Decentralised finance, or DeFi, is one area of cryptocurrency that is garnering a lot of attention. This refers to financial services that use smart contracts, which are automated enforceable agreements that use internet blockchain technology instead of intermediaries like a bank or lawyer.

The entire value locked up in DeFi contracts has exploded from US$2.1 million to US$6.9 billion (£1.6 million to £5.3 billion) between September 2017 and the time of writing. It has climbed by US$2.9 billion since the beginning of this year.

As a result, the value (market capitalization) of all the tradeable tokens employed in DeFi smart contracts has skyrocketed. It is now around $15 billion, nearly double what it was at the start of the month. Several tokens have increased in value three or four times in a year — and some have increased far more. Synthetix Network Token, for example, has surged more than 20-fold, while Aave has increased about 200-fold. So, if you bought Aave tokens for £1,000 in August 2019, they are now worth nearly £200,000.

Maximum upheaval

DeFi, which is mostly based on the Ethereum blockchain network, is the next phase in the disruptive financial technology revolution that began with bitcoin 11 years ago. Cryptocurrency trading on decentralized exchanges (DEXs) like Uniswap is one area where decentralised applications (dApps) have taken hold. There is no corporate or other entity providing the platform; it is totally peer-to-peer.

You can now do the following with other DeFi services:

  • Using sites like Compound or Aave, you may borrow and lend cryptocurrency to earn interest.
  • Augur allows you to wager on the outcome of events.
  • Synthetix allows you to create and trade derivatives of real-world assets like currencies and precious metals.
  • Participate in a no-lose lottery on PoolTogether, where everyone receives their money back and one lucky member wins all of the interest earned in a common pot.
  • Purchase stablecoins, which are cryptocurrencies tied to the value of a specific currency or commodity. DAI and USDC, for example, are both tied to the US dollar.

Because you may stack dApps together to maximize your rewards, DeFi is frequently referred to as “Lego money.” For example, you might use your smartphone to buy a stablecoin like DAI and then lend it on Compound to earn interest.

Even though many of today’s dApps are niche, future applications may have a significant impact on daily life. For example, you will most likely be able to buy a piece of land or a house on a DeFi platform using a mortgage agreement that allows you to repay the cost over time.

What’s the big deal about this craze?

First, regulators have been behind the curve, allowing DeFi to thrive in the void. In traditional unsecured lending, for example, it is permissible for lenders and borrowers to know each other’s identities and for the lender to assess the borrower’s ability to repay the amount. There are no such criteria in DeFi. Instead, it’s all about mutual trust and maintaining privacy.

Regulators must strike a fine balance between inhibiting innovation and failing to protect society from risks such as individuals investing their money in an unregulated environment or banks and other financial institutions losing their ability to make a living as intermediaries. However, it appears that accepting change is the more sensible option — and this appears to be the case. The US Securities and Exchange Commission (SEC) made a significant step toward accepting DeFi in July when it approved Arca, an ethereum-based fund for the first time.

This is both welcome and critical, as one of the most significant barriers to financial innovation is the hostile climate generated by antiquated legislation from a bygone period. Some DeFi ventures have failed as a result of this, including significant ones like New Jersey-based Basis, which returned US$133 million to investors in 2018 after concluding it couldn’t perform within SEC restrictions.

The involvement of major players is a second cause of the DeFi boom. Many high-street banks are beginning to accept DeFi and are looking for ways to become involved. For example, as part of the Interbank Information Network, coordinated by JP Morgan, ANZ, and the Royal Bank of Canada, 75 of the world’s largest banks are testing blockchain technology to speed up payments.

Institutional investors are interested in DeFi

DeFi is being taken seriously by major asset management funds as well. Grayscale, the world’s largest crypto investment fund, is the most visible. It was handling approximately US$5.2 billion in crypto assets in the first half of 2020, including US$4.4 billion in bitcoin.

COVID-19 has the third impact. The pandemic has pushed interest rates substantially lower over the world. Some countries, such as the eurozone, have entered negative territory, and others, such as the United States and the United Kingdom, could follow suit.

In this environment, DeFi has the ability to provide far higher rewards to savers than traditional banks: Compound, for example, has been paying a 6.75 percent annualised interest rate for individuals who save with the stablecoin Tether. You not only get interested, but you also earn Comp tokens, which is a nice bonus. DeFi has the ability to open up finance for the two-thirds of people without bank accounts who own a smartphone.

Another key reason for the increase in people investing in DeFi tokens is to prevent missing out on their rapid growth. In practice, many tokens are worth nothing or nearly nothing, therefore we’re witnessing a lot of excessive excitement.

Whether we like it or not, we are on our way to a new financial system that is more liberalized and decentralized than the previous one. The essential question is how to appropriately lead its development with checks and balances that minimize dangers while spreading potential rewards widely. That is the task before of us in the next years.