What is DeFi and how will it reshape capital markets

Oct 31, 2021
Financial institutions

Decentralized finance (known as DeFi) refers to a new financial infrastructure—built on blockchain technology—that allows for transparent, permissionless and borderless financial interactions in which the fees traditionally charged by intermediaries are fed back to the DeFi participants. Using distributed ledger technology and smart contracts, decentralized applications built on blockchains like Ethereum enable trustless, peer-to-peer financial transactions that remove centralized entities and intermediaries. From simple prediction markets to the tokenized factoring of trade receivables, DeFi is booming.

To understand DeFi as a whole, it’s crucial to understand the concepts of the smart contract, the token, and the exchange. This piece is the first in a series that will explain these elements of DeFi, explore their transformational potential, highlight associated risks and consider the impact DeFi may have on traditional market structure.

Core elements

The backbone of DeFi is the smart contract. Unlike the Bitcoin blockchain, Ethereum and other smart contract-enabled blockchains run like a large decentralized computer with network participants that process transactions of Ethereum’s native currency ether (ETH) and also run the lines of code for smart contracts and to power decentralized applications. Smart contracts can range from a simple “if this, then, that” self-executing contract, or they can run complex computer programs and replace centralized broker-dealers.

Tokens, another key element of DeFi, are created and managed with smart contracts. They allow for assets other than ETH to be traded on top of the Ethereum network. Tokens come in many different flavors, from utility tokens that operate as a form of payment within their own unique ecosystem to tokens that intend to represent an asset in the physical world.

One example of the latter is stablecoins, which are central to the DeFi ecosystem. Most commonly pegged to the dollar, stablecoins can maintain their peg through centralized reserves held by the issuer or programmatically with a smart contract. Over the past 18 months, the market cap for stablecoins tied to the U.S. dollar has grown from $5 billion to over $100 billion, according to Coin Metrics. In a mid-July meeting of the President’s Working Group on Financial Markets, Treasury Secretary Janet Yellen stressed the need for a U.S. regulatory framework for stablecoins. The working group “expects to issue recommendations in the coming months,” according to the Treasury Department.

The third piece of critical infrastructure for the DeFi economy is the exchange. DeFi has largely replaced the functions of centralized entities with smart contracts. With a decentralized exchange (DEX), a smart contract operates the platform and enables the trading of tokens. The largest DEX, Uniswap, launched in November 2018 and its trading volume grew from $330 million in June 2020 to a peak of $83 billion in May 2021, according to data from CoinGecko and The Block.  

DeFi’s growing impact

The use of DeFi is growing at a rapid pace. The share of DEX trading volume compared to centralized exchanges has risen from 1% in January of 2020 to over 9% as of June 2021, according to CoinGecko data. Another sign of growth is that the gross value of assets locked in Ethereum smart contracts has swelled from $845 million on June 1, 2020, to $57.1 billion one year later, data from DeBank and The Block shows. DEX trading volume was $162.5 billion in May, but that number is a drop in the bucket compared to the $10.9 trillion in U.S. equities trading volume for the same month, according to data from Cboe.  

DeFi is also rapidly expanding beyond lending and exchanges. The recent rise of non-fungible tokens has broadened DeFi into the world of collectibles and art trading. DeFi is also expanding into more complex financial instrument markets as well, from derivatives, futures, and swaps to complex platforms enabling the tokenization of factored trade receivables.

The question remains as to whether DeFi can continue its rate of capital inflow. While attention from traditional capital market participants is likely to fuel continued DeFi growth, in order to maintain its exponential rate of growth DeFi will need to overcome some of its traditional limitations. 

One criticism of DeFi has been its inefficient use of capital; historically most decentralized lending apps have required 150% to 200% overcollateralization. Newer platforms such as Liquity are offering stablecoin loans with as little as 110% collateral. Uniswap has even recently launched a new version of its app to allow liquidity providers to make their capital available within specific price ranges rather than among all possible prices, thus enlarging their percentage of the liquidity pool within their specified price range and allowing them to earn more in terms of trading fees.

What to do?

It is difficult to gauge whether DeFi will ultimately become a significant disrupting force to the traditional capital market structure. Given its rapid growth, it is likely worth some level of attention, and those active in the current capital market structure will likely see some effects from this growth. Continued education on more advanced DeFi topics may yield insights and opportunities to leverage this innovation into a first-mover advantage. Those with just a passing interest may want to simply stay alert for news coverage of DeFi trends, and evaluate when a more serious study may be necessary.

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