DeFi: The Future of Finance?
Bringing DeFi to life
A fundamental principle of the cryptosphere is that digital value can be represented and secured through the use of cryptographic technology, without reliance on a trusted intermediary.
DeFi takes this a step further and adds another fundamental principle: digital value can be transacted and controlled through the use of cryptographic technology, again without reliance on a trusted intermediary.
The self-driving car analogy
To attempt a very crude analogy, it may be helpful to think of the jump from ordinary cryptoasset trading to DeFi activities as like switching from a normal car to a self-driving one. The engine and the fuel are likely to be the same, but things start to get more sophisticated when it comes to controlling the car:
The engine (blockchain)
- DeFi is powered by the same blockchain technology as many cryptoassets. Most DeFi solutions to date have been built on the Ethereum blockchain and other public, permissionless blockchains.
- Permissionless, or open, blockchains are an attractive option for DeFi solutions as no one ‘owns’ the blockchain (or the smart contracts that can be built on top of it).
- The more open and programmable a blockchain is, the easier it is to build services off the back of it and to create public application programming interfaces (API) that would enable services to be connected and combined.
The fuel (cryptoassets)
- A large number of cryptoassets are native to Ethereum and fuel the continued operation of the Ethereum blockchain and its surrounding ecosystem. Other blockchain networks use their own native cryptoassets to fuel transactions.
- Stablecoins can also perform helpful settlement functions and stablecoins that are pegged to fiat currencies also provide additional interconnectivity between DeFi activities and the traditional financial system.
- It remains to be seen whether any central bank issuing its own digital currency (CBDC) would design a form of CBDC that could be transacted over public blockchains or integrated into DeFi products and solutions, but it is certainly a topic of interest. At a recent conference, the Bank for International Settlements (BIS) asked: ‘Does safe DeFi require CBDCs?’ and considered the role that central banks might play as DeFi-based markets evolve and what this means for CBDCs.
The steering system (protocols and smart contracts)
- A dedicated crypto trader may feel that cryptoasset trading activities provide a means of getting from their current financial position (A) to their desired financial position (B). But getting from A to B without DeFi services can require a highly hands-on approach.
- The promise of DeFi is that it can take control of the wheel: automating transactions in cryptoassets, using smart contracts to execute and settle trades once defined parameters are met, or using similar protocols to lock up cryptoassets as collateral and release them once the collateralised obligations are discharged.
- As compared to CeFi, DeFi effectively replaces the financial institution with a smart contract. That smart contract can operate a cryptoasset account that can hold funds and buy or sell other assets based on certain conditions. However, once programmed, the smart contract typically cannot be altered – it will always run as programmed.
The user interface (DApps)
- Every self-driving car worth its salt has a snazzy user interface taking up space on the dashboard.
- Similarly, the ‘front end’ of DApps seeks to make complex DeFi technology as user-friendly as possible and provide customers with the functionality that allows them to instruct the DeFi protocols and smart contracts to operate autonomously.
- To the end user, a DApp looks just like any other app, but behind the scenes it can make calls to its ‘back end’, ie interact with the protocols and smart contracts that control movement of cryptoassets on the blockchain.
Stepping away from the self-driving car analogy, the fact that DeFi protocols are programmable and can be made to interact with one another means that there is potentially a huge variety of DeFi models. With the right regulatory environment, the possibilities for DeFi growth seem vast.
Dr. Alexander Glos Partner & Co-head Financial Institutions Group
Frankfurt am Main
Matthew O'Callaghan Partner
Brian Rance Partner
Timothy Howard Partner
Brock Dahl Data privacy and security, Head of U.S. Fintech
Washington, DC, Silicon Valley
Kenneth Hui Counsel
Dr. Daniel Klingenbrunn Principal Associate
Frankfurt am Main