What is DeFi?
DeFi (Decentralized Finance) refers to peer-to-peer financial instruments built on a blockchain network. Blockchain networks like Bitcoin and Cardano introduced cryptocurrency, which challenged and changed our ideas about money. Now we are venturing into the next chapter of blockchain - questioning the role of institutions like Visa, Paypal, or Wells Fargo. DeFi seeks to migrate financial instruments like loans, bonds, stocks, futures, ETFs, etc to the blockchain. These tools could eliminate our need or change the role of Wall Street intermediaries like brokerages, exchanges, and banks.
With DeFi you can swap cryptos, put up your crypto for others to borrow, or take out an instant loan against your crypto holding. There’s also limited experiments with derivatives, Wall Street versions of futures or stock options in the US.
DeFi is a financial marketplace; like any marketplace, it offers products. By definition, there is no central authority creating and controlling these products. Instead, any user with a blockchain wallet may provide either the products or the funds needed for things like loans or trading. This is possible because of Smart Contracts. Smart Contracts are software, built to run on a blockchain network. Developers of DeFi ecosystems prescribe and encode all of the rules of a given DeFi platform in a suite of Smart Contracts.
What is different about DeFi?
Our article introducing Decentralization explained some of its core benefits: trustless security, data integrity, and network strength. Let’s explore what these mean for DeFi:
You do not need to apply to an authority or have credit history to start using a DeFi platform. The only requirement is a crypto wallet with a balance and an internet connection. The entire public can provide liquidity - the coins that are traded on DeFi. Therefore, all can share in the success or failure of the system.
This is in contrast to centralized markets, where employees get laid off when the company doesn’t do well, but only top management get bonuses when the company succeeds.
You don’t need to provide personal identifiable information to participate in DeFi. Just connect your crypto wallet, typically via a browser extension, and you’re off to the races. This is true whether you’re engaging with $100 or $1M. This means someone in Haiti can participate in the same offering as a Swiss native.
This is unlike centralized markets that often limit participation according to demographic and personal factors. Access to traditional financial tools might be open only to residents of a particular country. Many people are unable to open a bank account: whether due to past mistakes, or elements they don’t control. Other times, you must prove you have a certain amount of wealth to participate in financial markets.
DeFi products and services are powered entirely by you, when you log in and interact with it. Therefore, DeFi operates on your time. You can move your assets any hour of the day; no human permission or participation is required. DeFi is more or less “always open.”
This is very different from traditional, “centralized” finance, which generally operates on banking hours. It has things like “opening and closing bells,” waiting periods, work hours, and bank holidays. Some services are most accessible “in person” in a bank lobby; even in this virtual age, location can limit access.
DeFi is user-driven and moves at the speed of a given blockchain network’s “Transactions Per Second” (TPS). There’s no arbitrary waiting period. There’s no pre-approval process. Changes are a result of active use. Interest, yield, and other rates and fees are automatically updated every second, in response to real-time data.
In contrast, traditional financial markets are not always open. Even if your bank provides 24/7 telephone service, transferring funds to other institutions is still limited by inter-bank protocols. One of the most-used interbank protocols in the US, called “SWIFT”, isn’t swift at all. One step of the multi-step process exists just to relay the message that you want to transfer funds. Every institution involved in the transfer has to implement and execute their own protocols, which may revolve around human work hours. Depending on the relationship your bank has with the destination bank, each step can take 1 to 3 days!
Since they use Smart Contracts, all of the rules that govern DeFi products are known and available for public scrutiny. When a rule or fee needs to change, a new contract is created and everyone can see it. When there are multiple steps or multiple Smart Contracts involved in a transaction, you are able to see the complete history using a blockchain explorer.
To understand how this compares to traditional institutions, let’s again consider the SWIFT money transfer protocol. Depending on the origin and destination of a transaction, messages and money might go between 2 to 5 banks before reaching their destination. That information is not public; there is no transparency about the intermediary steps. Another example is insurance. Many more organizations than the name on your payment statement may be responsible for honoring the terms of your policy. You might even be buying (re)insurance without knowing it.
Why is it important?
These differentiators of DeFi make it both very difficult to participate unfairly, and near impossible to do so in secret. Financial tools are what individuals and communities use to build wealth. If those tools are imbued with these properties, then everyone has the same opportunities, regardless of their birthplace, race, sexual preferences, or income.
Bigger, Better, Faster DeFi on Cardano
Until Cardano, DeFi ecosystems built on other blockchain networks mostly used an “account model” or “global state” type of accounting. With “global state” accounting, you have to scan the entire blockchain to figure out who owns what. There’s awesome computer science wizardry like Merkle trees and Merkle Patricia trees to let you scan quite quickly but that’s still extra work and leads to security vulnerabilities. Also with “account model” accounting, the ability to process many transactions per second (TPS) is a critical metric. Indeed, it is the challenge that DeFi systems must solve to live up to the aforementioned promise of “Near Real Time.” If the entire ledger is available all the time, to every Smart Contract, clever and bad actors can use that knowledge to cheat. Front-running, for example, is a common practice in “account model” blockchain networks. It’s when the people who run the network nodes rearrange the order of transactions so that their transactions are processed first. This can lead to longer processing time for other users, or higher transaction fees.
Cardano uses a different accounting model which forces applications and systems to work with local states when creating transactions—you only see data pertaining to your exact transaction. This is not only efficient, it has less attack vectors around creating new transactions. Each piece of data is tokenized in something called a UTXO (Unspent Transaction Output). Using UTXO tokens lets DeFi systems on Cardano process transactions in both a serial step-by-step, or parallel side-by-side order. This means that in a single transaction, Cardano can easily serve 10, or 50 people at once, instead of the 10 or 50 separate transactions that would be required on systems that use global state. So while TPS is important, it’s not as important for DeFi built on Cardano. Cardano is currently rated for 250 TPS, which is already high for the current ecosystem and is expected to go higher. The huge differentiator is that each of those 250 transactions may serve 10, 50 or a 100 people!
This local UTXO state management also means that Cardano can calculate exactly how much computer resources will be required to process your transaction so you get to know the exact processing cost before you submit your transaction. On global state systems, this is not the case, since there’s no way to know how long it will take to check the entire blockchain that is always changing.
Lastly, the fees on Cardano and it’s UTXO accounting system are typically 10 to 200x lower than global state systems, because it takes a lot less computer power to validate a handful of UTXOs vs having to reason about the entire blockchain.
DeFi on Cardano is still in its infancy: the first DeFi platforms came online within the last few weeks. Even so, more transactions were processed in the last 90 days than in the entire history of Cardano. We are excited to see what DeFi products people get excited about when the flood gates open. We expect not only new records set, but also that the Cardano UTXO model will inspire new standards and possibilities for the whole DeFi landscape!