What is Decentralized Finance?

DeFi brings new opportunities to the world of finance

Disclaimer: Keiter does not endorse any of the platforms or cryptocurrencies discussed in this article.

Foundational Concepts

In 2009, Satoshi Nakamoto created Bitcoin, an open-source, decentralized, peer-to-peer network for securely and immutably sending Bitcoin to others. This occurs without the need for banks to hold and transfer funds with intermediaries like ACH Network, FedWire, or the Swift network to orchestrate the transaction between the sender’s and recipient’s banks.

Since 2009, Bitcoin’s underlying technology, since dubbed blockchain, has inspired the creation of a variety of decentralized networks with additional functions beyond the simple exchange of the underlying cryptocurrency. Notably, the Ethereum network not only allows for the exchange of its own currency, Ether (ETH), but it also has functions for Smart Contracts. A Smart Contract is an agreement, documented in a computer programming language called Solidity that is immutably saved to a blockchain. The contract automatically executes when certain criteria are met. This allows contract participants to engage with one another without an intermediary, and as a result, smart contracts are being used to disintermediate existing transactions.

Smart Contracts Example

• Let’s look at how Patreon, an existing web platform, could be disintermediated with smart contracts. Patreon connects content creators and their fans. Among the platform’s functions, it allows creators to set contribution tiers; fans contribute money to the creator in accordance with their subscription tier each month. Patreon sits in the middle of the transaction and takes a fee for providing the platform and facilitating the transactions. Patreon also censors content based on their corporate values, which might not be your values or the values of the creator whom you might want to support. A Smart Contract could replace this functionality by programmatically allowing users to contribute monthly sums, and the contract would automatically release the contribution on a schedule. It would be a censorship free, reduced fee mechanism to fund creators. In fact, Creaton (creaton.io) aims to do just that.

Decentralized Finance

Decentralized Finance (DeFi) takes the capabilities of Smart Contracts to the world of finance. DeFi efforts are disintermediating existing financial products and creating completely new financial products. Let’s examine some of the possibilities.

Insurance

Parametric insurance is an existing insurance product wherein explicit triggers define when an insurance claim is paid. The decision to payout a policy is linked to a data element rather than an actual loss. For example, a policy may provide for a payout to a business if a magnitude 7 earthquake is reported or a payout to farmer being paid in the event that rainfall in a given area did not exceed a certain amount in a given period of time. These insurance products would be a perfect candidate for DeFi.

How, you might ask, does rainfall or other real-world data make it to the Smart Contract? That’s where other blockchains called oracles come into play. Just as the Oracles of Greek mythology connected the Gods to the people, the oracles of the blockchain connect real world data to a smart contract.

DeFi Insurance Product Examples

• Take the example of the farmer’s drought insurance. An Ethiopian farmer, who might not have access to traditional insurance markets, could buy insurance in a smart contract. The contract itself would specify the oracle, and all parties to the contract therefore agree on the data source that powers the trigger. The contract states that if the rainfall in a specific geographic area is less than 5 inches between June 1 and August 30, then the farmer is automatically paid the amount of the policy.
• Another example could be for a quick payout for car insurance. A car could have a series of sensors, and if the vehicle undergoes a certain amount of G forces, the sensors send a signal to the oracle which provides the data to the blockchain, triggering a payout to provide immediate financial support.

Automating Compliance with SEC Regulations for Private Companies

Private companies who raise capital have to comply with SEC regulations such as Reg A and Reg D. These regulations define a number of requirements including requirements that identify who is permitted to own the security, i.e., accredited investors. Because of the compliance requirements, raising funds and selling shares in a private business is complex, costly, and time consuming.

Today, companies such as Securrency offer smart contract-based tools to allow entrepreneurs to automate compliance with these regulations. As a result, a company’s capitalization table would live on a blockchain rather than in a lawyer’s office.

But that’s only where the benefits begin. The token not only represents a share of a company, it also identifies the compliance rules that govern its own existence: who is allowed to own it, when a lockup period expires, disclosures, and other rules that govern where the share goes throughout its life. When paired with an identity and authentication mechanism, shares in private companies are more easily traded while complying with SEC rules. Additionally, the tokens can be configured to comply with foreign rules as well, enabling buying and selling of equities cross border, all while complying with the regulations in both jurisdictions. The technology is still young, but it is not hard to imagine a state where shares of private companies can be bought and sold in markets as easily as one can buy shares of Apple, Inc., on Robinhood.

Stablecoins

Stablecoins are cryptocurrencies that serve as a bridge from traditional finance to decentralized finance. Some common stablecoins are USDC, Tether, and DAI. One stablecoin costs one dollar. When you buy a stablecoin from the stablecoin provider, a coin is minted, and the provider holds the dollar. When you exchange a stablecoin back into a dollar, the coin is destroyed.

Stablecoins allow individuals and businesses to engage in dollar-denominated activity on the blockchain. A common use case is to capture profits of a trade without the need to convert from crypto back into real dollars, which is time consuming and expensive. So, let’s say you buy 1 Ethereum token at $2,500 and it rises to $5,000. You want to capture profits, but you don’t want to incur the fees at exchanges to convert back into genuine dollars. Instead of converting to genuine USD, you could convert it to a stablecoin which represents a dollar.

Stablecoins sound great, but there are concerns as to sufficiency of their reserves, i.e., does one stablecoin really represent one dollar in high-quality reserve assets. We know that the organizations behind stablecoins need to make money, so they are not simply keeping your $1 dollar in reserve for every one token they issue. They need to earn yield, and that is by investing your dollar in other assets, which of course creates risk. Tether especially has been the subject of much criticism. USDC, a stablecoin managed by Circle, obtains monthly examinations from Grant Thornton to provide assurances over the sufficiency of their reserves.

Stock Exchange

When you buy or sell a stock through your brokerage account, the transaction appears instantly in your portfolio, but the transaction does not actually settle for two days.  For example, if you bought Apple, Inc., stock on Monday, you would not actually have the shares until Wednesday. This is referred to as T+2 days.

Traders can run into “good faith” violations if they trade excessively with unsettled funds. As an example, let’s assume the following fact pattern and all the trades occur on the same day:

• Your portfolio is fully invested, and you have no settled cash to invest.
• Among your investments, you own a share of ABC stock
• You sell your share of ABC stock for $10. The cash at this point is unsettled.
• You then use the $10 to buy a share of XYZ stock.
• XYZ stock crashes and you sell to exit the position. You have committed a good faith violation.

It’s easy for people to commit good faith violations, especially when they don’t have margin accounts or have a fully invested brokerage and want to make some quick trades. It used to take T+5 days when actual paper certificates were shuffled around, then it was reduced to T+3, and then in 2020 it was improved to T+2.  However, with the use of tokenized assets, settlement could be near instantaneous.

Just the Beginning

When the Internet first came into common parlance in the mid to late-90s, it was impossible to predict the emergence of technologies that could only exist on the Internet. The Internet was clunky and slow, and most people at the time thought only of existing products that could be moved to the Internet. Platforms like YouTube, Facebook, and Twitter were in the minds of only a few visionaries.

In 1998, Paul Krugman, New York Times editorial writer and Nobel Prize winning Economist, famously stated that “By 2005, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.”

The examples described in this article are an immeasurably small fraction of the potential of decentralized finance. The DeFi space is exploding and predicting how the industry will take shape over the next decade is utterly futile. But we can start by thinking about how blockchain and cryptocurrency can solve current challenges and watch as the crypto-visionaries venture into the unknown to create incredible decentralized finance technologies.

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