The DeFi Boom: Use cases, current issues and investing in DeFi

There has been much hype over the Decentralised Finance (DeFi) space in the last year with DeFi projects like Uniswap reaching US$4b in market capitalisation. DeFi or Decentralised Finance are essentially projects that seek to remove intermediaries and single points of failure from traditional finance use cases or centralised financial platforms (CeFi). Current projects tackle, in varying comprehensiveness, remittance, payments, credit, savings, trading, derivatives and insurance. This article will give an overview on the key features of DeFi, use cases in remittance, stablecoins, decentralise exchanges, decentralised lending, and financial inclusion. We’ll then discuss current issues with the DeFi model and some thoughts on investing in DeFi tokens.

Key Features

The fundamental attributes of DeFi projects are 1) the absence of intermediaries and financial institutions in the financial transaction, 2) decentralised governance and 3) its fully transparent nature.

Without intermediaries, transactions are made more efficiently with the removal of centralized systems — no more human management, inaccuracies, long settlement periods, manual reconciliations, human bias, and fraudulent actors. A decentralised governance system and the fully transparent nature of projects are other key features.

Projects generally aim towards a community governance model where members across the world vote on outcomes and disputes based on their relative stakes in the network. The network relies on the “Wisdom of the Crowd” to make decisions, innovate, or even pivot. Members vote on executable code (mostly on the Ethereum smart contract), removing the need for an intermediary (i.e. an employee or a foundation member) to implement the decision. This also prevents governments from shutting it down, because each member has a copy of the blockchain to validate transactions (similar to BitTorrent). As we will discuss below, this model is still relatively new and, accordingly, there are many teething issues that are yet to be solved.

By virtue of its publicly available code, these DeFi networks are fully transparent and verifiable by other users on the network. This model relies on the community to correct bugs and errors (similar to Wikipedia) and to police bad actors.

Remittance

The first and earliest use cases of DeFi was Bitcoin, used as a means of remittance across borders, bypassing traditional intermediary banks and the long settlement periods. Typically, only the cross- border flow of funds has been decentralised (bypassing offshore clearing houses and correspondent banks), for first and last mile, centralised intermediaries are often still involved.

The original thesis for the remittance use case was clear. As the market capitalisation of Bitcoin grew, the ability to make large transactions over the network without moving the market increased. This attracted more frequent and large remittance use cases on the network which further increased the Bitcoin market capitalisation, resulting in a flywheel effect. For instance, initiating a US$5m remittance transaction in 2016 when market capitalisation was US$5b+ would have moved the market significantly, making it too costly for the transaction to be feasible. At a market capitalisation of US$600b+ today, remitting a similar amount will have a much smaller impact on the price of Bitcoin, making the transaction relatively more feasible.

Unfortunately, as the ecosystem grew, increased speculation and intra-day Bitcoin trading resulted in prohibitively high volatility of Bitcoin prices. As a result, this saw the introduction of several other coins which aimed to increase transaction speeds and lower volatility such as Ripple and Stellar. These coins started out promising but eventually suffered the same price volatility which rendered them inadequate for most remittance use cases. Projects such as Tether began offering stablecoins which claimed to be backed one-to-one with the fiat currency it is pegged to.

Stablecoins

The initial days of stablecoins had issues around auditability and trust in the coin issuer. Not long after the first wave of stablecoins, many reputable firms and governments issued their own stablecoins backed by either fiat or commodities like gold. While the reputation of these centralised stablecoins mitigated most counterparty risks, the market was still not comfortable with potential bad actors, fraudulent employees, or government intervention. They sought a new type of stablecoin, one that was truly decentralised, fully transparent and cannot be shut down by government intervention. Developers responded with two solution types; algorithmic and trust based driven stablecoins (like Basis Cash, the anonymously revived form of Basecoin) and crypto-backed stable coins (like Dai) with the latter gaining the most traction.

