Decentralized Finance

Decentralized Finance (DeFi) is likely to have a significant impact on how banks operate in the future – and even has the potential to shift the structure of the whole financial system at a macroeconomic level. Before we discuss and substantiate this hypothesis, we would first like to introduce the core concept of DeFi.

Decentralized Finance or “DeFi” in short, is an umbrella term encompassing the vision of a financial system that functions without any intermediaries, such as banks, insurances or clearinghouses, and is operated just by the power of smart contracts. DeFi applications strive to fulfill the services of traditional finance (also coined as Centralized Finance, or just CeFi) – but in a completely permissionless, global and transparent manner.

The vision of a new financial system accompanies the blockchain space since its inception. However, while it has been an aspirational dream for the blockchain community in the past, the vision of a new financial system has come some steps closer.

Since 2020, DeFi is growing at an astonishing pace and billions of USD have been put in the ecosystem. The growth is mainly led by applications (also denominated as protocols) that are built on the Ethereum blockchain. In the following, we give an overview of the actors in the DeFi ecosystem from an economic point of view, introduce the maturity stages of DeFi and explain the potential of DeFi to outperform the traditional finance system in the years to come.

The primary business model of commercial banks is to accept deposits and to give loans to its clients. Borrowing and lending are an elementary cornerstone of an efficient financial system as holders of funds get an incentive to provide liquidity to the markets and in exchange earn a return on their otherwise unproductive assets.

DeFi protocols enable for the first time to borrow or lend money on a large scale between unknown participants and without any intermediaries. Those applications bring lenders and borrowers together and set interest rates automatically in accordance with supply and demand. Moreover, those protocols are truly inclusive, as anybody can interact with them at any time, from any location, and with any amount.

In fact, the recent hype around DeFi applications is largely driven by the advancement of borrowing and lending protocols, such as Compound. In contrast to traditional finance, loans in DeFi are commonly secured by over-collateralization. However, companies such as Aave are currently working on enabling uncollateralized loans similarly to traditional finance.

So-called stablecoins are based on blockchain protocols that have the principle of price stability inherently encoded and, thus, fulfill the function of a reserve currency. The introduction of stablecoins set the foundation of the functioning decentralized financial system, as they enable participants to engage with each other without the underlying risk of price volatility. There are three options how a cryptocurrency can reach price stability.

First, stablecoins can reach high degrees of price stability by pegging a currency to other assets. For example, for each issued unit of USD Coin a real US Dollar is held in reserve.

From a decentralized finance perspective, another interesting approach is the issuance of stablecoins by using other cryptocurrencies as collateral. A central protocol for the Defi ecosystem is Maker DAO, which issues the cryptocurrency DAI that is backed by other cryptocurrencies and ensures with its algorithm that the value of 1 DAI is hovering around the value of 1 US Dollar.

Thirdly, there are more experimental approaches that aim to reach price stability without the use of collaterals. For instance, the protocol Ampleforth automatically adjusts the supply of token in accordance with demand.

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