DEFI

Crypto 101: What is DeFi?

DeFi (pronounced DEE-fye) is short for decentralised
finance. It’s an umbrella term for the part of the crypto universe that is
geared toward building a new, internet-native financial system, using
blockchains to replace traditional intermediaries and trust mechanisms.

I AM FALLING ASLEEP.

Don’t. I promise it’s interesting.

OK, I’LL GIVE IT A CHANCE. WHAT DO YOU MEAN BY “USING
BLOCKCHAINS TO REPLACE TRADITIONAL INTERMEDIARIES AND TRUST MECHANISMS”?

Let’s back up a bit. To send or receive money in the
traditional financial system you need intermediaries, like banks or stock
exchanges. And in order to feel comfortable doing the transaction, all parties
need to trust that those intermediaries will act fairly and honestly.

In DeFi, those middlemen are replaced by software. Instead
of transacting through banks and stock exchanges, people trade directly with
one another, with blockchain-based “smart contracts” doing the work of making
markets, settling trades and ensuring that the entire process is fair and
trustworthy.

SO DEFI IS CRYPTO’S VERSION OF A STOCK EXCHANGE?

That’s part of it. But DeFi also includes things like
lending platforms, prediction markets, options and derivatives.

Basically, crypto people are building their own version of
Wall Street — one that is largely decentralised and deals exclusively in
crypto, with crypto versions of many of the products offered by traditional
financial firms, and without much of the red tape and regulations that govern
the existing financial system.

WILD WEST WALL STREET! OK, NOW I’M INTERESTED. HOW BIG IS
DEFI?

DeFi’s total value locked, or TVL — a standard way of
measuring the value of crypto held in DeFi projects — is currently about $77
billion, according to DeFi Pulse. That would make DeFi something like the 38th
largest bank in the United States by deposits, if it were a bank.

SO NOT HUGE, BUT NOT SMALL EITHER

Right. And TVL isn’t the only way to measure DeFi’s growth.
You could also look at trading activity on decentralised exchanges, which has
grown by triple-digit percentages in the past year.

Or you could take a cue from regulators and politicians, who
are increasingly looking to DeFi’s growth with concern. Michael Hsu, the acting
US comptroller of the currency, said in a speech at a blockchain conference in
September that many DeFi products reminded him of the credit default swaps and
other complex derivatives that were popular on Wall Street in the years leading
up to the 2008 financial crisis.

And Sen. Elizabeth Warren, D-Mass., singled out DeFi in a
December crypto hearing, calling it “the most dangerous part of the crypto
world.”

WHY ARE PEOPLE SO WORRIED ABOUT DEFI?

In short, because DeFi is mostly unregulated, with few of
the consumer protections and safeguards that exist in the traditional financial
system.

CAN YOU GIVE ME AN EXAMPLE OF SOMETHING THAT WOULD BE
REGULATED IN THE TRADITIONAL FINANCIAL SYSTEM BUT ISN’T REGULATED IN DEFI?

The best example is probably stablecoins. Stablecoins are
cryptocurrencies whose value is pegged to the value of a government-backed
currency, like the US dollar.

Stablecoins are a critical part of DeFi markets, because if
you’re a crypto investor, you don’t want to constantly be changing tokens
back-and-forth to dollars, or keeping all your assets in cryptocurrencies whose
values might fluctuate wildly. You want a crypto coin that behaves like a
boring, stable dollar, which you can use without needing to interact at all
with the TradFi system.

TradFi?

It’s what DeFi people jokingly call traditional finance.

CLEVER. SO, BACK TO STABLECOINS. WHAT’S DANGEROUS ABOUT
THEM?

Well, regulators have argued that despite the name,
stablecoins aren’t actually that stable.

As my colleague Jeanna Smialek explained in an article on
stablecoins last year, the worry stems from the fact that stablecoin issuers
aren’t legally required to back their coins one-to-one with safe, cashlike
assets. Investors who buy stablecoins might reasonably assume that each USD
Coin or Tether (the two most popular stablecoins pegged to the US dollar) is
worth $1 and that they will be able to redeem their stablecoins for actual
dollars whenever they want.

But there’s nothing in the law, at present, that requires
stablecoin issuers to have one-to-one backing. And if they don’t have enough
reserves to cover the stablecoins they’re issuing, the whole thing could
collapse if enough investors decide to pull their money out all at once.

THAT SOUNDS BAD!

It would be, especially since stablecoins are the backbone
of DeFi trading. And there are questions among investors and regulators about
whether some of the leading stablecoin issuers actually have enough assets to
pay out their holders, in the event of a large-scale redemption.

SO STABLECOINS MIGHT NOT BE STABLE. WHAT ELSE IS POTENTIALLY
WORRISOME ABOUT DEFI?

