Decentralized Finance – a protocol-based financial system

Generally, in the blockchain industry, each year can be summarized into one or more trends. In 2009 it was Bitcoin, in 2011 Mt. Gox, in 2015 Ethereum, in 2017 Initial Coin Offerings and in 2019 clearly Decentralized Finance (DeFI). “The decade in Blockchain – 2010 to 2020 in review” also summarizes key milestones and events over the last decade. Personally, I have long been convinced that blockchain technology is an inside-out market. That is, major innovations, real benefits, and adaptation of the technology occur first in the financial sector. Moreover, disruptive innovations only emerge at the frontier fields that challenge conventional thinking and action. The arena for this is startups building on public blockchain infrastructure and establishing crypto-economic protocols. Here, these new use cases are being tested and developed “in the wild” by a group of early adopters. Over time, these mechanisms become more robust, prove themselves, and merge with or replace traditional infrastructure.

DeFi refers to digital asset and financial smart contracts, protocols, and decentralized applications (dApps) developed primarily on the Ethereum Blockchain. In simpler terms, it is financial software built on blockchain technology that can be combined as individual components like Lego bricks. Computers, software, and the internet have disrupted all industries. In the process, each innovation builds on the foundation of the previous one, and digital products and services are becoming increasingly sophisticated. “Software is eating money” subsumes the DeFi phenomenon quite well. This also opens a new design space for the financial industry, within which DeFi protocols become “money legos” that allow combinatorial innovation and an unprecedented level of automation.

DeFi is Open Finance

This references a paradigm shift away from today’s closed financial systems and toward open, protocol-based finance that is interoperable, programmable and composable. The idea is not necessarily to create a completely new system, but to democratize the existing one and make it more equitable, with the help of open protocols and a transparent database. Kain Warwick of Synthetix describes a general definition as follows: “DeFi is the replication of existing financial services by creating trustless protocols with predefined rules that allow open participation, where consumers of these services pay fees which are automatically distributed to protocol participants.”

A fundamental change here is the shift from companies and platforms to protocols. The so-called protocol economy promises to optimize the economic and digital infrastructure of the Internet itself in many ways. In the larger context, this includes, among other things, the consolidation of data-driven platform monopolies. The basic infrastructure of the Internet is based on open protocols and standards that anyone can use to develop compatible interfaces against it. Email uses SMTP and the World Wide Web itself is a protocol with the Hyper Text Transfer Protocol. Over the last decade, however, the Internet has come of age under the control of privately held companies that are increasingly leveraging their market power and network effects.

The article “Protocols, not platforms: a technological approach to free speech” by Mike Masnick gives a detailed argumentation because we should rather build our digital infrastructure on protocols instead of corporate platforms in the future. These give us a better basis for ensuring individual freedoms, better protecting our data and privacy, as well as generating more innovation and new business models.

In “The invisible protocol thesis: tomorrow’s crypto unicorns,” Jamie Burke of Outlier Ventures argues that demand for the first essential blockchain protocols will take place through the adaptation of 3rd party developers building end-user applications based on them. He distinguishes between the two categories of “decentralized infrastructure-as-a-service” and “decentralized platform-as-service.”

In terms of DeFi, it is important to understand that it is primarily the combination of different protocols that will create the greatest added value and benefit. While individual dApps will stand out, they can only thrive within a complex ecosystem of other infrastructure and services. In the process, strong network effects will emerge between them. A trend that can already be observed today on the Ethereum Blockchain. The article “Network effects in an open financial world” by Ivan Martinez is recommended.

The network effects are based on the three core properties of DeFi:

  • Interoperable: the current financial system consists of walled gardens with limited portability or multi-sided access. If interoperability is possible, it is only under the control of intermediaries and gatekeepers that extract rents. DeFi is defined by platforms that can interoperate with a high degree of transparency and whose individual functions are complementary.
  • Programmable: bitcoin has revolutionized money. Ethereum has enabled new types of financial instruments and digital assets that are more flexible than existing products and services. Tokenization and automation through smart contract-based financial contracts will enable a new era of financial mechanisms and growth
  • Composable: like Legos, the composability of various standardized elements is limited solely by our imagination. Composability refers to the concept that something can be selected and put together in different combinations. Ethereum itself has already illustrated the value of composability. A variety of protocols, such as MakerDao, UMA, 0X protocol, Augur, or Compound Finance are implemented on Ethereum. These, in turn, leverage each other’s complementary features or are bundled into a user-centric web interface by 3rd party developers into an application with better user experience.

Basically, any financial system needs numerous features to become a powerful economic engine. There exist some generally accepted characteristics that an economic system includes. According to these, a functioning financial system includes global, efficient markets that

  • Enable borrowers and lenders to transfer capital
  • Allow trading and exchange of financial products (e.g., derivatives) with required liquidity
  • Enable individuals/investors to move, secure, form, and allocate capital
  • Provide capacity to manage and mitigate risks
  • Provide regulatory certainty for investors and individuals

A financial system that provides an adequate amount of market liquidity to borrowers needs lenders and vice versa. This cock-and-bull problem is initially solved by market speculation. Cryptocurrencies and assets are a new speculative asset class that is not yet established. Some interesting protocols have emerged from this demand, such as MakerDao, Dharma, and Compound Finance. In the trading and exchange space, decentralized protocols, such as 0X, Kyber Network, and Uniswap, have emerged alongside centralized platforms, such as Coinbase, Bitfinex, and Binance. In “Decentralized liquidity – maturing the backbone to decentralized finance”, we go deeper into the provision of liquidity as one of the core mechanisms. For derivatives, there are other protocols, such as UMA and Synthetix, which have an increasing product market fit. The DeFi Pulse website provides an overview of this growing ecosystem. In addition, there are a variety of wallets, tools and other integrations built on top of these protocols. In addition, staking is becoming an increasingly important form of capital allocation.

Risk management and regulatory security are not yet as far along as those to previous categories. In general, the use of blockchain technology will mitigate some of the risks of the existing financial system that exist due to a non-transparent data and information base, intermediaries, and proprietary systems. However, there are still some technical risks associated with the young technology and the use of smart contracts. On the regulatory side, there is still a lot of ambiguity, but with initiatives such as the federal government’s blockchain strategy and similar ones at the international level, entrepreneurs should experience more regulatory certainty in the future.

A new era of DeFi’s – One for all: Venice Swap

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