Imagine a world where you can make trades, deposit into a savings account or buy insurance,
all without going through an intermediary like a bank. That's the promise of DeFi,
an umbrella term for a range of financial products developed around the blockchain.
DeFi services have attracted billions of dollars in funds,
and proponents of the trend believe that it will become an even bigger industry,
rivaling the mainstream financial institutions we’re familiar with today.
But the crypto winter of 2022 has exposed cracks in the DeFi space.
Billion-dollar projects went belly up, and investors lost hundreds of millions of dollars
to cybercriminals exploiting weaknesses in various DeFi platforms. So what is DeFi exactly? And does
it truly have a shot at becoming the future of finance... or is it a road to nowhere?
The term DeFi – short for Decentralized Finance - was first coined in a group chat on the messaging
app Telegram in 2018. It was born out a brainstorm amongst software developers,
who were searching for a name for an envisioned network of financial services
built on blockchains – that would cut out the middlemen typically involved in facilitating them.
With traditional finance, your funds are stored and managed by centralized institutions,
like banks. These firms make money by lending out your cash and charging interest on top of
the loans. They also collect various fees and commissions for the provision of their services.
The modern payments system is riddled with third parties who pocket a cut from daily
movements of money. For example, retailers are required to pay interchange fees – sometimes
as high as 2% – every time a shopper uses a credit card to make a purchase.
In the land of DeFi, new infrastructure is being built that takes these banks and institutions out
of the equation. Anyone with a computer can create some software and launch their own financial
service on a blockchain, meaning the barrier to entry is much lower than in traditional banking.
Carol Alexander is a finance professor in the
U.K. – and follows blockchain and cryptocurrencies closely.
You could be a start-up with just a few people.
Whether it's taking people's crypto and giving interest
on that or peer-to-peer lending or any type of project that you want.
One of the most popular applications of DeFi is in lending. Users can lend out their crypto,
just like a traditional lender does with government-issued currency
and earn interest; or they can borrow funds by putting their tokens up as collateral.
Rates on these decentralized lending platforms are
adjusted by an algorithm based on how much demand there is for the loans.
All these exchanges are managed by pieces of code called smart contracts.
These are agreements written on blockchain networks - most often on
ethereum - which execute automatically once certain conditions are fulfilled.
The proliferation of digital financial services means individuals and companies can now expect
to send and receive funds in a matter of seconds. But the actual time it takes for those flows of
money to settle can take much longer, often hours, or a matter of days. For example,
many banks use a third-party messaging system called SWIFT for fund transfers.
In DeFi, there’s no central authority sitting in the middle of each transaction,
meaning transactions can be accepted while funds appear on the other side much more rapidly.
The real value in blockchains is that they are like the motorway on which Web 3.0 is built.
The blockchain is the motorway, the smart contracts are like the cars.
You have different types of motorways for different types of cars. Nonfungible tokens
are a certain type of car, and then you have other applications that are launching a new
decentralized project where you can get financing without going to a bank. The
real value of the crypto coins that are associated with each of the blockchains
is that they’re like the fuel. Solana have a coin called sol. Cardano have ada. Ethereum has ether.
DeFi didn't truly take off as an industry until 2020. That year, the sector saw exponential
growth, with the total value deposited into DeFi products climbing 30-fold.
But DeFi protocols aren’t covered by consumer protection laws, making them riskier than products
from regulated institutions. There are also doubts about how decentralized DeFi platforms are, with
regulators warning some services may be governed by limited groups of influential entities.
It’s been called the “Wild West” of crypto — hoards of computer programmers trying to
bring traditional financial products such as loans to the blockchain. Investors were
enticed by the promise of earning sky-high returns on savings in certain digital tokens.
But as promising as the idea may sound, it’s not all sunshine and rainbows.
As the value of the DeFi market has risen, the number of criminals
seeking to exploit it has also grown. According to a report from Elliptic,
overall losses caused by DeFi scams and thefts totaled $12 billion in 2021.
I've come to a conference in London where crypto companies and regulators
have gathered to discuss efforts to clean up the crypto industry. DeFi is a key theme here,
as blockchain platforms start encroaching on the realms of traditional finance.
Criminals are enterprising individuals. They go where the money is.
Gurvais Grigg is global public sector CTO at blockchain analysis firm Chainalysis,
and a former assistant director for the FBI.
There's nothing inherently evil or wrong with DeFi
or cryptocurrency and blockchain itself. However, you can't have
trillions of dollars move into a new asset class and not attract criminals and grifters.
Jim Lee, chief of the Internal Revenue Service’s criminal investigation division,
says the U.S. tax agency is working closely with the private sector to root out DeFi crimes.
The U.S. have hundreds of crypto type investigations,
federal criminal investigations in some investigative status.
The speed at which crypto moves or money moves these days,
it's incredibly powerful to have partnerships around the globe
to ensure that we're, we're on top of the criminals in a very small space.
Tell me about you know some of that collaboration that’s now happening between
the crypto world and DeFi but also government agencies and regulators.
Partnerships are critical. Crypto moves so fast these days. It's here, it's part of everyday life.
The collective partnership and relationships around the globe, just make this space very small
for criminals that want to try to take advantage of it and our job is to make sure the ecosystem
is stable.
Just like a car, every DeFi service is ultimately the product of the labors of people
who, by their very nature, aren’t perfect.
If a single part of the mechanism inside a vehicle
doesn’t work as intended, it becomes vulnerable to errors.
The same is happening in DeFi. And, in some cases, those errors are proving costly.
Take blockchain bridges, for example. These are tools that allow people to transfer
tokens from one crypto network to another,
at a fraction of the cost it typically takes to make an on-chain transaction.
Instances of sloppy programming and software bugs
have meant such bridges are becoming increasingly vulnerable to attacks.
More than $1 billion worth of crypto has been lost to bridge exploits so far in 2022.
But the use of new software tools has made it easier to trace crypto criminals’ ill-gotten
gains. Companies are employing sophisticated data science and machine learning techniques
to analyze data on public blockchains and track down fraudsters and thieves.
Unlike other forms of fraud in fiat, with cryptocurrency in the blockchain, we have
a record, right, and that transparency and speed of accessing that record globally
makes investigations of these types of frauds accelerate over traditional finance.
DeFi faces an uphill battle if it wants to compete with the titans of traditional finance. While the
entire market is now worth over $60 billion, this pales in comparison to the trillions of dollars
held with incumbent financial institutions. The implosion of controversial stablecoin
venture Terra, among other mishaps, mean that investors have also soured on crypto generally.
Stablecoin. It is plunging today.
So, is DeFi ready for prime time?
For now, the industry is still very much in its infancy.
Mistakes are being made, and scams remain a common sight. But investment is being made
to improve the security of DeFi platforms, and governments are expected to usher in new
regulations to wipe out bad actors and ensure better protection for investors.
It will come through once we've got rid of the cowboys. Some of these exchanges
and some of these stablecoins are really corrupting a very good system that I hope
will provide a rebalancing of the inequality of wealth through generations.