DeFi in a nutshell

More than a buzzword, Decentralised Finance (DeFi) provides a broad range of benefits in financial services for users. But what is DeFi? Igor Mikhalev, BCG Platinion, and Igor Struchkov, Firmshift explain

For a long period of time the traditional financial system has been built around centralised institutions: banks, insurance companies, stock exchanges, etc. Those institutions act as trusted intermediaries - as people rely on capital reserves and the long-lasting reputation of large financial institutions to protect their investments or deposits.

Besides financial stability, these intermediaries also perform the assessment of the risk profile and return on the investment. While this is a very important role when speaking about enterprise finances, it usually becomes an unacceptable overhead for small companies and individuals to pass the necessary checks. As a result, SMEs have less access to external financing and pay higher transaction costs and risk premiums.

And nowadays we see constantly growing demand for capital and financial services from emerging economies and SMEs. It appears that in its current stage centralised finance is unable to resolve this.

But fortunately, now we have an alternative - Decentralised Finance, or DeFi. DeFi eliminates the need to trust centralised parties and thus makes digital services open, democratic, and permissionless.

Another advantage of removing intermediaries is the possibility of full automatisation. Most operations in DeFi are performed by special computer programs - smart contracts. These smart contracts are stored on a blockchain and cannot be tampered with after they are deployed. This approach greatly reduces transaction costs while providing high levels of security and privacy.

Due to its level of accessibility, DeFi is well suited to emerging economies and countries with limited access to traditional financial services, providing access to credit, exchange, and investment opportunities. However, the excessive collateral required by borrowers to access DeFi loans makes it impractical for these groups unless they already own the cryptocurrency. In addition, many DeFi protocols require a certain level of knowledge to safely use them, without which users could be inadvertently exposed to risks.

DeFi is an ecosystem that is based on public blockchains at the low (settlement) layer, digital assets (also called tokens) at the asset layer, decentralised applications (dApps), and aggregators (see Exhibit 1).

Exhibit 1: The Decentralised finance stack                            Source: Fabian Schär, BCG, Crypto.com

DeFi dApps provide a broad range of financial services. Here is a complete list of DeFi application categories as of July 2021:

• Payments - services that allow sending and receiving money around the globe. Examples are: Lightning network, Tornado cash.

• Decentralised exchanges - allow instant swaps of digital currencies / assets. Examples are: Uniswap, Curve Finance, PancakeSwap, Balancer, Loopring, Liquifi.

• Borrowing and lending - allow borrowing and lending of digitals assets. Examples are: Aave, InstaDApp, Compound, Maker.

• Stablecoins - crypto assets pegged to real-world currencies. Examples are: USDT, DAI, USDC.

• Trading - protocols for trading digital assets. Examples are: dYdX, WowSwap.

• Derivatives and synthetic assets - protocols that derive value from other assets. Examples are: Synthetix.

• Prediction markets - protocols that allow staking on events or outcomes and win. Examples are: Augur, Polymarket.

• Investments - dApps that facilitate investments and portfolio management. Examples are: Token Sets, Zapper.

• Lotteries - protocols that distribute lottery tickets and determine winners in a decentralised way. Examples are: PoolTogether.

• Insurance - decentralised insurance services and mutual funds. Examples are: Nexus Mutual, Etherisc.

• Crowdfunding - services that allow collecting funds for projects. Examples are: Gitcoin Grants.

• Yield aggregators and multi-protocol interfaces - improve user experience and increase profits by combining several protocols in a single product. Examples are: yearn.finance, 1inch.

There are also a bunch of supporting services and protocols like price oracles, tokenization services, cross-chain bridges, and interoperability facilitators.

Though DeFi dApps use different protocols and financial models, they all have several similar characteristics:

• Non-custodial. Traditional financial services require a trusted third party to act as an intermediary and take custody of funds to perform an operation. For DeFi, assets are deposited in smart contracts on the blockchain. No parties other than the user himself can control the movement of funds if certain conditions are not met.

• Permissionless and borderless. Since the vast majority of DeFi protocols are built without requiring any permissions to use them, and smart contracts usually operate on public blockchain networks, anyone with an Internet connection can use DeFi services.

• Autonomous and self-sustaining. All DeFi functions are codified in smart contracts that are validated and executed on public blockchains. DeFi protocols economically incentivize their users to perform the necessary tasks, e.g. provide liquidity to exchange pools or initiate transactions to liquidate undercollateralised loans. As a result, DeFi protocols can deliver their services completely autonomously.

