Decentralized Finance: Automation of Financial Markets

The term decentralized finance - often abbreviated as DeFi - refers to solutions built using internet protocols, and decentralized software solutions, including public blockchains, and web interfaces. DeFi systems deploy 'digital vending machines' created by smart contracts to create automated solutions, resembling those of legacy financial services, without the need of human intervention - in form of middlemen - or a corporate structure.

Current primary DeFi building blocks, include standardized smart contracts forming digital bearer instruments (i.e., tokens), un-hosted wallets (which are technically more like "blockchain browsers"), non-custodial exchanges, decentralized lending markets, blockchain derivatives, and on-chain asset management solutions. DeFi systems generally do not require intermediaries or centralized organizations. Instead, they are based on open networked systems, and decentralized applications (DApps).

Contracts are executed by automated software applications, and transactions are performed in a secure and verifiable way - i.e. verified by a public blockchain. Thus, this architecture can in principal create interoperable value transfer networks with a high degree of transparency. The later is largely absent from legacy financial systems.

Moreover DeFi solutions allow for equal access rights ("censorship-resistance), and little need for custodians, central clearing houses, or third-party escrow services, as most of these functions les can be assumed by transparent software solutions.

So far, DeFi offers a small number of applications, due to being limited to digitally native assets. For example, one can buy U.S. dollar (USD)-pegged assets - so-called stablecoins (an unfortunate term, which will be addressed in a later article) on decentralized exchanges, move these assets to an equally decentralized lending platform to earn interest, and subsequently add the interest-bearing instruments to a decentralized liquidity pool or an on-chain investment fund.

The backbone for all DeFi systems and applications are smart contracts. Smart contracts generally refer to small applications executed by a blockchain and validated through consensus of node operators. In the context of public blockchains, the network is designed so that each participant can be involved in and verify the correct execution of any the change in control over a set of bytes. As a result, smart contracts are somewhat less efficient compared to traditional centralized database solutions.

However - setting propaganda by corporate media aside - they are vastly more secure, as mart contracts will always be executed as specified and usually allow anyone with the right skill-set to verify the resulting state changes (blockchains are not databases but state machines) independently. When implemented securely, smart contracts are transparent and minimize the risk inherent to all mediated systems: the Principal-Agent Problem.

To understand the innovation inherent to smart contracts, one first must evaluate legacy server-based web applications. When a user interacts with such an application, he cannot observe the application's internal logic. Moreover, the user is not in control of the execution environment. Either one or both could be manipulated by the operator (i.e. a commercial bank). As a result, the user has to trust the application service provider. Smart contracts mitigate against both risks and ensure that an application executes as expected. The contract's code ("law") is stored on the underlying blockchain and can therefore be publicly scrutinized. The contract's behavior is deterministic, and function calls - i.e. in the form of transactions - are processed by hundreds - and often thousands - of network participants in parallel, ensuring the execution's legitimacy. When the execution leads to state changes, for example, the change of account entries, the validity of these changes are subject to the blockchain network's consensus rules and will be reflected in and protected by the blockchain's state tree.

Smart contracts have access to a rich instruction set and are therefore quite flexible. Additionally, they can store digitally native assets - i.e. cryptocurrencies (another term in need of disambiguation) and thereby assume the role of a custodian, with user-defined criteria for how, when, and to whom control over these assets can be released. This allows for a growing number of new applications.

The original concept of a smart contract was developed by Nick Szabo in 1997; he used the example of a vending machine to describe the idea further and argued that many agreements could be "embedded in the hardware and software we deal with, in such a way as to make a breach of contract expensive…for the breacher."

In 2013 Vitalik Buterin proposed a decentralized blockchain-based smart contract platform to solve any trust issues regarding the execution environment and to enable secure global states. Additionally, this platform enables contracts to interact with and build on top of each other (composability). The concept was further formalized by Gavin Wood in 2015, ultimately implemented in the smart-contract system Ethereum. DeFi applications remain a niche market with relatively low volumes—however, these numbers are growing. The value of funds that are locked in DeFi-related smart contracts recently crossed 110 billion USD.

It is important to note that these are not transaction volume or market cap numbers; these values refers to digital assets locked in smart contracts for use in various ways. The growth of these assets alongside some truly innovative protocols suggests that DeFi may become relevant in a much broader context and has sparked interest among policymakers, researchers, and financial institutions.

P.S. These notes are part of a larger effort to debunk the state of the financial system, which will be published as a book under the title Streaming Money later this year.