BY DR SOHA MAAD
Introduction
Decentralised Finance DEFI is threatening the future of banks. This article overviews DEFI, its historical evolution, its various technologies, applications, and ecosystem. Following this overview, the article establishes a comparison between Decentralised Finance DEFI and Centralised Finance CEFI. The article presents the opportunities and risks of DEFI, and DEFI regulation framework. The article analyses DEFI global impact and reflects on the future of DEFI. The article concludes with recommendations for Arab banks to build capacities to get around with DEFI complex technology and leverage the opportunities brought by decentralised finance whilst containing risk and avoiding misuse.
What is DeFi?
DEFI stands for Decentralized Finance, a blockchain-based form of finance that does not rely on central financial intermediaries to offer services. Instead, it utilizes smart contracts on blockchains.
A smart contract is an automated code that runs on the blockchain and cannot be changed. Transactions happening in a smart contract are processed by the blockchain without any third-party intermediary.
As such, DEFI is a collective term for financial products and services, built on blockchain technologies, in the public blockchain space. It is an open and global financial system. DEFI promises greater control and visibility and gives wider exposure to global markets and alternatives to local currency and banking options. With DEFI, there is no centralized authorities who can block payments or deny user access to anything.
DEFI HISTORICAL EVOLUTION
Cryptocurrencies witnessed a history of innovation that goes back to the 1980s, with advancements in cryptography. A series of events have shaped the crypto space. The first cryptocurrency, Bitcoin, was the most prominent. Despite its spectacular growth in the past 12 years, mainstream institutions did not accept a Bitcoin loan because of its significant price volatility. This makes Bitcoin a poor asset to plan any investment accurately. Things changed quickly in the crypto space, and decentralized finance (DEFI) is the emerging current trend.
Historically, central authorities have issued currencies that underpin economies and gave them more power as more people began to trust them. However, trust has been broken from time to time, which questioned the centralized authorities’ ability to manage money. DEFI was developed based on the idea of creating a financial system that is open to everyone and minimizes the need to trust and rely on a central authority.
The launch of Ethereum and, more specifically, smart contracts, in 2015 made DEFI possible. The Ethereum network is a second generation blockchain that encouraged businesses and enterprises to build and deploy projects that formed the ecosystem of DEFI.
DEFI brought a plethora of opportunities to bring about a transparent and robust financial system that no single entity controls. The turning point for financial applications started in 2017, with projects facilitating more functionalities in addition to money transfer.
Financial markets can enable great ideas and drive the prosperity of society. However, power in these markets is centralized. When people invest in the current financial system, they relinquish their assets to intermediaries, such as banks and financial institutions. This keeps the risk and control at the centre of these systems.
Historically, bankers and institutions failed to see risks in the market, as in the case of the 2008 financial crisis. When central authorities control money, risk accumulates and endangers the system as a whole.
Bitcoin and early cryptocurrencies, which were initially developed to give individuals complete control over their assets, were only decentralized when it came to issuance and storage. However, providing access to a broader set of financial instruments remained challenging, up until the emergence of smart contracts that enabled DEFI.
DEFI has grown into a complete ecosystem of working applications and protocols that deliver value to millions of users. Assets worth over $30 billion are currently locked in DEFI ecosystems, making it one of the fastest-growing within the public blockchain space.
DEFI TECHNOLOGies
DEFI technologies include:
- Blockchain: DEFI consists of applications and peer-to-peer protocols developed on decentralized blockchain networks that require no access rights for easy lending, borrowing, or trading of financial tools.
- Ethereum network: Most DEFI applications today are built using the Ethereum network, but many alternative public networks are emerging that deliver superior speed, scalability, security, and lower costs.
- Smart contracts: DEFI utilizes smart contracts on blockchains. Smart contracts are automated enforceable agreements that do not need intermediaries to execute and can be accessed by anyone with an internet connection.
- Token: A token represents a set of rules encoded in a smart contract. Each token belongs to a blockchain address. It is essentially a digital asset that is stored securely on the blockchain. Tokens are most often known to be cryptocurrencies such as Bitcoin or Ether tokens. However, they can be anything from votes to licenses to ownership of a song.
