This is the first in a series of articles on decentralised finance (also known as DeFi), a new revolution that has taken the financial services sector by storm. The financial services sector is about to change in every aspect, from how we move and store value to how we access credit, invest, trade, transact, and insure against risk.
DeFi will enable new business models and organizational capabilities that can not only change the way we conduct financial transactions, but also redefine the architecture of the financial services sector and other related financial institutions, as well as change the way financial services companies interact with corporate clients and with each other.
Decentralised Ledger Technologies
At the heart of this revolution is the widespread adoption of decentralised ledger technologies (also known as DLTs, for example, blockchains) that allow us to create new asset classes, business models, and governance systems for the incoming digital age. DTL technology as blockchains are tamper-resistant ledgers of transactions distributed across a network of nodes maintained by many stakeholders. These shared ledgers stored in each node serve as common sources of truth. They can complement or even replace the records of banks, corporations, and large FinTechs that act as an intermediary in many of the digital transactions.
Blockchains are the first medium for digital value when currency and trade assets are fully digitized, just as the internet was the first medium for digital information. Financial services are no longer centralized within an industry; they are decentralised across blockchain networks such as Algorand, Bitcoin, Ethereum and Solana.
The revolution began in 2008, when visionary Satoshi Nakamoto (pseudonym of one or more cryptographers) wrote the white paper “Bitcoin: A Peer-to-Peer Electronic Cash System,” introducing a radical new concept: digital cash that can be minted, moved and that can store value without intermediaries such as banks and governments.
DeFi, built on top of a distributed network of nodes (not corporations), extends Satoshi’s concept of peer-to-peer (P2P) electronic cash to lending, trading, investing, and managing risk. These innovations are possible thanks to a breakthrough called smart contracts, an immutable self-executing program based on a blockchain such as Algorand and Ethereum, which allows individuals to transact, do business and create value in a trustless and P2P way without the need for traditional intermediaries and gatekeepers.
In Web 1.0, the internet was primarily a broadcast medium for publishing static information, including text, images, and video. Over time the internet has evolved into a collaborative communication medium in Web 2.0, becoming a platform for online mass participation (such as Wikipedia), workspace communities (for example, Google Meet ), engaging in social media (for instance Facebook and YouTube) and hosting web apps (like Dropbox and Google Docs), which have become indispensable for our daily social and work interactions. In Web 2.0, we have depended on centralized intermediaries such as banks, social media giants, and digital conglomerates to perform essential functions for us, including moving and storing value, verifying identities, and managing record keeping, contracting, and other business logic tasks to establish trust in online transactions.
Several problems arise from this reliance. One issue with such intermediaries is that they are centralized, which makes them vulnerable to cyberattack and corruption. Financial intermediaries also add friction to online transactions, which can include days or weeks delays, high fees for international money transfers, and other profit-oriented behaviors. In addition, banks, social media companies, and Internet service providers are gatekeepers who exclude many people. For instance, in the banking sector, more than 2 billion people have no access to financial services. These gatekeepers also capture all the data and a great deal of the value created online. Some of the largest companies in the world, such as Google, Microsoft, and Meta, are digital conglomerates that have built their fortune, at least in part on user data. However, they do not protect our privacy—for example, the breaches of Facebook, Twitter and even Zoom recently.
The incentives of management, shareholders, and deposit holders are often misaligned by those in control, resulting in managers acting in the short term for their own sake at the expense of everyone else. We saw this misalignment in the actions of the big banks during the 2008 financial crisis, when managers took out large risks to earn handsome bonuses at the expense of customers, shareholders, and ultimately taxpayers.
Web 3.0 was developed to address the limitations of Web 2.0. Web 3.0 is built on top of blockchain networks that enable us to create, move, and manage digital goods, and interact with them via decentralized applications (also known as dapps).
In addition to these so-called “Layer 1” platforms, there can be additional blockchains (also known as “Layer 2” platforms) that help scale the Layer 1s so they are more efficient. For example, a Layer 2 platform called Polygon reduces costs and increases the efficiency of protocols such as Ethereum by moving some transactions out of the main chain. This is beneficial because the network can be congested due to the growing popularity of DeFi. Not all blockchains are created equal. The Algorand blockchain, for example, was designed with financial transactions in mind and has a more functional architecture with less coding and more security. Algorand smart contracts lay in Layer 1 as opposed to Polygon smart contracts that lay on Layer 2.
Interoperability protocols, such as Cosmos and Polkadot, connect the various Layer 1s with each other so that assets can be transferred seamlessly between different platforms. The Cosmos network supports an “Internet of blockchains” known as IBC (the inter-blockchain communication protocol) that allows many other chains to connect with one another so that assets and applications can interoperate across different chains. IBC connects assets worth more than $150 billion. Finally, Layer 3 stands on top of these layers: the dapps in DeFi and beyond.