Decentralised Exchanges

Decentralised exchanges (commonly known as DEX) allow for peer-to-peer cryptocurrency trading without the need for depositing or withdrawing crypto assets. There is no intermediary that takes custody of funds and users have full transparency on how the DEX executes orders, the spread it takes and the true underlying liquidity within the exchange. Like other DeFi projects, decentralised holders of the underlying DEX tokens vote on governance issues with some projects also offering a portion of the trading fees to token holders (often via a staking model to avoid being classified as securities).

Proponents of DEXs often cite the following advantages over centralised exchanges:

Near zero risk of server downtime, as hosting is distributed throughout the nodes. Centralised exchanges regularly go down for updates and general maintenance. Exchanges of traditional asset classes that typically operate from 9am to 5pm, 5 days a week, can schedule maintenance during off-market hours. However, the 24/7 trading and volatile nature of cryptocurrencies means that the slightest interruption at any point of time can result in massive losses to traders.

DEXs cannot unilaterally halt trading of a coin, unlike a centralised exchange, even if it goes against its own vested interest. Centralised exchanges that list their own coins or affiliate coins can (and sometimes do) halt trading if the price of the coin falls or is under attack from short sellers. Uniswap, for instance, cannot interfere with traders dumping its native coin, Uni — unless the majority of its owners agree to do so.

DEXs are unable to falsify liquidity — for long. Liquidity on an exchange is probably the most important determinant of user adoption. Wash trading is a prevalent issue within centralised exchanges who are constantly competing for users. While DEXs are susceptible to wash trading as well, their transparent nature makes it easily discoverable using free tracking services like Etherscan.

The popularity of DEXs has grown since 2016, crossing US$45b in monthly traded volume in January 2021. However, it has lagged the volumes on centralised exchanges, with niche coins accounting for the bulk of trading volume. The nature of DEXs presents inherent barriers to adoption that are still unsolved. Common issues include:

Transaction speed — The on-chain nature of these transactions means that trades are only confirmed after 5–20 minutes (versus centralised exchanges which confirms a trade almost instantaneously). This effectively makes DEXs unsuitable for higher frequency traders.

Limitations on coin offerings — A major appeal of DEXs is the vast number of coins available for trading. However, because most DEXs operate on the Ethereum network, only ERC20 compatible coins are supported. Popular coins like BTC, XRP, LTC operate on different blockchains are only available via wrapped derivatives (i.e. WBTC) which requires a centralised venue to convert into BTC.

Front-running — Given the transparent nature of DEX, orders are made public, which makes trades easy to front-run. This deters institutions from making large orders on DEX, reducing liquidity.

Unpredictable fees and slippage — DEXs usually run on the Ethereum network which requires gas fees to execute trades. The cost of these gas fees (in fiat terms) fluctuates depending on the prevailing ETH price and the congestion in the network at the time of trade (i.e when network activity is high, traders will need to put up more gas fees to ensure their orders are executed). Slippage on DEXs is also high due to long trade confirmation times.

While this space is still nascent, with technological innovation continuing at breakneck speeds (given the large financial incentives), many of these problems could be solved in the near future.

DeFi Lending

DeFi lenders, short for decentralized lending platforms, provide secured loans to users in an algorithmic manner without any intermediaries. Borrowers put up stablecoins or cryptocurrencies as collateral (usually up to 75% loan-to-value ratios). The platform sources the lending capital from the public, allowing funders to earn interest on supplied stablecoins and cryptocurrencies. The interest rates are driven by demand and supply of borrower and lenders, with the platform usually taking a net interest margin.

Again, DeFi lending platforms are governed by its community, who own the native DeFi lending tokens, and who typically also receive a utility for holding those tokens either through lower borrowing fees, higher interest income on deposited cryptocurrencies or higher loan-to-value ratios for loans. In addition, holders of these tokens earn from the net interest margins generated by the platform (often in the form of a yield).

