In the crypto space, few buzzwords get thrown around quite as often or as readily as “decentralized finance,” which some believe has the potential to disrupt—and potentially supplant—the traditional centralized financial system enjoyed by today’s big banks.
Below, we define decentralized finance, compare it against traditional financial services, and explore the technology that makes it possible. We also take a look at the potential benefits that it has to offer and walk through a number of ways that interested investors can potentially invest in the space.
What is decentralized finance (DeFi)?
Decentralized finance (also known as DeFi for short) is a term used to refer to a wide variety of next-generation financial services that are built on a public blockchain and dependent on smart contracts to function.
Because DeFi is built on a blockchain, it is considered to be a peer-to-peer system. This means that the functions traditionally carried out by a central authority (such as a bank, broker, or other third party) are instead facilitated directly between individuals. With DeFi, it’s possible to bank, borrow, lend, trade, and make payments—all while enjoying the security, speed, transparency, and other benefits offered by blockchain technology.
Centralized Finance vs. Decentralized Finance
To better understand just what makes decentralized finance so potentially powerful, it’s first important to understand the way that centralized finance works.
In a centralized financial system, like the one most of society operates within today, it is very difficult to engage in the system without needing to go through one or more intermediaries, which sit between individuals. These middlemen include central banks, which are responsible for printing money and controlling monetary supply; corporate banks, which hold your money (and provide other services like lending); brokerages, which facilitate trading; payment processors, which process and facilitate transactions; and others.
With the exception of central banks, all of these third-parties are corporations. That means that their primary goal is to earn a profit. How they do so varies, but it often boils down to charging a fee for the service that they provide. A bank may charge a monthly service fee for a checking account, for example; a brokerage, a trading fee, etc.
It’s also possible to be charged twice for the same service. Credit card companies, for example, often charge customers an annual membership fee. At the same time, they will typically charge merchants each time they must process a transaction. Often, these transaction fees are passed on to the customer in the form of higher prices—meaning that the customer has been charged multiple times simply for the privilege of accessing their money.
In a decentralized financial system, these intermediaries do not exist. DeFi aims to allow individuals and businesses to transfer money directly from one party to the other without needing to rely on one or more middlemen to process the transaction. This means that a DeFi ultimately aspires to allow private individuals to buy, sell, trade, lend, borrow, save, invest—and more—free of the fees, regulations, and restrictions inherent in a centralized system.
What makes DeFi possible?
In the current, centralized financial system that exists today, banks and other intermediaries do serve an important role as guarantor during a transaction. This builds trust in the system, which is a requirement—especially for a digital or cashless society.
In DeFi, this trust is facilitated by technology instead of organizations. For this reason, DeFi is sometimes known as “trust-less banking.” Three primary pieces of technology make this possible: Blockchain, smart contracts, and cryptocurrency.
Blockchain and DeFi
Blockchain is, at its heart, a ledger or database that is used to record transactions and other data. But whereas a traditional database is stored in a central location such as a server or computer file, a blockchain is distributed.
Multiple copies of the blockchain exist, spread across multiple nodes of a computer network. When a transaction is made and recorded to the blockchain, it must be verified and recorded by each of these nodes so that they are in agreement with each other. As a part of the verification process, these nodes also ensure that the transaction being recorded does not conflict with any previous transaction already recorded.
Because the database is distributed, it is incredibly difficult (if not impossible) to alter a record once it has been entered into the blockchain. This provides a high level of security against potential fraud or abuse. The blockchain is also secured and encrypted through cryptography, adding to its security.
The security, immutability, and transparency inherent in blockchain essentially serves to replace the trust that is normally placed in the central banking system. This allows individuals to transact directly with one another without needing to go through an intermediary.
Currently, the Ethereum blockchain network has the greatest number of DeFi projects built on top of it. According to State of the dApps, Ethereum has just under 3,000 applications (as of April 27, 2022) integrated into its network, nearly 800 of which are in some way related to financial products or services.
