To start, here's a simple model of how traditional finance works - and how it’s worked for hundreds of years prior to the launch of blockchains and decentralized finance (DeFi):
You have money, but you don't want to stash it under your mattress. You could, but there are risks, like your house burning down, or a burglary, or countless other circumstances. Also, the Bank of Mattress, so to speak, doesn't pay interest.
Instead, you go down the street and put your money into an actual bank. And they’ll pay you for the trouble, via interest. It isn’t charity. They want your cash as they make money on your money by either making loans that pay higher interest, or otherwise. This is called a spread. Bigger spreads are better for banks.
On the surface, there's nothing wrong with this. Running a bank is expensive. Bankers need to be paid, offices need to be built and maintained, and ads must be purchased to keep money flowing in (and out) the doors.
It's mostly a win, win. Your cash is safe, you earn some money, and the bank has capital (deposits) to make more loans. Sure, you don't get paid much for your deposit, but the bank does all the work.
For the last 600 years, this is how it's worked. Mainly because there hasn't been an alternative. But by just walking into your local bank, you can tell they've been getting the better end of the deal.
Decentralized Finance (DeFi) is a new model. With DeFi, there are no middlemen (banks). Instead, DeFi is built on the premise that banking can be automated. In doing so, both borrowers and lenders benefit as costs (like offices and bankers) are removed. You will frequently get paid more on your deposits and likely pay lower rates on your loans.
As one example, think about tracking deposits and withdrawals. It seems simple, but imagine what would happen if banks trusted their clients to honestly tell them how much money was in their accounts. For obvious reasons, it would be a disaster. So until recently, we needed banks to act as a trusted third party.
Blockchains change that. At a high level, a blockchain is just an open database. Anyone can make changes to that database, but it is done through a network that verifies accuracy. Without going into the details, just know that blockchains establish trust between peers without the need for third parties.
In short, blockchains make it possible to replace much of what banks do with software. Imagine you need to borrow some money. You're probably going to use a bank. You might try to shop around to get the lowest interest rate, but, really, how many websites or bank branches are you going to visit?
With DeFi lending protocols, you indicate how much you want to borrow, and in seconds get offers from all around the world. You'll pay less because the money comes straight to you from another person. That person doesn't have to generate a huge spread because, unlike a bank, they don't have much overhead. Because individuals are competing against each other to lend you that money, better (in many cases lower) rates are made possible.
When you compare that to banks with their mostly one-size fits all rates, DeFi allows you in some cases to benefit by paying less interest and fees, while the lender (another person in some cases) wins by getting a higher interest rate than they'd get from a savings account.
DeFi does more than just lower costs. The modern banking system really isn't so, well, modern.
Consider how money flows around the world. The global payment rails were built in the 1970s (for more information click here). Saying technology has come a long way since then is an understatement. Yet banking has largely been left behind. Transactions, from cups of coffee to wire transfers still require layers of systems across multiple networks to function.
So ask yourself this: in an age where you can video chat with someone on the other side of the world, why should it take days to send money to that same person? And why does sending money even cost money?
DeFi seeks to upend parts of the system, from payment systems, insurance, investing, lending to even marketplace services.
Accessible: With DeFi, there are no applications to fill out. You don't need permission to do what you want with your money.
Fast: Transactions can be completed in seconds. Wire transfers take days.
Transparent: Reputable DeFi protocols disclose how they operate and let you track what they're doing. It's as if a bank kept its books open for all to see.
With all of that said, DeFi is in its infancy. There will continue to be bumps in the road and hurdles to climb as the ecosystem matures. There are two broad categories of risk to be aware of:
Regulatory: Banking is a heavily regulated industry. For example, there is FDIC insurance that protects an amount of depositors’ money that is held in a bank. But so far, regulators have mostly taken a hands-off approach to DeFi.That is sure to change. In the future, some DeFi projects may be regulated out of existence. That, and there is little to protect a deposit or agreement other than code.
Technological: The good news: anyone with some programming chops can build a DeFi protocol. The bad news: anyone with some programming chops can build a DeFi protocol. Solid code takes time, effort, and skill. DeFi also requires an in-depth knowledge of finance and incentive design. Plus, some DeFi protocols have experienced hacks, bugs, and blowups.
DeFi also comes with all of the usual financial risks.
When using a DeFi lending protocol, you are exposing yourself to counterparty risks. That’s to say, the other person (or institution) might not live up to their end of the bargain. Traditional finance tries to mitigate this risk through the three C’s: credit checks, collateral and contracts. For the most part, DeFi depends solely on collateral (what you must pledge in order to facilitate the transaction). Smart contracts (read about them here) often will enforce the agreement, which will involve the loss of that collateral if the terms are not met.
Then there’s the issue of transparency. If you give your money to a bank or other regulated institution, you can be pretty confident in how they generate yield and, importantly, who holds your funds.
That’s not always true when it comes to DeFi. Theoretically, it should be more transparent than traditional finance, but in practice that’s not always the case. Let’s consider a scenario posed by University of Basel professor Fabian Schär. Say you want to check who owns a DeFi token. That’s simple, you can just look at the blockchain. But what if that token is used and owned by other protocols? In that case, you’d have to look across multiple blockchains to find the ultimate owner. What you might find is that a single token is held by multiple protocols, each with its own idiosyncratic risks.
And because the industry is lightly regulated, it’s your responsibility to understand what’s happening under the hood. If a traditional financial player uses your money to break the rules, you’ve got clear legal grounds to try and recoup any losses that may result. With DeFi, you may not have a legal remedy at your disposal.
DeFi is already disrupting traditional financial services. While this sounds far-fetched (sea changes always do), the signs are unmistakable. DeFi mortgages, credit cards, and lending already exist. And that's all just in the real world. DeFi will likely become the de facto model for banking in the metaverse.
Over the coming years, DeFi could slowly chip away at the banking establishment. But there's still a long way to go. Regulatory clarity is needed. In addition, improvements must be made to the user experience as technical expertise is still required in setup for many to take advantage of what DeFi protocols are doing.
Domain’s investment team at Domain Money Advisors is dedicated to seeking DeFi projects that appear to show the most promise based on the investment process the team lays out here. With decades of experience in the banking system, the investment team understands the fundamentals of what it will take to succeed in this space and the potential risks that it faces.
The team looks for projects that bring efficiencies and liquidity to their users. They invest in leading technologies with large total addressable markets, defensible market share, a market fit and a method for value to accrue to the tokens involved, among other criteria.They also monitor performance and risk to respond to the market as needed.
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