The DeFi lending space has taken off over the last 6 months with the largest platform, Compound, securing north of US$2b in outstanding debt as of January 2021. Cryptocurrency-backed loans are not new — crypto firms have been providing these for a couple of years, offering the same utility to both lenders and borrowers in a centralised manner. Decentralised lending, however, provides the following advantages:

Eliminates fraud risks — All lenders, traditional or otherwise, have a lending protocol which defines the credit risk they are willing to take, the type of borrowers they will work with, the loan-to-value ratios and acceptable collateral types. CeFis risk fraudulent actors bending these protocols. For instance, crypto CeFi lender Cred, claimed to be a victim of internal fraud and filed for bankruptcy as they were unable to repay around US$140 million in deposits. DeFi lending programmatically forces adherence to lending protocols which prevents fraudulent actors from bending the rules.

Transparent fractional reserve — Crypto-backed lending, centralised or decentralized, results in a parallel fractional reserve banking-like scenario in the cryptocurrency market. This has been a contributor to the recent rise in market capitalisation of cryptocurrencies. With some platforms offering up to a 100% loan-to-value ratio for borrowers, it is important for the ecosystem to keep tabs on the amount of assets securitised and how much leverage there is in the cryptocurrency market to ensure stability in the system. Centralised lenders at best disclose aggregated numbers on an infrequent basis. Decentralised lenders by default publicly provide this crucial information in real-time.

Despite its growing popularity, DeFi lending is still a fraction of CeFi crypto lending, with intensified competition from traditional crypto exchanges, stablecoin issuers and e-wallets. Major CeFi crypto players like BlockFi are gaining traction amongst institutional investors who like the fact that their deposits are kept with Gemini, a licenced and regulated custodian by the New York State Department of Financial Services. CeFi, however, shall be a post for another day.

DeFi for Financial Inclusion

Many are financially excluded today because of a gatekeeper (e.g. a bank who finds it unprofitable to serve a customer, an exchange who cannot serve a refugee who has no identification papers to pass KYC checks, etc.) Remittance via cryptocurrency was the very first attempt at financial inclusion. All it takes is a smart phone and internet connection to send and receive crypto assets or stablecoins, and onramp and offramp via cash-based peer-to-peer transactions. While there are issues with this model, it allowed the unbanked to bypass gatekeepers like banks and remittance agents.

Centralised exchanges have become the gatekeeper for what cryptocurrencies are tradable and what are not, often for good reasons such as restricting access to scam coins. However, as a business, they too avoid coins that are unprofitable to serve (back in 2017 the going rate for listing a coin on popular exchanges was as high a US$1m). During the Covid19 lockdown in the Philippines, one popular blockchain-based game, Axie, allowed many who lost their jobs to earn as much as the national daily wage by playing, accumulating, and selling in-game assets on a decentralised exchange, UniSwap. Could a centralised exchange provide a marketplace to facilitate the transaction? For sure. Would they? Probably not. This leaves niche communities and poorer projects excluded from such financial services.

Issues plaguing DeFi and the rise of HyFi

As with all nascent industries, teething issues are expected. We cover several below and explore how centralised entities are incorporating decentralised elements (thus HyFi — Hybrid form of Finance) to solve these issues:

Regulatory risks:

  • KYC/AML: DeFi is perfect for laundering money. Users do not go through typical Know-Your-Customers (KYC) and Anti-Money Laundering (AML) checks unlike centralised financial platforms, as no centralised power can unilaterally exclude individuals from participation. Given the increasing cryptocurrency hacks and increased adoption of cryptocurrencies by criminal groups, regulators are watching the DeFi space like hawks. Current regulatory regimes mitigate these risks by regulating the onramp/offramp process (conversion of cryptocurrencies to fiat and vice versa) but the rise of DeFi has made validating source of funds extremely difficult.
  • Taxation: Inability to tax DeFi activity is another major reason why global regulators are heavily incentivised to shut them down. That said, crypto trading profits are already taxable in many jurisdictions, regulated centralised crypto exchanges and crypto lenders pay income taxes and provide tax authorities with user activities to facilitate investigations of tax avoidance. DeFi provides users with anonymity and prevents regulatory enforcements on crypto related tax laws.