DEFI applications
There are several applications of DEFI. DEFI platforms allow people to lend or borrow funds, speculate on price movements using derivatives, trade cryptocurrencies, earn interest on funds, and more. DEFI applications revolve around the functions of providing peer-to-peer or pooled lending and borrowing platforms, enabling DEXs (Decentralized exchanges), tokenization, and predictions markets. Below is an overview of the most popular DEFI applications and protocols available in the market today:
DEFI lending and borrowing: DEFI gave finance a new direction by enabling lending and borrowing. Widely regarded as ‘Open Finance’, decentralized lending offered crypto holders lending opportunities to gain annual yields. Decentralized borrowing allowed individuals to borrow money at a specific interest rate. The aim of lending and borrowing is to serve financial service use cases while fulfilling the needs of the cryptocurrency community. Top DEFI lending and borrowing platform is Compound Finance. Launched in 2018, Compound Finance project is a lending protocol developed on the Ethereum blockchain that allows users to gain interest by lending out assets or to borrow against collateral. The Compound protocol makes this possible by creating liquidity for cryptocurrencies through interest rates set using computer algorithms. Users of Compound earn interest by depositing cryptocurrencies. Once cryptocurrencies are supplied on the Compound platform, users can use them as collateral for loans. $COMP is the token for Compound protocol. It is a token used by its holders to suggest and implement development changes to Compound protocol. Changes include: selecting which digital assets to support; adding modifications to how $COMP tokens are distributed; and adjusting collateralization factors to the platform.
Decentralized exchanges: Decentralized Exchanges (DEX) are one of the essential functions of DEFI, with the maximum amount of capital locked compared to other DEFI protocols. DEXs allow users to exchange or swap tokens with other assets, without a centralized intermediary or custodian. Traditional exchanges (centralized exchanges CEX) offer similar options, but the investments offered are subject to that exchange’s will and costs. The extra cost on each transaction is another negative aspect of CEXs, which DEXs address. The top decentralized exchange is Uniswap. Founded in 2018, UniSwap is the largest automated token exchange by trading volume deployed on the Ethereum blockchain. The project was launched after receiving grants from multiple capital ventures, including the Ethereum Foundation. UniSwap automated transactions between cryptocurrencies through smart contracts. UniSwap today offers three functionalities: swapping tokens, adding liquidity, and removing liquidity. For swapping tokens users are required to create an account on Metamask to utilize this service. Once a Metamask account is created, users can select tokens they own to swap for another type of cryptocurrency. To provide liquidity, users deposit an equivalent value of tokens into the token’s associated exchange contract. Once users have tokens for liquidity, they can add them to a “pool” on the UniSwap interface. Users who provide liquidity on UniSwap earn exchange fees, calculated per the value of tokens offered for liquidity. $UNI is the governance token of UniSwap. The token was launched in September 2020 and was awarded to anyone who has used Uniswap.
Stablecoins: Stablecoins are a viable solution to volatility issues surrounding cryptocurrencies and are helping DEFI gain prominence. Stablecoins’ value is tied to a relatively stable asset, like gold or the United States dollar, in order to keep its price consistent. Stablecoins became useful during risk-off moments in the crypto space, providing a safe venue to investors and traders. Stability makes them a reliable collateral asset. Stablecoins also play an important role in liquidity pools which is an integral part of the DEFI ecosystem and DEXs.
MakerDAO: Founded in 2015, MakerDao is an organization building technology for savings, borrowing, lending, and a stable cryptocurrency on the Ethereum blockchain. The project was one of the earliest DEFI protocols. Maker protocol tokens are $DAI and $MKR. $DAI is created by locking a cryptocurrency in the Maker protocol. $DAI is used like any stablecoin. It can be traded against other digital assets or used to make purchases.
Prediction markets: Predictions markets are platforms where individuals can make predictions on the realization of future events, ranging from sports or politics to predictions on stock prices and more. DEFI opens these markets for participation. The concept of decentralized prediction markets has long been touted as a possibility through smart contracts. The top prediction market is Augur. Augur is a decentralized prediction market platform. The DEFI platform Augur uses Ethereum to harness the “Wisdom of the Crowd” to create real-time predictive data. The first version of Augur was released in 2015. Augur offers you two primary actions:
- Market creation: Users can create an Augur market by spending some amount of Ethereum. When creating a market, users need to set the taker fees and maker fees, which should be low enough to incentivize people to bid and high enough to cover the Ethereum cost.
- Trading Events Shares: Users can buy or trade shares. Traders can make money by buying positions at a low cost and selling them when the price goes up. People who predict an event correctly will also receive rewards when the market closes.
Augur token is $REP (reputation token). $REP is an ERC-20 token used on the Augur platform to create a prediction market, purchase participation tokens, or dispute an outcome. As the name suggests, $REP represents token holders’ reputation in the market. For any action that requires tokens, users stake their reputation.