That being said, there are many other blockchains capable of hosting decentralized applications, including those like Solana (SOL), Cardano (ADA), and other so-called “Ethereum Killers” who hope to one day supplant Ethereum as a primary platform for DeFi.
Smart Contracts and DeFi
A smart contract is a program or piece of code that exists on a blockchain and which facilitates transactions. Once the predetermined conditions coded into the smart contract are fulfilled (for example, a certain amount of money being transferred to an account) then the program automatically executes itself.
Smart contracts allow for the development of decentralized applications, or dApps, that integrate with a blockchain—including many DeFi projects. These applications play an important role by making it easier for the end user to interact with the blockchain. As with blockchain, they work to replace the trust that is normally placed in traditional intermediaries like banks.
Cryptocurrency and DeFi
A cryptocurrency is a digital asset like a token or a coin, which is secured by cryptography and which lives on or integrates in some way with a blockchain. Bitcoin, Ether, Ripple, Cardano, and Solana are all examples of well-known cryptocurrencies, though thousands of others also exist.
Cryptocurrencies can be used in a number of different ways. One of their primary use cases, and the main reason they were originally conceived, is to replace fiat currencies (like dollars or Euros) for digital transactions. When they are used in this way, cryptocurrencies become a store of value which are passed between parties who conduct a transaction.
Cryptocurrencies are also often required as payment to access a blockchain’s network. For example, if an individual wanted to conduct a transaction on the Ethereum network, they would need to pay a “gas fee” in ETH. Exactly how much would depend on how demanding the transaction was on the network’s resources, and how many other transactions were currently pending elsewhere on the network.
Investing in Decentralized Finance
If you’re bullish on the prospects of decentralized finance disrupting the financial industry, you might be wondering: How do I get started investing in the DeFi space? As with blockchain and Web 3.0, there are multiple ways that you can potentially do so.
You could, for example, invest directly in specific DeFi projects by purchasing the tokens those projects issue. But because the space is so young, and because there are currently so many different DeFi projects in various stages of development, there is no way of truly knowing which of these projects will have staying power and which will be a flash in the pan. While there is potential for a very small number of these projects to become winners over the long term, many experts believe that the vast majority of these projects will eventually fail to gain traction or otherwise fold.
As mentioned above, most DeFi projects are layer-2 applications built on top of a blockchain, which typically issue their own cryptocurrencies. With this in mind, it’s possible to invest in the underlying infrastructure of DeFi as a whole by purchasing select cryptocurrencies which allow for DeFi development.
Ethereum is currently the most popular layer-1 blockchain for DeFi project development. Other platforms like Solana, Cardano, and Avalanche (amongst others) are also gaining in popularity. Additionally, Bitcoin, at its heart, facilitates a decentralized payment network that cuts out middlemen such as transaction processors. With this in mind, an investor might choose to invest in a basket of cryptocurrencies that enable DeFi development.
Finally, it’s also possible to gain exposure to the DeFi space by investing in the stocks of established financial institutions—such as banks, credit card companies, and transaction processors—as it is believed by many that these businesses will eventually evolve into the DeFi space through product development or acquisition.
Here at Allio, we believe that cryptocurrency has exciting potential to help build the infrastructure of tomorrow’s technological and financial ecosystem but currently as an asset, doesn’t have the regime in place to drive its price up. Bitcoin, due to its limited supply could come into high demand if the global financial system ever experienced hyperinflation. Rather than have our clients purchase a wallet or trade on a messy exchange with hidden fees to purchase coins, we prefer to seek this upside via the use of an ETF which includes the added benefit of not being directly exposed to the speculative underlying asset. That said, they are still volatile and investors should only purchase them if they’re willing to lose that entire portion of their portfolio. For that reason, we offer our clients the choice for whether they’d prefer to have crypto exposure, alongside traditional asset classes—like stocks, bonds, commodities, and real estate— for a truly diversified macro investment strategy.