DeFi: the future of finance explained

An explainer by Finematics covering the future of decentralized finance (DeFi), comparing it to the current financial system, exploring the problems DeFi solves, its growth metrics, and whether it has a chance to create a parallel financial ecosystem on Ethereum.

This transcript is an accessible copy of the original video transcript (opens in a new tab) published by Finematics. It has been lightly edited for readability.

A century of financial innovation (0:00)

The financial system that we know today went through decades of technological advances. The earliest attempts to make finance more efficient started as early as the 1920s with the introduction of accounting machines and punch cards. This was followed by the rise of mainframe computers that significantly sped up the banking system in the 1950s and beyond.

The next revolution was the invention of ATMs and credit cards, which started being popular in the 1970s. Also in the 1970s, another important element of the financial system — the stock market — started going through a radical transformation. Manual order entries and loud trading pits started being slowly replaced by computers and algorithms.

From the 1990s, thanks to the growing adoption of the internet, the computerization of finance got supercharged. Accessing bank accounts, making wire transfers, buying stocks — all of these operations were now possible from the comfort of our own houses.

Then comes the fintech revolution. PayPal, Robinhood, TransferWise, Revolut, and other fintech startups understood the tech-first approach known from other non-financial tech companies and offered their users seamless access to financial services — a completely different experience when compared to the clunky banking user interfaces.

Problems in traditional finance (2:09)

Despite a century of innovations, the financial system is far from being perfect:

• Settlement of stocks, bonds, and other financial instruments takes days to clear and requires a massive amount of human capital involved in the process
• Key decisions impacting millions, if not billions, of people are made behind closed doors by a group of privileged few
• Billion-dollar banking scandals surface months if not years after the fact
• Massive inefficiencies and high costs when it comes to international banking and remittance services
• Unequal access to financial services, with billions of unbanked people across the globe
• Banks hiring thousands of employees just to keep maintaining inefficient processes and being compliant with ever-changing banking regulations
• A super-high barrier to entry for new players, making it almost impossible to start a new financial company without access to a massive amount of capital, stifling innovation

The whole financial infrastructure consists of siloed systems built with proprietary technologies and algorithms that each company has to build from scratch. The beautiful user interfaces provided by fintech companies only cover the fact that the financial system is built on old and inefficient foundations. Something that seems instant for the user can take days to fully process behind the scenes. On top of that, the backbone of the financial system hasn't evolved much since mainframe computers were introduced.

This is exactly why we need something new — something better that can address some of these problems.

What is DeFi? (3:58)

This is where decentralized finance comes into play. Instead of relying on old and inefficient infrastructure, DeFi leverages the power of cryptography, decentralization, and blockchain to build a new financial system. A system that can provide access to well-known financial services such as payments, lending, borrowing, and trading in a more efficient, fair, and open way.

• Efficient — all operations are settled almost immediately, regardless of counterparties being in completely different geographic locations with inconsistent laws and regulations. Most DeFi protocols can operate with no or minimal human involvement.
• Fair — all services are completely permissionless and censorship-resistant. Permissionless, as everyone with a browser and an internet connection can access them. There is no document verification, no need to provide income statements. Nationality or race doesn't matter — everyone is treated in the exact same way. Censorship-resistant, as no other parties can deny us access to these services. Even multiple bad actors cannot change the rules of a sufficiently decentralized system.
• Open — everyone can build a new DeFi application and contribute to the ecosystem. In contrast to traditional finance, new applications can leverage existing protocols and build on top of existing solutions. On top of that, everything is transparent and visible on the blockchain — trading volume, number of outstanding loans, total debt — all of these can be reliably checked on the blockchain. Even better, these numbers cannot be tampered with.

All of this is possible thanks to the invention of Bitcoin and Ethereum and their underlying technologies. In particular, Ethereum as a smart contract platform allows for creating any arbitrary financial applications. Because of these characteristics, Ethereum became the go-to blockchain for the vast majority of DeFi activities.

DeFi growth metrics (6:18)

Decentralized finance has recently been experiencing tremendous growth. Some of the key metrics:

Total value locked (TVL) — this represents the value of all tokens locked in various DeFi protocols such as lending platforms, decentralized exchanges, or derivatives protocols. This number has grown from less than one billion dollars in April 2020 to over 32 billion dollars in February 2021.

Trading volume across decentralized exchanges has grown from around half a billion dollars in April 2020 to over 50 billion dollars in January 2021 — a 100x increase.

Total value settled on Ethereum reached over one trillion dollars in 2020, more than PayPal.