• Open source and transparent. The core philosophy of DeFi is that everything should be open source. Anyone can check the open source code for vulnerabilities. In addition, the public can examine how the system works, making it difficult to make unnoticed and arbitrary changes.

• Low overhead. Since all functions are performed using smart contracts, people do not have to do any additional work. This means that once the system is configured, in theory, there can be no cost associated with the ongoing operation of the service.

• Dynamic. Interest payments in DeFi can be done as often as it takes to mine one block (3-15 seconds), which is much more dynamic and convenient for consumers than every few months typical for traditional finances.

• Transactional. Blockchain transactions occur atomically - meaning that any operation will be recorded on the blockchain if and only if all the sub-operations succeed. Furthermore, a single network request to comprise multiple transactions across multiple protocols.

• Composable and modular. One of the most attractive features of DeFi, is that protocols can be built on top of each other to extend functionality. In addition, protocols can be disassembled and reassembled to create new products.

Though DeFi services provide significant advantages over centralised ones, there are certain problems and risks associated with them:

• Blockchain scalability and high network fees. Scalability and efficiency of modern blockchain networks usually are not enough to use DeFi with a comparable volume to centralised services.

• Limited liquidity. Despite an impressive growth, DeFi services are still in demand of financial resources to provide the necessary market liquidity.

• Security risks. Though DeFi smart contracts are usually open source, the current level of security audit is not always high enough to guarantee the security for all operations.

• Over-collateralised. Although easy-to-use and accessible, DeFi lending services and synthetic assets require a very high level of collateralisation.

• Regulatory risk. DeFi services are not yet approved as legal financial instruments in many countries.

• Binding to a single network. Most DeFi protocols work well within one given blockchain network (e.g. Ethereum). But cross-chain functionality is usually limited or even cannot be implemented in a fully decentralised manner. This makes it difficult to transfer assets between different networks and limits the DeFi market liquidity.

Although DeFi is a relatively new industry, it already has enough potential to change the financial world.

Payments can be done trustlessly and efficiently using payment networks (e.g. the Lightning Network for Bitcoin) that use off-chain mechanisms to conduct transactions with low delay and cost, while storing the final results securely on a blockchain.

Decentralised exchanges (DEX) allow fast and simple digital asset swaps without account creation or depositing assets to some centralized entity. All the operations are performed by smart contracts. In case of liquidity pool DEX, even a counterparty is not needed, as swaps are performed against a liquidity pool under control of a fully automatic market maker (AMM) algorithm.

Decentralised lending services provide a way to borrow crypto assets without any KYC or risk assessment procedures, just in one blockchain transaction. The only thing needed is a sufficient amount of collateral to secure a debt repayment.

And more DeFi protocols and services are coming up almost every day - to provide better and faster financial services and strongly compete with traditional centralised finance.

To learn more about DeFi’s applications in finance - exchanges/lending/payments, check our next instalment in August.

About Igor Mikhalev

Igor Mikhalev is an Expert Principal at BCG Platinion’s Amsterdam office. He is a Business Technology & Innovation Strategy leader and a researcher with more than 15 years of experience in startup, academic as well as state-of-the-art corporate and consulting environments. You may contact him by email at mikhalev.igor@bcg.com .

About Igor Struchkov

Igor Struchkov is a Software Development Manager and Researcher at Firmshift B.V. He has about 20 years of experience in software development, project management, enterprise and blockchain software architecture, mathematical modeling. You may contact him by email at i.struchkov@firmshift.com .

About BCG Platinion

As a part of The Boston Consulting Group (BCG), Platinion provides consulting services in design and development of advanced technology solutions that fuel creation of new-generation business models. Today, our presence spans the globe with offices in Europe, North and South America, South Africa and Asia Pacific.

BCG is a global management consulting firm and a world leading advisor on business strategy and transformation. We serve clients in the private, public, and not-for-profit sectors around the world, including more than two-thirds of the Fortune 500.

About Firmshift

Firmshift B.V. is an innovative global software engineering company headquartered in Amsterdam, the Netherlands. It has a globally distributed team of highly skilled professionals capable of implementing world class projects in various areas including financial systems, 3D modeling, artificial intelligence and blockchain. Among our featured clients are Boston Consulting Group, Wolters Kluwer, Societe Generale.