Team risk:

  • Concentration risk: All DeFi projects start off as a CeFi. A core team initially decides how to distribute governance or native tokens, market the project and manage official communication channels. Most DeFi tokens are initially held by founding members and investors, who therefore control the governance process. Even as token ownership diversifies across multiple addresses, the anonymous nature of these protocols means there is no way to prevent individual actors from controlling the network using multiple wallets. Concentration risks of DeFi tokens also negates the core tenet of preventing government intervention. If major token holders are concentrated in a particular jurisdiction, a government can in theory confiscate these tokens to gain control of the network. DeFi projects recognise this and some (like Compound) try to mitigate it by delaying the decentralization process to the public until concentration risks are resolved.
  • Feasibility of “True Decentralisation”: Other concerns around true decentralisation persist, e.g. a centralised entity is still required to pay webhosting services to keep the lights on, manage and control official websites and communication channels. Unless token holders read and audit code, “official announcements” by individuals can cause massive selloffs and manipulation in token ownership, which ultimately affects network governance.

Governance Issues:

  • Minority oppression: All democratic systems suffer from the tyranny of the majority. The current form of corporations has evolved over hundreds of years to include safeguard on minority oppression, where courts can provide relief for minority shareholders who have been unfairly treated by majority shareholders. DeFi projects provide no such relief.
  • “Wisdom of the geeks”: While the underlying premise of DeFi was to rely on the decentralised Wisdom of the Crowd, the “Wisdom” is sought via votes made on proposals executable by code. This means that the participating community needs to be code-literate, which is not feasible as the project scales. As a result, there is a risk that only a segment of the network will make decisions on behalf of the entire network.

Newer projects such as Nexus Mutual addresses some of the above issue in a HyFi model. It provides a decentralised smart contract-based insurance platform where some decisions are governed by its decentralised members (holders of its tokens) who decide on claims, governance and risk assessments which are enforced by smart contracts on the Ethereum blockchain. However, unlike DeFi, the platform is run by a centralised team, registered as a discretionary mutual in the UK adhering to KYC/AML laws and restrict participation by users from sanctioned countries.

Investing in DeFi

At its core, investing in DeFi is a bet on outsized returns via regulatory arbitrage. DeFi performs the same functions as CeFi without all the expenses from legal, compliance, regulatory reporting, taxes and audits.

On a more macro level, investing in the DeFi lending and DEX sector is a bet on the volatility of the crypto market (similar to the VIX). It provides upside exposure to the general crypto market with some downside protection (with DeFi lending benefiting more than DEX). When the prices of general cryptocurrencies go up (relative to fiat), these platforms benefit from higher income (i.e. higher net interest margins from lending and higher trading fees in fiat equivalent terms). However, regardless of price direction, if there is volatility in the markets and high trading volume, DEXs will continue to generate income. DeFi lending platforms benefit further from volatility as users borrow stablecoins to purchase cryptocurrencies when the market is going up and borrow cryptocurrencies to purchase stablecoins when the market goes in the opposite direction. Either way, the DeFi platform benefits. The common and fatal risk for these platforms is price stability (i.e. long-drawn-out crypto winter).

When it comes to identifying individual DeFi lending and DEX projects/ coins to invest in, it is more of a beauty pageant rather than a horse race. The opensource nature of these projects means that unhappy community members can always uproot and leave by forking the existing network (like SushiSwap and Bitcoin Cash). There is no inherent defensibility except for its community (and maybe vested interests of large financial institutions and crypto whales). One is essentially betting that initial momentum continues and users do not churn in the future.

Conclusion

We continue to watch this space which is rapidly evolving. There is no doubt that many of the issues discussed here will be addressed in the future, and new and innovative use cases will emerge in this space.

Written by Joshia Kwa, Associate at Integra Partners.

Integra Partners invests in early stage companies in the areas of financial services, insurance and healthcare. Visit us at integrapartners.co