Is DeFi the future of financial infrastructure and money?
During the 20th century, the USA drove the technological developments of the financial system creating the major banking powerhouses we know today. This in turn gave the United States more power than ever before to become the world’s financial centre.
Today, the infrastructure for financial applications we use day to day is very much based on these legacy financial systems and institutions. However, there is a major shift that is happening in the underlying infrastructure powering these financial applications, most notably within the decentralised finance (DeFi) space.
DeFi is a developing market sector within the intersection of blockchain technologies, digital assets and financial services. According to DeFi Pulse, the value of digital assets locked into DeFi applications grew from less than $1 billion in 2019 to over $10 billion in 2020, and over $80 billion at its peak so far in 2021. Could this mean a new era in banking and finance?
This article will provide an introduction into the new emergent area of DeFi infrastructure which is powering DeFi apps today. While it’s easy to get caught up in the hype and speculation within the space, I want to try to explain what exactly it is, the potential impact it could have on how we manage our finances and the key differences compared to traditional finance.
Using underlying blockchains and transparency by default
Unlike traditional financial applications which use core banking systems as the underlying ledgers of record, DeFi apps use blockchains as their underlying core ledger.
Compared to traditional financial applications which are all closed-source and built on top of proprietary systems, DeFi applications are typically entirely open sourced and built on top of open underlying blockchains. Traditional financial systems can be seen as opaque and run on a fractional reserve system, which are prone to market shocks. Contrast this with DeFi systems which are completely transparent and overcollateralised – allowing companies to weather downturns much more efficiently.
In order for developers to gain the trust of users, the majority of DeFi apps are completely open source – including the front end and the smart contracts themselves. In addition, since the apps all run on top of a common platform (the underlying blockchain), they are completely interoperable with each other and can be programmed to work with any other DeFi app in the ecosystem.
This is commonly referred to as the “money legos” or “composability” aspect of DeFi. All of these apps are like individual lego pieces which can be remixed to work with other lego pieces to build something new.
One of the biggest reasons why we have seen so much innovation within the DeFi space is because these apps are interoperable, and it allows the developer ecosystem to have more creative expression on the products and services they create.
Open and accessible to all
With traditional financial applications, new users typically need to go through a lengthy onboarding process, income verifications, credit checks, or even in person meetings just to be able to use or access a given financial product.
Because of these arbitrary rules, these onboarding processes can be prone to bias, including lending descrimination, denial of basic banking services, opening credit lines without consent, charging illegal fees and more.
With DeFi applications, all you need is a wallet address to interact with these systems. DeFi apps don’t ask for income verification, they don’t need credit checks and, in most cases, they don’t even need to know who you are outside of the wallet address you are using.
This is commonly referred to as DeFi apps being permissionless. If you have the funds inside your wallet for the transaction you want to do, you can do it. There are no institutions or intermediaries to stop you or deny service to you. This is one of the most underappreciated aspects of DeFi products.
Traditional fintech architectures vs. DeFi architecture
Here is a more direct comparison chart of some of the key differences between centralised and decentralised financial applications (simplified for brevity’s sake):
|Custody||Held by institution or custody provider||Held directly by users in non-custodial accounts or via smart contract|
|Unit of Account||Fiat currency||Denominated in digital asset or stable coin|
|Execution||Facilitated via intermediaries||Facilitated via smart contract|
|Settlement||3-5 business days depending on transaction, during M-F business hours||Seconds to minutes depending on blockchain, 24/7 operating times|
|Clearing||Facilitated via clearinghouses||Facilitated via blockchain transaction|
|Governance||Specified by exchanges and regulators||Governed by the protocol developers and users|
|Auditability||Authorised third-party audits||Open source code and public ledger, can be audited by anyone|
|Collateral||Transactions may involve no collateral, intermediates take on risk||Over-collateral generally required|
|Risks||Vulnerable to hacks and data breaches||Vulnerable to hacks and data breaches of smart contracts|
Potential missing DeFi infrastructure
Having said all this, DeFi apps could benefit by borrowing some of the legacy concepts, particularly in terms of compliance and consumer experience. For example, they could definitely make the front-end of these apps a much better customer experience for end users.
The DeFi space also doesn’t really have a concept of customer relationship management nor typically collects any amount of consumer data. While great from a privacy perspective, there is great value in understanding the customer better. There are security audits DeFi products do, but they feature none of the security guarantees most consumers are accustomed to in the traditional financial world. Notifications or alerts also don’t really exist at all in the DeFi space.
In terms of products, there are tools to measure blockchain activity, but not to measure engagement within DeFi applications. Most of the developers in the crypto space are building right on top of the layer one protocol itself. There aren’t any concepts of developer platforms or middleware yet.
In traditional finance, if you make a mistake, a financial institution can initiate a rollback of the transaction – this doesn’t exist at all in DeFi yet. On top of this the wallets people use to interact with DeFi apps are seen as external products. There aren’t any offerings of white label wallets to embed these directly into the apps themselves.
As such, there is still a lot to do in terms of improving the DeFi space, particularly for mainstream customer usage. But despite all of these challenges, after meeting hundreds of founders in the DeFi space and witnessing the progress these teams are making, one thing is clear to me. The pace of innovation is certainly ramping up.
About the author
Chris McCann is a general partner at Race Capital, entrepreneur and community builder. Race Capital operate as a software company who invest early in enterprise, infrastructure, fintech, middleware, artificial intelligence and more.
Prior to Race Capital, Chris founded and led the community program at Greylock Partners, a San Francisco-based venture capital firm with $3.5 billion under management which led investments in Facebook, LinkedIn, Dropbox and Coinbase, among others.