Decentralized finance — DeFi for short — is a hot topic in the cryptocurrency space. But is there real substance behind the hype? What exactly is DeFi and why does it matter?
Today’s financial system is built on capital flow and data flow, but financial capital and data must still pass through highly centralized institutions like banks, which introduces risks and inefficiencies. In a DeFi world, blockchain technology can help move capital and financial data in a decentralized fashion, eliminating many of those inefficiencies and risks.
Let’s look at this system in more detail.
Remaking the traditional financial system
What is capital flow? The most simple example is making a payment. When you buy something at a store, your payment will go from your bank account into the merchant’s bank account, perhaps via a third party like a credit card company. A more complex example of capital flow is investment, where money flows from a securities account into the trading market.
In today’s financial world, capital flows within institutions. But what if these financial institutions were replaced by application layers on a blockchain? Various financial functions — like issuance, custody, payment, lending, asset management, trading, insurance and sales — can be delegated to corresponding functional protocols on the blockchain and put together in various applications. In other words: instead of needing banks to perform these functions for us, they can be performed by automated systems.
When capital flows, there is always data flowing in parallel. At the most basic level, when you want to open a bank account, you need to show identification. When an institution wants to invest or raise funds, it will conduct legal and financial due diligence research on the other party. All of these activities result in data generation and storage.
In the context of finance, stored data might include a person’s identity, background, purchasing power, behavioral characteristics, and social network. Similar sorts of data are generated about companies and other organizations in the context of the financial agreements that these institutions make with each other. This data can be used as a basis for providing credit to individuals or evaluating an investment in an institution.
In other words, the entire financial system is based on data flow and capital flow. But in the traditional financial system, the transfer channels are relatively inefficient, making the transfer of capital and data rather difficult. Funds are constantly moving between different regions or financial institutions, often with delay times and/or fees. Meanwhile, customers have to constantly provide the same background information to different financial institutions. Isolation between institutions and regions hinders data and capital flow, giving rise to price premiums and information asymmetry.
Blockchain technology can help solve these problems. Money can be moved almost instantaneously to anywhere on earth via blockchain. And data can be stored and processed on a blockchain, too. That’s the basic argument for DeFi.
Now, let’s take a closer look at how a decentralized financial system operating on a blockchain (or blockchains) might work. When imagining a fully realized DeFi system, we can split its basic functions into three basic “layers” of system architecture: the underlying layer, the protocol layer and the application layer.
The underlying layer refers to the public chain and decentralized storage. The functions of an underlying public chain are similar to the clearing, supervision, and information storage functions that are performed in the traditional financial system. But because they are on the blockchain, transactions are public, anyone can supervise and verify transaction veracity. This layer is also the carrier of protocol layer and application components.
The basic protocol layer can be further divided into financial protocols and data protocols, which respectively would govern capital and data flow through the system. These are essentially the “rules” of how capital and data move through the blockchain system, and since they’re transparent and executed automatically, they could likely produce much faster regular transaction times than traditional financial systems, particularly for international transfers and other more complex transactions.
The application layer would consist of various financial applications, such as exchange gateways, capital lending platforms, wallets, exchanges, etc. But the key is that these applications could be built and modified easily with access to modularized protocols from the protocol layer. A lending application, for example, could make use of existing finance protocols on the chain to quickly and easily handle transfers, as well as existing data protocols on the chain to confirm loan applicants’ identities.
These protocol modules would be freely distributed in the DeFi ecosystem for app builders to choose and access according to their needs. For example, a decentralized exchange could be implemented by combining existing wallet protocols, lending protocols, escrow protocols, and exchange protocols.
When fully realized, the implications of this will be significant. In this more open ecosystem, building products that serve users’ needs will be simpler. Power over the system will be decentralized, public, and easily supervisable. It should result in a financial system that is faster, and cheaper and overall better for users, as well as lead to new kinds of financial instruments.
We stilll have a way to go before reaching a system with this level of sophistication, however. The data protocol layer in particular is still in the early stages of development, and there are some major obstacles that will need to be overcome before the gigantic mountains of data collected by traditional financial institutions can be effectively and efficiently implemented into the blockchain.
The financial protocol layer contains stablecoins, wallet protocol, exchange protocol, asset management protocol, lending protocol, escrow protocol, etc. Solutions for all of these functions exist, but a unified system that makes them all fully modular isn’t yet ready for primetime.
The application layer is in a similarly early stage, in large part because of a lack of open-source protocols. Though most applications are building their own protocols to serve themselves, their protocols haven’t been verified by the community due to the lack of open-source code, team limitations, and the overall nascent market.
Most existing DeFi applications are also still fairly centralized due to their relatively small early-adopter networks. And subjectively speaking, they’re also often poorly implemented, with difficult user experiences and generally underdeveloped products.
That’s to be expected for a nascent technology like blockchain. The dream of a cohesive, modular DeFi system that’s ready to replace traditional finance is still a work in progress. There’s a lot of work to do, but we shouldn’t give up. DeFi has the potential to disrupt the financial industry at every level.
Rin Huang is Vice President of Fenbushi Capital (which is an investor in LongHash).