Finance 3.0: DeFi, Dapps, and the Promise of Decentralized Disruption

DeFi has the capacity to transform financial services, but challenges and risks need to be properly addressed to fulfill its potential.

The classical columns of a large bank building are being shoved aside by two figures on the left and the right, with bright fractal imagery escaping from within, representing the decentralization of finance.
Stephan Schmitz

A truism of Silicon Valley is that startups succeed when they find “product-market fit,” the elusive alignment between their offerings and customer demand. Many never do. Often the product that takes off looks very different from the one that was originally envisioned. More than a decade after the launch of the Bitcoin network, we may at last be witnessing a killer application for blockchain and cryptocurrencies. It is called decentralized finance, or DeFi.

Beginning in the 1990s, the internet heralded an epochal change in finance. Services moved from paper to digital, and from proprietary networks to a common platform. As in other sectors, the internet promised decentralization: traditional gatekeepers would give way and an array of new options would empower users. Yet ultimately, the biggest banks only got bigger. Then, in the depths of the Global Financial Crisis in 2008, Satoshi Nakamoto’s Bitcoin white paper appeared on an internet mailing list, introducing a distributed digital ledger and peer-to-peer payment network that functions without a central bank or intermediaries.

In a famous 2014 essay in The New York Times, venture capitalist and former Netscape founder Marc Andreessen argued that “Bitcoin matters” because it would free individuals and businesses from the limitations of traditional payment systems, such as high fees and credit card fraud. He concluded that it “offers a sweeping vista of opportunity to reimagine how the financial system can and should work in the Internet era, and a catalyst to reshape that system in ways that are more powerful for individuals and businesses alike.”

Since that prediction, the bitcoin cryptocurrency has gone from a curiosity popular among a small hobbyist community to a widely-recognized financial asset class with a market capitalization that exceeded $2 trillion at its peak earlier this year. Hundreds of other cryptocurrencies have launched, with a few, such as the Ethereum blockchain’s ether, also generating large investor and developer interest. El Salvador even declared bitcoin as legal tender, with its president promising the same efficiency and empowerment benefits that Andreessen did years before. 

Yet strangely, despite their successes, cryptocurrencies have been a failure at the one thing they were originally designed to do: replacing fiat currencies for ordinary retail payments. Widely adopted cryptocurrency networks such as Bitcoin are far too slow for large-scale payment processing. Merchants don’t want to hold these highly volatile assets, and most banks refuse to touch cryptocurrencies due to concerns about risks and regulation. 

A similar pattern developed with smart contract applications, which first came to prominence with Ethereum. Smart contracts are software modules that execute on a blockchain with the same decentralized trust and immutability as cryptocurrency transfers. They promised to disrupt networked computing just as cryptocurrencies had promised to disrupt finance, by replacing centrally controlled code with decentralized applications (dapps) operating unstoppably on distributed global networks. Ethereum and several of its competitors have succeeded in attracting significant developer communities, and have seen their corresponding tokens accrue value. Yet they too have largely failed to generate significant native activity, at least until recently. At the end of 2019, according to DappRadar, only one Ethereum dapp exceeded 1,000 daily active users.

Furthermore, the blockchain services that managed to attract users abandoned Bitcoin’s radical promise of decentralization. Cryptocurrency exchanges such as Binance and Coinbase, for example, are centralized intermediaries that take custody of user assets and conduct most of their transactions off of the blockchain. 

DeFi as a killer app

And then along came DeFi. In a way, the promise of DeFi is the same one that Satoshi staked out: transforming finance by shifting its foundations from centralized to decentralized. The difference is that bitcoin and other cryptocurrencies change the foundational asset for financial activity, while DeFi changes the transactional infrastructure, making it permissionless, so that any user or developer can participate from anywhere in the world, as well as transparent, because the source code is auditable. DeFi treats finance as a collection of software protocols rather than a collection of proprietary firms.  

What is a bank, really, but an application to take and store deposits on one side while lending and collecting interest on the other? While modern financial services are highly digital, they still rest on traditional foundations that are built around physical assets and human participants. Financial services firms use software, just as a brick-and-mortar retailer employs software for its inventory management, payroll processing, and other functions. That is very different from a system built entirely out of software. Even online retailers such as Amazon still operate through managers who make decisions about what products are listed, how product pricing algorithms are structured, what information shows up on the site, and so forth. DeFi goes a step further. There is nothing in a DeFi service but software code running as smart contracts on a blockchain. No central intermediary controls user funds; DeFi protocols operate directly on assets in user-controlled wallets.

