DeFi: State of Mind
“A handful of individuals control the algorithms of the world. It’s time to decentralize” Tyler Winklevoss
From gold to fiat
In 770 BC the Chinese were the first to develop the paper-based monetary system. In 600 BC Lydia (now Turkey) minted the first official coin, which was made of gold, silver, and other metals. Subsequently, with the increase in trade between nations, the need for a standard medium of exchange increased. Little by little, gold became a symbol of wealth and power, but it was not until the 19th century that it began to be used as a standard of value across the world. Between 1848 and 1855 the gold rush broke out in California in search of this precious metal; until finally, in 1944, derived from World War II and the accelerated growth of capitalism and the industry, the Bretton Woods agreements were established, where the gold standard was eliminated, using the US dollar as the international reference currency. In addition, the World Bank and the International Monetary Fund were created.
Centralization era
In 1606 the first central bank was constituted in Amsterdam, with the aim of controlling the country’s monetary policy, preserving the value of money, and maintaining financial stability. From this moment on, it is these organizations that have been in charge of setting interest rates, printing money and controlling the currency of the countries. These structures, together with their control organisms, have been the ones that have determined people’s trust in fiduciary currencies (fiat); however, there have been cases of countries such as Venezuela and Argentina, where their currency has had significant depreciations despite the efforts of these institutions, or the case of countries such as El Salvador and Hong Kong, which use the US dollar as the official currency or a currency pegged to the US dollar value in search of stability, becoming dependent of the US government and its control mechanisms.
The power of decentralization
With the rise of blockchain and crypto assets in recent years, endless possibilities have opened up towards a decentralized world. Thanks to protocols such as Ethereum, which allows to execute smart contracts automatically and safely, and the evolution of cryptocurrencies, which promise a future of accessibility of payments and global financial services, today we can imagine a future with a decentralized financial system (DeFi).
According to Binance, Decentralized Finance (DeFi) may refer to “a movement that aims to create an open-source, permission-less, and transparent financial service ecosystem that is available to everyone and operates without any central authority. The users would maintain full control over their assets and interact with this ecosystem through peer-to-peer (P2P), decentralized applications (dApps).”
The main differences between a centralized financial system (CeFi) and a decentralized one (DeFi) are the following:
The DeFi movement arises from the birth of bitcoin in 2008; however, it was not until December 2017 that the first decentralized app with relevant use was created, MakerDAO, a digital lending platform based on stablecoins. As of February 2021, the locked value (TVL) in DeFi protocols globally is USD$38.14bn, representing a growth of 3,714% compared to the value locked in February 2020 (USD$1bn).
The range of use cases that can be developed under DeFi protocols is very extensive, however, the most realistic and relevant uses that exist today are the following:
- Stablecoins: Despite not being a dApp, stablecoins are a fundamental part of DeFi. Derived from the high volatility of cryptocurrencies, these crypto assets are born, with their inherent characteristic being that they are pegged to the value of a less volatile asset (such as the US dollar), allowing users of dApps to hedge against price fluctuations and have a reliable mean for exchanging value.
There are centralized and fiat-collateralized stablecoins, such as Tether (USDT), where users have to trust an operator that allegedly holds USD$1 in reserves for every USDT$1 minted. On the other hand, there are decentralized and crypto-collateralized stablecoins, such as DAI, where at any time users can validate that the collaterals exist in crypto assets such as Ethereum (ETH) by voting on the protocol and deploying smart contracts.
- Lending: They are protocols that enable peer-to-peer crypto-asset lending (P2P), adjusting interest rates in relation to the level of demand (borrowers) and supply (lenders) that exists in the ecosystem. Most of them act as a liquidity pool in Ethereum, eliminating the friction of negotiating or matching loan terms between peers, and making them accessible to anyone who has a supported wallet and has the required collateral to operate. Some of the most widely used applications are Compound, MakerDAO and Aave.
- Crypto decentralized exchanges (DEX): Exchange protocols that allow users to trade tokens without the need to rely on a central operator, mitigating asset theft and accounts information leakage. There are two types of DEX; the first ones are based on the book value, where assets can be exchanged without having to leave the wallet in which they are stored, but depending on whether there is liquidity from the counterparty, as are dYdX and dex.blue. On the other hand, there are protocols in which the same users are the ones that provide the liquidity in exchange of commission for each transaction, for example Uniswap and Sushiswap.
Note: Platforms like dYdX or Bitmex also allow users to take long or short positions in crypto assets, enabling margin trading and leverage by taking collateral from the liquidity pool.
- Derivatives: Protocols that allow the creation of synthetic tokens that behave according to the value of underlying assets, including real assets such as fiat and commodities, and crypto assets and crypto-based indexes. In this way, it enables any user to have exposure to the exchange of these assets easily without necessarily owning them, allowing them to carry out operations with options, futures, and swaps contracts of these synthetic tokens. Some protocols in this space are Synthetix and UMA.
- Payments: Those are protocols that through digital wallets allow any user to make payments instantly, securely and without commissions. These payments can be made through cryptocurrencies, tokens, stablecoins or reward points. Some of the most popular projects in this space are Flexa, Matic Network and Lightning Network.
- Other use cases that have gained relevance through DeFi protocols are asset and investment management dApps (TokenSets), gambling and lottery-like protocols (PoolTogether) and insurance solutions (Nexus Mutual).
Although DeFi protocols are gaining traction across different financial use cases, there are still many caveats towards its adoption at a greater scale. Firstly, unlike traditional centralized finance solutions, in DeFi the identity of every user is untraceable, making it more difficult to determine the risk level of every value borrowed in liquidity pools, hence requiring for anyone looking to participate to lock the collateral themselves for the amount they want to mint or borrow, which can range from 150% in lending protocols to 750% in derivatives and DEX protocols. Another downside is the risk that still exists from hackers breaking into the codes and stealing funds locked within the protocols. Lastly, for DeFi to be widely used, it must run on top of intuitive apps and platforms, and while in many cases the protocols creators do not build the apps’ UI and UX in a user centric and friendly approach, the ability of DeFi protocols to act as lego blocks suggests the potential for multiple dApps creators treating the protocols as if they were API’s and increasing the offer of products to the public.
The great potential that DeFi represents for the financial system proposes the development of an industry that would capture trillions of dollars in assets, and in the Venture Capital ecosystem there are several funds trying to access the returns that its strengthening and development will generate. According to Simone Conti, from The Defiant, more than USD$500mm have been raised from VC investor in DeFi projects, and that amount is expected to keep growing in the coming years. The most active funds in this space are: 1kx, a16z, Coinbase Ventures, ConsenSys, DragonFly, DTC Capital, Framework Ventures, IDEO CoLab, Pantera Capital, Paradigm, Placeholder, Polychain and Union Square Ventures.
The financial services ecosystem will undoubtedly undergo a paradigm shift during the next decade, and only those with the vision and enough tenacity will be able to capture the returns of the innovation developed. It must be remembered that change is the only constant, and we are on the threshold of a world where fiat and crypto are the main contenders towards a fair, accessible, and transparent financial system for all.
Source: How to DeFi, Azmi E. et al., March 2020
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Gonzalo Soriano. VC Investor at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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