Decentralized Finance DeFi-ned

With the launch of Ethereum 2.0 approaching and Ethereum’s recent fifth anniversary, it is only fitting that our Blockchain, Cryptocurrency and Digital assets team look at the biggest  topic in the blockchain space at the moment: Decentralized Finance, or DeFi. In simple terms, DeFi is a financial ecosystem of decentralized applications (DApps) built on the Ethereum blockchain network. Originally termed “open finance”, the DeFi system is independent from the centralized, legacy financial system. Although in its early stages, DeFi already has $4 billion of value locked in it. In this article we consider what it means to have globally accessible, permissionless and trustless financial services available at the scroll of a finger without any centralized, intermediary involvement.

What can be done with DeFi?

The possibilities are virtually endless. There might be a time when every financial service currently offered by institutions is adapted for the cryptosphere, although it may take a while before laws and regulations adapt. The most popular current examples of DeFi include:

• Banking services: providing mortgages and underwriting;
• Borrowing and lending: e.g. lending cryptocurrencies and earning interest on them; depositing crypto as collateral and borrowing against it;
• Decentralized marketplaces (like Uniswap and DeversiFi): trading digital assets directly without the need for a centralized exchange due to the use of smart contracts; and
• Issuing stablecoins, a new class of cryptocurrencies backed by reserve assets that offer price stability.

Why is DeFi so revolutionary?

• DeFi services and transactions are globally available and transparent.
• DeFi removes the need for reliance on central banks and governments.
• DeFi allows increased access to financial services to those currently excluded from the financial system whether due to their physical location or resources.
• DeFi does not rely on third-person intermediaries, such as banks and arbitrators, since users interact with each other on peer-to-peer (P2P) networks.
• DeFi is not managed by a company and its employees. DeFi runs on the basis of smart contracts deployed on the blockchain, designed to be self-executing and require minimal to no human intervention.
• Anyone can create a DApp and anyone can use them.
• New DApps are interoperable with other DApps, much like piecing legos together.
• All that is needed to participate is an internet connection, a device and a cryptocurrency wallet.

As with any computer code however, smart contracts are not always invincible. Some DApps are still in beta testnet mode and are not (yet) insurable against cyberattacks or programming errors.

Yield Farming & Liquidity Mining

Any exploration of DeFi cannot ignore the current buzz around two new DeFi concepts, “yield farming” and “liquidity mining”. Yield farming describes earning a return on capital by lending crypto assets out on DeFi protocols such as Compound or Aave. Users providing liquidity earn interest and other rewards as a result. The “farmer” might also receive a new token in exchange for providing that liquidity, hence ‘liquidity mining’. Token holders are granted governance rights over the protocol and ultimately receive a percentage of protocol fees.

Both concepts seem to be largely responsible for the recent surge of interest in DeFi. However, some commentators are urging caution regarding the long-term sustainability of  investors ‘yield chasing’ which has fuelled recent DeFi token price growth.

The future of DeFi

DeFi is still a long way from the mainstream but undoubtedly has the potential to replace, even if only partly, centralized financial infrastructures and shift power to individual users and investors. Not every use case will benefit from decentralization and only time will tell how successful the DeFi revolution will be. In the meantime, watch this space and join the growing London DeFi Network, chaired by our Senior Associate, Allan Murray.

If you have any questions about DeFi regulation or if you require any legal assistance, contentious and/or transactional, in the field of blockchain, cryptocurrencies, smart contracts or digital assets, please contact our Senior Associate, Allan Murray via email at  allan.murray@ilaw.co.uk  or our Trainee Solicitor, Mariya Lazarova at mariya.lazarova@ilaw.co.uk. None of the above constitutes financial advice.

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Useful links:

https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4

https://defipulse.com/blog/what-is-defi/

https://academy.binance.com/blockchain/the-complete-beginners-guide-to-decentralized-finance-defi