“DeFi could point the way to Finance 3.0, alongside the broader Web 3.0 ecosystem of decentralized blockchain-based systems.”

DeFi isn’t new. MakerDAO, the stablecoin that underpins many DeFi services, was founded in 2014 and launched on the Ethereum mainnet in 2017. Many other DeFi services emerged from the 2017 initial coin offering boom. Until recently, however, they had very limited adoption. In the summer of 2020, however, DeFi hit its stride. MakerDAO, the decentralized exchange Uniswap, lending services Compound and Aave, derivatives platforms dYdX and Synthetix, and yield farming service Yield Finance, among others, saw explosive growth. Assets in DeFi smart contracts grew from less than $1 billion to more than $15 billion in 2020. By May 2021, this figure eclipsed $80 billion, and experimentation with DeFi models was flourishing. DeFi rapidly came to dominate the smart contract ecosystem. Some 95 percent of the growth in dapp activity in 2020 took the form of DeFi services on Ethereum.

DeFi promises to realize the original promise of cryptocurrencies by eliminating costly and controlling intermediaries from financial transactions. Yet it goes even further. In DeFi, the line between the retail and institutional side of the business is blurred, and the capital formation process is itself decentralized. Banks get their assets from depositors, but those depositors aren’t active participants in the bank’s lending activities. 

In DeFi, any cryptocurrency holder can “lock” assets into smart contracts, which commit those funds into liquidity or collateral pools. The owner earns a yield that is analogous to interest on a money market fund (although typically paying much higher rates). The assets in the pools can, for example, be used to backstop stablecoins such as MakerDAO’s DAI, issue interest-bearing loans that can be used for investments or purchases, fulfill trades on a decentralized exchange, or create synthetic tokens that track the value of gold or Facebook stock. Anyone can also perform market-making and arbitrage functions, such as liquidating an under-collateralized loan, which are typically the function of professional specialists. Governance of DeFi platforms is often based on token voting, where any holder can influence key variables such as interest rates.

Because DeFi services are simply open-source software code running as smart contracts on a blockchain, new functions can be composed from existing ones. For example, Sushiswap originated as a “fork” of Uniswap, copying and redeploying the open-source code of Uniswap’s smart contracts with a few changes, and has become a major DeFi player in its own right. Aggregators and yield farming services automatically move assets to the platform that offers the best pricing or yield. DeFi derivatives can mimic other financial instruments, and tokenization allows physical assets to function like digital ones. 

Why is all of this significant? Research by the economist Thomas Philippon, a professor of finance at New York University, shows that the unit costs of financial intermediation have remained nearly constant for more than a century. That seems hard to believe. Technology has led to monumental increases in automation and transaction volume over that time. The efficiency of finance is orders of magnitude greater now. Yet the role of intermediaries has not diminished. As simple transactions become cheaper, the market moves to more sophisticated arrangements that technology makes possible. Those new arrangements offer benefits to investors and to overall market liquidity, but they are also more costly. The network effects in financial markets are sufficiently strong that powerful intermediaries can continue to extract rents and limit competition, even when markets are nominally more open and efficient.

DeFi challenges all of that. It promises to make finance programmable by anyone, the way that earlier iterations of the internet economy did for content, commerce, and social interactions. And because every transaction is executed on a public blockchain such as Ethereum, financial terms and flows are radically transparent, in contrast to the opacity of traditional finance. 

What’s the catch?

At least, that’s the vision of DeFi. The reality, as with most blockchain activity, doesn’t yet match the promise. Most DeFi transactions today involve experienced cryptocurrency holders who are either seeking additional earnings on the digital assets they hold, or leverage to purchase more of them. A major reason for DeFi’s rapid growth was short-term yields and other returns that seemed too good to be true, perhaps because they were. Many of the tactics that inflated and then collapsed the initial coin offering bubble of 2017-18 have returned in DeFi, along with equally worrisome new ones. A mature DeFi sector will need to move beyond models that assume that money is always flowing in and that asset prices are growing or stable. It will also need to address concerns about money launderers and other financial criminals taking advantage of the decentralized nature of DeFi protocols to evade legal sanctions.     