Asset management: Another class of service offered by DEFI is asset management. It intends to make investing faster, less expensive, and more democratized. Ampleforth is an asset-management protocol of DEFI designed to be synthetic and smart commodity-money.
DEFI ECOSYSTEM
The launch of Ethereum paved the way for maximizing the potential of DEFI within the financial industry thereby encouraging the businesses and enterprises to build and deploy projects that formed the ecosystem of DEFI. With DEFI, a plethora of opportunities bring to reality a transparent and robust financial system. Overall, DEFI offers services, including borrowing, yield farming, crypto lending, asset storage and a lot more.
No exchange is involved in the decentralized exchange. The complete process operates via automated applications that are developed on top of blockchain platforms. Also, decentralized finance creates a fair and transparent financial system where anyone can participate. It allows unbanked people to access financial and banking services via blockchain technology.
DEFI aims to build an open-source, permissionless and transparent financial service ecosystem.
DEFI vERSUS CEFI
Traditional financial services such as payments, lending and borrowing were only available via established financial institutions and banks. But this has been transformed with the introduction of blockchain technology. When the concept of cryptocurrency started expanding, the discussion has shifted to a new set of considerations involving decentralized finance (DEFI) and centralized finance (CEFI).
Before DEFI was introduced, Centralized Finance CEFI was the standard for trading cryptos. It handled a stronghold over the cryptocurrency industry. In centralised finance CEFI, all crypto trade orders are handled through a central exchange. Moreover, the exchange identifies which coins they list for trading or how much fees traders need to pay to trade with their exchange.
Centralized entities run CEFI services like centralized crypto exchanges. Most CEFI service providers tend to abide by regulations outlined by the local authorities where they operate. These regulations make it mandatory for centralized financial institutions such as exchanges and trading platforms to implement Know Your Customer (KYC) and Anti Money Laundering (AML) practices.
The main idea behind a centralized exchange is that all the crypto trading orders are routed through a central exchange in centralized finance CEFI.
In Centralized Finance CEFI, users do not own their cryptocurrencies when buying and selling via a centralized exchange. Moreover, they are subject to the rules a centralized exchange imposes on them.
In Centralised Exhange CEX (the traditional cryptocurrency exchange such as Binance, Kraken or Coinbase), users send funds to the exchange to manage them within an internal account. Though funds are stored on the exchange, they are kept outside of users’ custody and are vulnerable to threats in case the security measures of the exchange fail. As a result, centralized exchanges have been the target of various security attacks.
Both Decentralized and Centralized Finance aims to achieve the same goal. They aim to make crypto trading popular and improve the trading volume. However, the way these two ecosystems carry out their objectives is different.
CEFI promises security of funds and fair trade on those funds. Investors with conventional currency can also take part in crypto trading. Moreover, CEFI exchanges provide them with customer support services that DEFI services do not offer.
On the other hand, DEFI intends to make the space intrusion free. It provides a space for investors to implement their strategies without having to deal with an intermediary entity.
Both DEFI and CEFI deliver a wide range of cryptocurrency-related financial services. In terms of features and financial services they offer, there are many similarities between CEFI and DEFI. There are also significant differences between them:
- Regulation: One of the biggest differences between decentralized finance and centralized finance is the fact that the system is regulated in case of CEFI whereas exactly the opposite is the case with DEFI. In centralized finance, the responsibility of safeguarding the money of the users is with the exchanges. On the other hand, the assumption behind DEFI is that the transactions would be successful as a result of smart contracts. In simple terms, the users are themselves responsible for managing their own funds and activities.
- Centralization: In a centralized finance environment, exchanges or trading platforms are owned by a single entity or often a corporation. They provide a variety of services to make crypto more accessible to their customers. However, centralized exchanges are in charge of everything including onboarding users and setting up ground rules. DEFI applications, on the other hand, aim to decentralize ownership and become community-owned.
- Permission: In centralized finance, users must sign up and submit to KYC (Know Your Customer) regulations. This is intended to prevent criminal activities like money laundering and abide by crypto regulations. In DEFI, as long as you have a non-custodial crypto wallet, you do not have to submit to KYC or sign up for an account. In CEFI, it is possible to prevent trade and impose limitations on users. However, the same is not possible in case of decentralized finance. Decentralized finance is permission-less whereas it is not the case with CEFI.
- Trust: In centralized finance, users have no other choice but trust exchanges and other centralized apps with their assets. In DEFI, users never have to trust anyone with their assets if they want to trade them using a peer-to-peer swap or anything. With DEFI, users trust that the technology will perform as proposed to execute on services being offered. On the other hand, with CEFI, users trust a business’s person to manage funds and execute the business’s services.
