agreements are recorded on the blockchain, the code controls
execution, and the transaction(s) is made irreversibly
- Smart contract benefits:
- No third-party intermediaries like lawyers are required, saving money
- There is no real counterparty risk, as the code should execute in a determined way and only pay out if the event triggered actually occurs
- Smart contracts are accurate and not open to interpretation
- Gas (transaction fees):
- Gas is the transaction fee for Ethereum-based transactions and smart contract executions
- Unlike bank transaction fees, gas is determined at-cost: the computational need to execute the operation. So, the more complicated the transaction, the higher the gas cost and vice-versa
- Gas is paid in Ether
- Stablecoin: stablecoin is cryptocurrency that is pegged to a relatively
stable asset
- Fiat-backed: Many stablecoins are USD-backed, given the relative stability of USD
- Cryptocurrency-backed: These stablecoins are collateralized using cryptocurrencies like Ether
- Commodity-backed: These are less common, but stablecoin can be backed by commodities like gold and silver
- DeFi use cases:
- Lending:
- DeFi aims to disrupt this space by using smart contracts and a decentralized system of processing and validation, making bankless lending technically possible
- Compound is currently the most popular DeFi lending protocol
- The more you supply to the lending pool, the more governance tokens you get as a reward – COMP in the case of Compound
- People chasing the best rates and places to get reward tokens are referred to as yield farmers. Yield farming is likely the source of much of the rise of DeFi
- Exchanges:
- With centralized exchanges (CEX) in crypto, there are serious risks of data leaks and
theft, etc., as users give up ownership of their assets during exchanges
- Decentralized exchanges (DEX) use smart contracts, as well as on-chain transactions, to resolve the intermediary problem
- Financial products and investment strategies:
- Derivatives, securities whose values are derived from underlying asset(s), are a growing part of the DeFi ecosystem
- Derivatives allow crypto traders to access/trade contracts for underlying real-world assets, like gold and silver
- Insurance, options, asset management, payments
- Risks:
- Financial risk: The price of the underlying asset (cryptocurrency of your choice) will likely be a lot more volatile than USD
- Technical risk: This refers to the potential technical inadequacies and hacks. While the blockchain concept itself is a generally trusted technology, the Dapps on top may have weaknesses that could lead to your money being irreversibly stolen
- Liquidity risk: When using a dapp with relatively little trade volume (which most are), there are risks relating to the lack of liquidity
- Immutability: Once a smart contract goes through, it cannot be reversed. Human errors will exist when writing smart contracts, and parties may not be made whole
- Decentralization: Because of the lack of centralization in an 'ideal' DeFi world, there will be no central figure to resolve certain issues
- Lack of government support / insurance: Governments will not provide FDIC-type insurance in the case of a decentralized protocol hack
- Transparency: Open source is the heart of DeFi and much of crypto. This level of transparency allows for hackers to view the code and look for potential exploits
- If DeFi protocols safely and successfully remake the financial system, significant money will flow in, potentially leading to an unregulatable economy and substantial tax avoidance
- Even if many existing DeFi products fail, the use of the underlying technology and smart contracts structure is almost certainly useful