The crypto firms that issue loans, credit cards and savings
accounts, without many of the protections or safeguards offered by conventional
banks, are also drawing concern. Regulators in the United States have begun
clamping down on firms that issue these products, saying they could represent a
risk to consumers.

Regulators are also looking into decentralised exchanges, or
DEXs, which allow users to swap crypto tokens with the help of market-making
algorithms.

And then there are all the hacks and scams …

Oh, great.

Yes. DeFi, like crypto in general, is a big target for
fraud. More than $10 billion was lost to hacks and scams in DeFi projects in 2021
alone, according to a report from blockchain analytics firm Elliptic.

There typically isn’t much recourse for victims of DeFi
scams. And unlike deposits in a regular bank, which are insured by the Federal
Deposit Insurance Corp., crypto tokens usually can’t be replaced or recovered
once they’re gone.

SO ONE OF THE FASTEST-GROWING AREAS OF CRYPTO IS A WILD WEST
VERSION OF WALL STREET WHERE THERE ARE NO INVESTOR PROTECTIONS, WHERE THE
THINGS THAT ARE CALLED “STABLECOINS” MIGHT NOT BE STABLE, AND WHERE YOUR MONEY
COULD BE IRREVERSIBLY STOLEN AT ANY TIME?

That’s an unflatteringly phrased but largely accurate
summary.

WHY WOULD ANYONE SIGN UP FOR THIS?

Four reasons.

First, many people like DeFi because it’s so new and
unregulated. Building an entirely new financial system is the kind of
intellectual challenge that doesn’t come around every day, and lots of people
are attracted to the sector’s wide-open, blank-slate potential. Plus, if you’re
a clever trader or an experienced financial engineer, you could do all kinds of
things in DeFi that you couldn’t do in the traditional financial system and
potentially make a lot of money very quickly.

Second, many DeFi fans argue that blockchains are
technologically superior to the existing banking system, much of which runs on
ancient databases and outdated code. (Most bank transactions, for example,
still rely on programs written in COBOL, a programming language that dates back
to the 1960s.) Crypto, they say, is the first form of money that is actually
devised for the internet, and as it grows, it will need a new, internet-native
financial system to support it.

Third, if you’ve bought into the crypto/web3 vision of a
decentralised economy, DeFi is the financial architecture that makes all of the
things you’re excited about possible. There’s no way, in the traditional
financial system, for a DAO to create a membership token out of thin air and
use it to raise millions of dollars. You can’t call up JPMorgan Chase or
Goldman Sachs and ask them to give you a quote for Smooth Love Potion, priced
in Dogecoin. (Well, you could, but they might have you committed.) But with
DeFi platforms, you can find people who are willing to trade almost any crypto
asset for almost any other crypto asset, with no central entity’s approval needed.

And fourth, there’s a more idealistic cohort of DeFi fans
who see all of this heading in a much more utopian direction.

Decentralising finance, these people say, could help fix
what’s wrong with our current financial system, in part by eroding the power of
big Wall Street banks over our economy and markets.

HOW WOULD THAT WORK?

These optimists contend that because DeFi replaces human
intermediaries and trust mechanisms with public blockchains and open-source
software, it’s cheaper (fewer fees), more efficient (faster transaction times)
and more transparent (less opportunity for corruption) than the traditional
financial system.

They say it democratises investing, placing tools in
people’s hands that only professional investors had access to before. And
because you can participate in crypto anonymously and without a bank’s
approval, they say, DeFi is a way to provide financial services to people who
aren’t well-served by the conventional banking sector and avoid many of the
discriminatory practices that have kept minorities from accessing financial
services in the past.

Ultimately, the optimists say, DeFi will become safer and
more robust over time, as more people use it and some of the early problems are
ironed out. And just as they believe that web3 will replace greedy tech
platforms with user-owned collectives, they believe that DeFi will replace
today’s banks and brokerages with a better, fairer system.

DIDN’T WE LEARN OUR LESSON IN 2008 ABOUT THE DANGERS OF
UNREGULATED FINANCE? COULD DEFI BRING ABOUT THE NEXT FINANCIAL CRISIS?

Right now, it’s unlikely that DeFi could produce any
disasters on the scale of the 2008 financial crisis. It’s still a relatively
small piece of the crypto world (which is a relatively small piece of the
overall economy), and many of the people pouring money into DeFi are the kind
of deep-pocketed investors who could absorb even big losses.

But the possibility that DeFi could grow big enough to
present a systemic risk isn’t lost on regulators, who are scrambling to make
the Wild West of crypto a little less wild.

©2022 The New York Times Company



Traciwininger
Author: Traciwininger

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