This is not only limited to cryptocurrencies, which can be quite volatile. Stablecoins that track the value of fiat currencies such as the US dollar also experienced tremendous growth in the DeFi ecosystem. The market cap of USDC, a popular stablecoin in DeFi, went from less than one billion dollars in April 2020 to over six billion dollars in 2021. DAI went from less than 100 million dollars in April 2020 to almost two billion dollars in 2021.

Real-world problems DeFi solves (8:00)

To understand the value proposition of decentralized finance even better, let's go through a few common problems in traditional finance and see how they can be addressed in DeFi.

The famous GameStop saga: after discovering that GameStop stock (GME) was overly shorted by some hedge funds, users of a popular Reddit group, WallStreetBets, started buying GME as they believed this could initiate a short squeeze. At some point, Robinhood and a few other stock brokers came up with the controversial decision to disable the possibility of buying GME and a few other stocks. A situation like this just wouldn't be possible on a decentralized exchange like Uniswap. There's no one who can disable or alter the trading capabilities of the platform. There is no single authority making decisions on behalf of the users. DeFi democratizes access to trading.

This situation exposes another problem: decisions made behind closed doors. A group of people deciding to shut out trading, or a bunch of bankers deciding what the best interest rate is for millions of people. In DeFi, interest rates are adjusted automatically based on the supply, demand, and risk parameters of certain assets that are configured by the protocol. Even if some DeFi lending platforms allow for changing certain risk parameters, all decisions are publicly visible and changes are voted on by multiple people who govern the protocol.

What about paying 10 to 30 percent of the value of a bank transfer just to send money across the globe? In DeFi, you can send USD-based stablecoins for a fraction of that cost. Even better, they'll arrive in a matter of seconds. With the settlement of different assets measured in seconds instead of days, the counterparty risk is dramatically reduced.

Accounting — every record is publicly available on the blockchain, so accounting becomes super easy and can most likely be completely automated. This can dramatically reduce the human capital needed.

Equal access to financial services — a DeFi protocol doesn't care who you are. It just follows predefined rules that are exactly the same for everybody.

Challenges of DeFi (10:48)

Although DeFi presents us with a unique value proposition, it comes with its own challenges. It brings more responsibility to the users, who are now truly owning their assets and have to make sure they store them in a secure way. There is not a lot of handholding here, especially when interacting with new DeFi protocols.

There are still certain regulatory risks. Although things like KYC or AML cannot be enforced in the DeFi protocols themselves, regulators may try to force wallet providers or dev teams responsible for certain protocols to add KYC requirements to their user interfaces.

Scaling is another issue that has to be tackled. The popularity of DeFi resulted in tremendous demand for block space on Ethereum, which in turn results in high gas fees for users. It's not uncommon to hear about 10-dollar or even 50-dollar Uniswap transaction costs. Scaling is already being tackled by Eth2 and layer 2 scaling solutions.

Hacks are another challenge of the DeFi space, making certain protocols — especially new ones — risky. Various DeFi protocols are also exploring different governance models, but whales and voter apathy are some of the common problems.

Uncollateralized loans and mortgages are big areas of traditional finance that are slightly harder to implement in DeFi. Fortunately, there are already protocols like Aave exploring different possibilities, such as credit delegation and tokenized mortgages.

The future of finance (12:38)

Despite the challenges, DeFi is a unique zero-to-one innovation, and sorting out some of these challenges is just a matter of time. So what will happen to traditional finance if DeFi keeps innovating and growing at this tremendous pace?

Traditional finance will have to adapt quickly, otherwise they are taking a risk of slowly becoming irrelevant. Like with all other big technological changes, they often happen gradually, then suddenly. We'll probably very quickly see some of the incumbents trying to tap into the possibilities of DeFi — for example, by leveraging liquidity or accessing more favorable interest rates in DeFi protocols. This will most likely start with fintech companies that are already involved in crypto, but it wouldn't be surprising to see banks using DeFi in a few years' time.

There are also a lot of areas of traditional finance that can significantly benefit from moving into DeFi in the future. As an example, instead of going public on the stock market, companies could issue security tokens and take advantage of globally accessible liquidity. On top of this, people investing in these tokens could lend them out and make an extra yield on their investment, or use them as collateral for taking a loan.

It's also very likely that DeFi will become the new backbone of the financial system. With simple user interfaces, most people will probably not even know they're using it, similar to how they don't know what is happening under the hood of their traditional trading application. At that point, DeFi will just become finance — more efficient, fair, and open finance.