DeFi services are quite immature. Hacks and other attacks against DeFi services produced losses of more than $100 million in 2020 and more than $150 million in the first half of 2021. Another $83.4 million was lost due to “DeFi-related fraud,” according to the blockchain analytics firm CipherTrace. The most worrisome attacks take advantage of unique aspects of DeFi itself. “Flash loans,” which temporarily generate capital that must be repaid in the same transaction, can be used to create artificial leverage and manipulate DeFi asset prices. Miners can also insert themselves into the transaction flow of blocks that they mine, extracting value from the transacting parties. The hope among DeFi developers is that such an adversarial environment will ultimately lead to better security. We still have a ways to go to reach that point.

The final major challenge facing DeFi is that public blockchains cannot support the necessary performance and interoperability. While DeFi doesn’t require the extremely high transaction volumes of retail payment networks like Visa and Mastercard, delays and fees are severely limiting factors with current technology. Today, most DeFi activity uses Ethereum, which is in the midst of a major upgrade to address serious performance difficulties and move away from problematic proof-of-work mining. A variety of third-party “layer 2” solutions are also offering performance improvements. Competing DeFi-optimized blockchains such as Solana and Binance Smart Chain are gaining some market share on the basis of higher throughput, but they have their own issues. 

Furthermore, the full benefits of DeFi’s programmability and composability require that all applications be on the same blockchain, or necessitate interoperability mechanisms that are still in their infancy. The same is true of bridges between DeFi and established finance. Most of the world’s financial capital will be in banks and other incumbent institutions for the foreseeable future, so even if DeFi is wildly successful, it will need to coexist and interoperate with traditional finance. 

The three “Rs” of DeFi’s future

What will determine whether DeFi realizes its potential and transforms financial services? While important open technical questions remain, the most important variables are retail, risk, and regulation.

DeFi isn’t yet popular among retail investors, small businesses, and ordinary borrowers — for good reason. Navigating the process of participating in DeFi liquidity pools and other activities still requires a level of technical sophistication, and the risks are considerable. The fundamental alchemy of finance is to transform self-interested risk-taking into socially-beneficial capital formation for relatively stable assets like houses and businesses. DeFi has yet to cross that chasm. Sophisticated speculation and arbitrage are parts of a healthy financial ecosystem, but only alongside more mundane activities by retail participants who are seeking safety and stability. DeFi must address both if it is to succeed where bitcoin and other cryptocurrencies have failed to conquer the mass market.

A primary reason that retail users hesitate is that DeFi’s risks are insufficiently understood. Some risks, such as the possibility that a counterparty will disappear rather than fulfilling an agreement, are reduced in a transparent environment of immutable smart contracts. Other concerns, however, such as cascading impacts of volatile asset prices, hidden risks in stablecoins that are supposedly fully backed, governance systems that can change important parameters on the fly, and unexpected behaviors of novel combinations of services, are greater in a DeFi environment than in traditional finance. A new discipline of DeFi risk management, as well as effective practices for managing and remediating such risks, need to be developed.

Finally, DeFi developers and promoters will need to address important regulatory concerns. Finance is highly regulated to protect both individual market participants and the stability of the global economy. Even though regulators cannot easily shut down global blockchains and distributed applications that have no central control point, they can dramatically limit market participation and essential interactions with the traditional financial system. Regulators and the DeFi community need to engage one another to identify ways to address regulatory concerns efficiently without impeding innovation. The DeFi Policy-Maker Toolkit, recently issued by the World Economic Forum and the Wharton Blockchain and Digital Asset Project, which I lead, is an initial effort to map out such a path.

Toward Finance 3.0?

The Finance 2.0 that emerged from the original internet revolution was in many ways more open and affordable for participants from around the world. It paved the way for innovations such as Paypal, Venmo, Stripe, Robinhood, Klarna, SoFi, and Alipay. It also created new hazards, as highlighted by the Global Financial Crisis, the collapse of Wirecard in Europe, and the explosion of opaque high-frequency trading. 

DeFi could point the way to Finance 3.0, alongside the broader Web 3.0 ecosystem of decentralized blockchain-based systems. This time, the hammerlock hold that intermediaries have on transactions might finally be broken, opening up a world of possibilities. As cryptocurrencies show, moving from visibility to maturity will be a huge challenge, with no guarantee of success. Yet the level of real financial activity in DeFi makes it a good environment for experimentation. 

Returning to the lingo of Silicon Valley venture capitalists, today’s DeFi is a “minimum viable product” whose most important function is testing market responses and serving as a basis for further evolution. It is from these foundations that the future of finance may be built. 

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The classical columns of a large bank building are being shoved aside by two figures on the left and the right, with bright fractal imagery escaping from within, representing the decentralization of finance.

Artwork By

Stephan Schmitz

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