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What’s behind the buzz about “decentralized finance”?

Matthew De Silva
Server racks at CERN, the European Organization for Nuclear Research.

Many in the crypto community believe the world’s traditional financial system is broken. Sending money to family and friends costs too much. So does trading stocks and taking out loans. And, perhaps worst of all, only a select group of people, known as “accredited investors,” are allowed to bet their money on early-stage startups, thereby exacerbating economic inequality.

Although companies like Robinhood and LendingClub have pressured incumbent financial firms to reduce their fees, crypto proponents argue the financial system itself hasn’t changed—at least not yet. They believe “decentralized finance,” or DeFi for short, is the best way forward.

What is decentralized finance?

DeFi is more of a concept than a specific thing. It’s a loosely defined collection of ideas to reshape banking, lending, and derivatives. As with bitcoin, the key is removing the middlemen.

Brendan Forster, co-founder and COO at Dharma, a crypto lending service, explained DeFi to Quartz as “the idea that financial services can be 10x better than they are today. DeFi is more global, more accessible, and more transparent than traditional financial services,” he wrote. “Whereas Wall Street [provides] financial services where the ultimate ‘settlement layer’ is courts and legal proceedings, DeFi [provides] financial services where the ultimate settlement layer is code.”

In essence, by putting financial services on a blockchain, DeFi advocates say these systems can become faster, cheaper, and globally accessible. DeFi might be described as the internet of money. To paraphrase Facebook CEO Mark Zuckerberg, if we can email virtually anybody in the world, why can’t we send them money as easily? Or offer them a loan? These are simple questions with broad implications, as Forster, an ex-employee of Microsoft and Uber, discussed at the Fluidity Summit in New York earlier this year:

Who supports DeFi?

Proponents of DeFi espouse utopian visions of a future without the fees and frictions of the current financial services industry. “[W]e are seeing things like hedging, shorting, derivatives, and more, all built on a decentralized platform where there are no intermediaries, no clearinghouses, and the need for trusted third parties is much less, sometimes not at all,” wrote Fred Wilson of Union Square Ventures in March. “I do not think DeFi will be the only thing that blockchain/crypto is good for. I think we will see blockchains scale in the next few years to allow mainstream consumer applications to be built. But until then, DeFi is a good place to hang out. It uses all of the same technologies, architectures, and value systems that we have come to know and love in crypto.”

Facebook, too, is take a step toward decentralizing finance through Libra, its proposed cryptocurrency. Venture capital firm Andreessen Horowitz is betting on Libra, as well as other DeFi projects, including MakerDAO and Compound Labs.

What are DeFi’s limitations?

There is plenty of money pouring into DeFi companies, but few have offered workable products.

In action, the services to date have been underwhelming. Bancor, one DeFi project, raised $150 million in three hours in 2017. Two years later, there’s just $8 million of daily trading volume on its platform, a far cry from what it imagined during the crypto market’s heyday. Bancor also isn’t available to US customers anymore, apparently due to “increased regulatory uncertainty.”

Meanwhile, loans through MakerDAO require overcollateralization (ie, pledging $300 of ether to borrow $200 of Dai, another crypto). The combination of interest rates and “stability fees” on the system is also very complicated and subject to change, making the system somewhat impractical.

Is DeFi really that popular?

In short, no. Although there is a vocal contingent of staunch believers, demand for crypto loans appears to be on the downswing.

For all of DeFi’s shortcomings, it would be premature to write it off completely. The economics are shaky, the networks are too slow, and nobody’s sure how to make the most of it. But DeFi applications could still serve as the foundation of a fully fledged alternative, digital economy. Regardless of whether it ultimately succeeds, the DeFi movement is worth keeping an eye on because it represents a frustrated and growing group of people demanding a fairer financial system.

MARKET WATCH

Crypto derivatives mount a comeback. Bakkt, a subsidiary of Intercontinental Exchange (ICE), plans to launch futures contracts settled in bitcoin starting next month. The first contracts begin September 23, and will provide investors the opportunity to bet on (or against) the price of bitcoin in daily and monthly increments, according to a blog post by Bakkt CEO Kelly Loeffler.

In contrast to cash-settled bitcoin futures, offered by CME Group, ICE’s contracts will be physically settled, meaning buyers can receive actual bitcoin when contracts expire. This will mark the first time a major US exchange deals with crypto directly. ICE’s futures also inject new life into digital asset derivatives, after Cboe backed away from its (cash-settled) offering in March.

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BITS AND PIECES
  • The future of decentralized finance (Linda Xie)
  • Facebook’s Libra in focus as US group visits Switzerland (Bloomberg)
  • The right response to the Libra threat (Project Syndicate)
  • Facebook’s Libra currency gets European Union antitrust scrutiny (Bloomberg)
  • Terrorists turn to bitcoin for funding, and they’re learning fast (New York Times)
  • IRS to cryptocurrency owners: come clean, or else! (WSJ)

Please send news, tips, and high-interest crypto loans to privatekey@qz.com. Today’s Private Key was written by Matthew De Silva and edited by Jason Karaian. Hope is being able to see the light despite all the darkness.

 

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