- Asset Control: In DEFI, users have full control over their assets and own the key pair for their wallet. Moreover, users who participate in DEFI use decentralized applications (dApps) built on the blockchain platforms to access DEFI services. In CEFI, centralized companies and institutions store client funds in their custodial wallets. These crypto wallets store users’ private keys. In return, these services provide customers with different services. Cryptocurrency trading is currently one of the most common solutions enabled by centralized finance.
- User preferences: If users prefer transparency and privacy, DEFI is the right model to choose. On the other hand, if the user priority is trust, sharing of risks, flexibility and increased options to invest, they should opt for CEFI.
Table 1 highlights differences and similarities between DEFI and CEFI.
|
DEFI |
CEFI |
|
|
Funds Custody |
The user has complete authority over funds custody. |
Outside of user’s custody |
|
Services available |
Borrowing, Lending, Payments, Trading |
Trading, Borrowing, Fiat-to-crypto, Payments and Lending |
|
Personal Information |
Proof of Work |
Pluggable Framework |
|
Security |
Not accountable for funds. |
Vulnerable in case of security bridges on the exchange. |
|
Market Cap |
$16 billion* |
$324 billion* |
|
Customer Service |
NA |
Provided by major changes. |
|
Risk Factor |
Security relies on the technology you are using. |
Centralized exchanges are responsible for security. |
Table 1. CEFI versus DEFI (source: Consultancy guide from CEO of leewayhertz)
DEFI ADVANTAGES
DEFI offers several benefits compared to traditional financial services. Using smart contracts and distributed systems, deploying a financial application or product is less complex and more secure. DEFI movement is shifting traditional financial products to the open-source and decentralized world while facilitating financial freedom worldwide and removing the need for intermediaries, reducing overall costs, and significantly improving security. DEFI advantages are:
- Permissionless: Users do not require permission to use DEFI. Users can directly access the services using a wallet and without providing personal information or depositing money with DEFI. This is because DEFI is openly accessible to all parties, without any barrier or discrimination. Moreover, individuals who plan to build on top of a decentralized platform can do that freely. It provides a high degree of accessibility and supports collaboration within the community. Products developed within the DEFI ecosystem are designed to benefit from each other. That is why, DEFI products are also known as money Legos.
- Trustless: The most significant benefit of using DEFI services is you do not need to trust that the service will perform as promoted. Users can authenticate that DEFI services perform as intended by auditing their code and using external tools such as Etherscan to identify if a transaction was correctly executed.
- Quick Innovation: Another significant advantage of DEFI is its quick rate of innovation. The Decentralized Finance Ecosystem is constantly building current capabilities and experimenting with new capabilities. The build-centric nature of the DEFI space has transformed into a rich ecosystem embedded with ground-breaking financial services.
· Efficiency: Removing intermediaries causes less friction and makes processing a financial transaction more fluid.
· Costs: In traditional finance, the intermediaries governing transactions are taking fees that are generally higher than the ones you currently pay on DEFI apps.
· Open and democratic system: According to the 2017 Global Findex report, worldwide, there are about 1.7 billion adults that are unbanked, meaning they are excluded from the financial system. With DEFI, users do not necessarily need to have a bank account to access financial tools, they only need an internet connection. If users meet the conditions of smart contracts, they will have exactly the same access to various products (loans and insurance, derivatives, and crowdfund).
DEFI RISKS
DEFI entails various risks including:
· Bugs in the smart contracts: Since smart contracts are immutable, if you have an error in the code, it will be repeated over and over again.
· Cyberattacks: Hackers can find breaches in DEFI contract code and exploit it for their own benefits.
· Volatility: DEFI is highly volatile like cryptocurrencies.
· Complexity: It is difficult to understand DEFI projects and to pick which ones to invest in due to the complexity of the technology.
DEFI regulation
DEFI is a rapidly-growing part of the cryptocurrency market that promises to deliver traditional financial products like loans and savings accounts without involvement from regulated middlemen as in the case of banks.
But regulators are increasingly concerned about platforms offering DEFI services that may not be as “decentralized” as advertised.
Decentralized finance could get split into regulated and unregulated segments.
DEFI has been loosely defined as a global ecosystem of web applications and eWallets that leverage smart contracts stored on public blockchains, instead of relying on centralized intermediaries like banks, stock exchanges or brokers.
