What is DeFi?
DeFi (pronounced dee-fye) is short for decentralized finance. It’s an umbrella term for the part of the crypto universe that is geared toward building a new, internet-native financial system, using blockchains to replace traditional intermediaries and trust mechanisms.
I am falling asleep.
Don’t! I promise it’s interesting.
OK, I’ll give it a chance. What do you mean by “using blockchains to replace traditional intermediaries and trust mechanisms?”
Let’s back up a bit. To send or receive money in the traditional financial system you need intermediaries, like banks or stock exchanges. And in order to feel comfortable doing the transaction, all parties need to trust that those intermediaries will act fairly and honestly.
In DeFi, those middlemen are replaced by software. Instead of transacting through banks and stock exchanges, people trade directly with one another, with blockchain-based “smart contracts” doing the work of making markets, settling trades and ensuring that the entire process is fair and trustworthy.
So DeFi is crypto’s version of a stock exchange?
That’s part of it. But DeFi also includes things like lending platforms, prediction markets, options and derivatives.
Basically, crypto people are building their own version of Wall Street — one that is largely decentralized and deals exclusively in crypto, with crypto versions of many of the products offered by traditional financial firms, and without much of the red tape and regulations that govern the existing financial system.
Wild West Wall Street! OK, now I’m interested. How big is DeFi?
DeFi’s total value locked or T.V.L. — a standard way of measuring the value of crypto held in DeFi projects — is currently about $77 billion, according to DeFi Pulse . That would make DeFi something like the 38th largest bank in the United States by deposits, if it were a bank.
So not huge, but not small either.
Right. And T.V.L. isn’t the only way to measure DeFi’s growth. You could also look at trading activity on decentralized exchanges, which has grown by triple-digit percentages in the past year.
Or you could take a cue from regulators and politicians, who are increasingly looking to DeFi’s growth with concern. Michael Hsu, the acting U.S. comptroller of the currency, said in a speech at a blockchain conference in September that many DeFi products reminded him of the credit default swaps and other complex derivatives that were popular on Wall Street in the years leading up to the 2008 financial crisis.
And Senator Elizabeth Warren, the Massachusetts Democrat, singled out DeFi in a December crypto hearing, calling it “the most dangerous part of the crypto world.”
Why are people so worried about DeFi?
In short, because DeFi is mostly unregulated, with few of the consumer protections and safeguards that exist in the traditional financial system.
Can you give me an example of something that would be regulated in the traditional financial system, but isn’t regulated in DeFi? The best example is probably stablecoins. Stablecoins are cryptocurrencies whose value is pegged to the value of a government-backed currency, like the U.S. dollar.Stablecoins are a critical part of DeFi markets, because if you’re a crypto investor, you don’t want to constantly be changing tokens back and forth to dollars, or keeping all your assets in cryptocurrencies whose values might fluctuate wildly. You want a crypto coin that behaves like a boring, stable dollar, which you can use without needing to interact at all with the TradFi system. TradFi? It’s what DeFi people jokingly call traditional finance. Clever. So, back to stablecoins. What’s dangerous about them? Well, regulators have argued that despite the name, stablecoins aren’t actually that stable.As my colleague, Jeanna Smialek, explained in an article on stablecoins last year, the worry stems from the fact that stablecoin issuers aren’t legally required to back their coins one-to-one with safe, cash-like assets. Investors who buy stablecoins might reasonably assume that each USD Coin or Tether (the two most popular stablecoins pegged to the U.S. dollar) is worth $1, and that they will be able to redeem their stablecoins for actual dollars whenever they want.But there’s nothing in the law, at present, that requires stablecoin issuers to have one-to-one backing. And if they don’t have enough reserves to cover the stablecoins they’re issuing, the whole thing could collapse if enough investors decide to pull their money out all at once. That sounds bad! It would be, especially since stablecoins are the backbone of DeFi trading. And there are questions among investors and regulators about whether some of the leading stablecoin issuers actually […]
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