Since last year, there’s been a significant wave of headlines about cryptocurrencies and the profits reaped by those who opted for them from the outset. The above is reminiscent of what occurred in 2017, with the difference that the discussion was chiefly about Bitcoin. What’s happened since then that’s caused people to refer to cryptocurrencies in general rather than just Bitcoin? The main culprit is the blockchain network called Ethereum.
Ethereum was created in 2015 with the purpose of expanding the capabilities of Bitcoin, as the language with which the Bitcoin network is built is difficult to program and it therefore restricts it to establishing a decentralised payment system. The improvement Ethereum brings is the possibility of building smart contracts and creating new coins (or tokens) on the same blockchain network. These contracts are basically computer programs that are devoted to executing actions in compliance with certain conditions. They differ from traditional contracts in that they’re digitally stored in the blockchain, they’re public and they allow for stakeholder interaction without the need for a broker to build up trust between the parties.
One of the first major use cases of the Ethereum blockchain involved project financing. Instead of seeking funding via the traditional channels, the teams obtained capital by issuing Ethereum tokens in exchange for Ether, the native currency of the Ethereum network. This capability led to the proliferation of new cryptocurrencies in 2017 and, as is common with new technologies, a bubble was created, only for it to burst within a few months.
If we recall what happened in 2000 with internet technology and the .com bubble, many of the companies ceased to exist, but those that had real value survived and the technology itself has had a disruptive effect ever since. The winners of the token bubble of 2017, which gained a great deal of prominence in 2020, were the protocol tokens focused on decentralised finance, also known as DeFi.
The main purpose of DeFi is to build a parallel financial system based on the internet and blockchain, aiming to: 1. Increase the mass of population with access to a financial system. In 2017, the World Bank estimated that there were 1.7 billion people without access to a bank account. Anyone with internet access will be able to access financial services, regardless of their location, ethnicity, gender, etc. (while this isn’t a problem in developed countries, it is in certain developing ones, where women and ethnic minorities have restricted rights). 2. Improve the agility of international transfers. Generally speaking, sending money to another country requires communication between multiple financial institutions, lengthening the process by up to a few days. 3. Increase asset privacy. With DeFi users are the custodians of the codes to access their wallets and they can operate without requiring the authorisation of a centralised institution such as a bank.
There are currently protocols on the Ethereum network that allow users to lend and borrow, exchange assets, manage portfolios, take out insurance policies and derivatives and even enter lotteries and gamble.
In the case of loans, the most traditional system is made up of banking credits. The user deposits the money in the bank in exchange for a fixed rate of interest, without knowing what the bank will do to generate said interest at any time. It’s simply an act of trust in the banking institution. DeFi seeks to eliminate this opacity. One decentralised example today is where lenders deposit a cryptocurrency in a smart contract, thus creating a fund with all the currencies that all the users have placed in it. The borrowers, on the other hand, can borrow these coins from the contract provided that they leave enough collateral to ensure repayment of the loan. The smart contract has a built-in code defining the interest rate of each of the parties in keeping with the supply and demand related to the asset. This will vary, depending on how the ratio changes. The fact that all these smart contracts are public and that the users can view the status of the contract in which they’ve placed their assets at any time eliminates the degree of opacity of the previous traditional example.
In the case of asset exchanges, the best-known traditional systems are the stock markets, on which investors can set purchase and sale prices for the assets and, when these are exchanged, the transaction takes place. This process requires the action of a central entity (the stock market) in order to create trust and provide a guarantee to the two parties involved that the purchasing party will pay the money that’s been promised and that the selling party will deliver the agreed assets. In the case of DeFi, the most widely-used system today is that of liquidity funds, whereby any user can place a couple of cryptocurrencies (such as Bitcoin and Ether) in one. When people want to exchange Bitcoin for Ether, they can go directly to the liquidity fund and deposit the currency they want to sell and obtain the currency they want to purchase. The prices of the currencies will be updated after each transaction, as the smart contract is programmed to ensure that the price fluctuates in accordance with the ratio of each of the currencies deposited in the liquidity fund. In addition, to encourage people to place assets in the fund so as to facilitate the transactions, part of the fees paid during each transaction will go to the liquidity providers.
That said, like any financial activity, DeFi isn’t risk-free. There are financial risks, which are similar to those of the traditional system. There are also technical risks, particularly in view of the fact that the smart contracts execute the actions as they are defined. Moreover, the degree of difficulty in mastering the tools and the functioning of the different protocols for digital wallet management have meant that the adoption of DeFi has been limited thus far, even in developed countries.
So far, we’ve seen how DeFi replicates the traditional financial models, giving users the power to form part of the process and also the duty to take responsibility as the custodians of their own assets. In any event, going back to the example of the Internet, many of the uses we can see now were developed long after its creation, such as social media and video-on-demand platforms. We’ll have to wait and see how far DeFi goes and whether it’s capable of partially replacing the current financial system.