China has essentially banned the use of DEFI and private digital assets, and Russia is debating whether to take a similar approach.
The Bank for International Settlements is concerned that there is a “decentralization illusion” in DEFI.
Until recently, regulators have largely ignored this emerging parallel financial system.
DEFI protocols might appear out of regulatory reach. Copies of blockchain transaction history are stored in nodes all over the world.
Historically, regulators have only held purview over legal entities within their jurisdiction. This changed with the Foreign Account Tax Compliance Act (FATCA) of 2010, which saw United States authorities regulating beyond their currency and coordinating with other jurisdictions by signing intergovernmental agreements (IGAs) for enforcement.
The European Union EU followed a similar approach with the General Data Protection Regulation (GDPR) in 2018, writing regulations from their ivory tower to control the data of Europeans wherever they are in the world. Though it remains unclear how authorities can enforce against organizations outside the EU.
There is opportunity for the appropriate level of regulation to give DEFI enough breathing space to make a difference, boosting transparency, increasing financial inclusion and enabling credit to unbanked people.
DEFI has the potential to create fairer, more transparent and more liquid markets through completely new mechanisms, helping everyone to reduce fraud and front-running, resolving fragmentation and creating markets that are efficient, resilient, fair and equally accessible to all.
Defining the right regulation could make or break DEFI. Given such an opportunity to rebuild finance from the ground up, regulators should put clear objectives.
DEFI presents several opportunities. However, it also poses important risks and challenges for regulators, investors, and the financial markets. While the potential for profits attracts attention, sometimes overwhelming attention, there is also confusion, often significant, regarding important aspects of this emerging market.
DEFI regulation should address various issues including:
- Transparency: Although transactions often are recorded on a public blockchain, in important ways, DEFI investing is not transparent
- Pseudonymity: A second foundational challenge for DEFI is that these markets are vulnerable to difficult to detect manipulation. DEFI transactions occur on a blockchain, and each transaction is recorded, immutable, and available for all to see. But that visibility extends only down to a certain identifier. Because of pseudonymity, the blockchain displays the blockchain address that sent or received assets, but not the identity of the person who controls it.
- Identity: Without an efficient method for determining the actual identity of traders, or owners of smart contracts, it is very difficult to know if asset prices and trading volumes reflect organic interest or are the product of manipulative trading.
DEFI GLOBAL MARKET AND IMPACT
Decentralised Finance (DEFI) has experienced tremendous growth since mind-2020. While it is still in its early days, DEFI has shown that decentralising financial services at scale is possible.
One of the biggest idea of using blockchain technology to reinvent the finance space lies in how the market can become permissionless and open to anyone. A further attraction is the concept of composability, which means anyone can mix and match any existing DEFI offering to build a new one. The composability of such a network, effectively made of blocks of interlocking components, also means that newer innovations and needs in the finance space can be easily built on top of the network and plugged together, with everything being governed by smart contracts.
Industry experts and media outlets have begun to report that DEFI may “kill banks” or at least reshape the financial industry as we know it.
Almost $90 billion has already been deposited into Ethereum-based DEFI protocols. Some outlets are also reporting that DEFI’s growth on the Ethereum blockchain is up 780% in 2021 according to a study by JP Morgan.
FUTURE OF DEFI in the arab world
Arab banks, government and regulation authorities should build capacities to understand the complexity of DEFI and leverage the opportunities while supporting innovation in areas related to distributed technology and finance.
There is a quantum leap in the new possibilities of the functionalities of money through the innovation of distributed technologies. This is shaping the global financial system.
The DEFI space is gradually catching up with the traditional financial system and despite some of the obstacles which are certain while operating on the bleeding edge of innovation, the world of decentralized finance is on the path to prosperity. Over time, it is difficult to predict how this space will shape when the power to build financial services will democratize.
In recent years, an array of macro and technological trends are contributing to the exponential growth of DEFI. Whether in the form of decentralised exchanges, lending and borrowing of different asset types or through insurance products, DEFI is evolving and expanding swiftly to mirror the traditional financial services ecosystem. This new form of decentralised financial technology may eventually have an impact on the future of centralised finance entities in the Arab world, with DEFI potentially being seen as an alternative that is cheaper, quicker and more relevant.
References
Euronews, blog.liquid, analyticsinsight.net, leewayhertz, .coindesk, seekingalpha, techcrunch,, netguru, hedera; PwC Switzerland, pymnts.com/blockchain, CNBC, techcrunch, United States Securities and Exchange Commission, Wikipedia, Investopedia.
