Hooray for DeFi, and What Is That Again?

Take a glance at any random corner of Web3 today and you’ll quickly discover an ecosystem overflowing with joy and unbridled enthusiasm. Yes, there’s a tribe of serious entrepreneurs and VC firms methodically investing to earn a calculated return, but there’s also experimental building on a scale far beyond the familiar baseline of traditional industries. Unlike classic commoditized markets with predictable ROI (think: commercial warehouses or mortgage refinance), Web3 entrepreneurs are building without limits (or 5-year strategic roadmaps). Creation is its own inherent reward. This is a world unhampered by micro-optimization, where new business models can spring up overnight and die just as quickly. A few lucky ones will find their footing and go on to dominate the landscape.

Crypto is an exuberant, chaotic mess. Amid so much breathless enthusiasm it’s easy to lose oneself and begin assuming all component parts of the ecosystem are equivalent. Utter the term Decentralized Finance (or DeFi), and you can be instantly drawn into a discussion of Smart Contracts, Tokens, or the Blockchain. But these things are not alike. Defi is a particular application enabled by these other technologies. It is possible, though unlikely, to create similar decentralized financial infrastructure using traditional servers, IP addresses, and bank routing numbers.

To make sense of this situation we must refine our terms. “DeFi” is overly broad for meaningful discussion and distinction. Saying “let’s talk about DeFi” is almost equivalent to saying “let’s talk about banking”. Is this checking? Savings? CDs? Investment vehicles? Lending? Let’s dig in.

Stop me if you’ve heard this one before: Decentralized Finance is a fully permissionless system allowing individuals to invest, trade crypto currencies, and earn a better interest rate than banks. DeFi is completely decentralized with no corporate headquarters or CEOs, making it impossible for governments to censor.

Unfortunately, almost everything about that story is wrong.

Distributed

Crypto-native financial applications exist on a blockchain (most commonly Ethereum, but competitors exist). Contracts are tiny pieces of software executed as function calls. While these calls may be triggered by a human action, the response from the DeFi contract is entirely automated. Transactions are available for post-execution audit but are not subject to pre-execution review or approval. Transactions assume approval and are only auto-blocked if they violate the parameters of the DeFi software contract. Once executed, transactions are immutable.

The sort-of-permissionless nature of DeFi stands in stark contrast to “CeFi”, or Centralized Finance product offerings. These are the traditional banks and brokerages who currently provide financial services to the world and may execute human oversight over any transaction at any time. Transactions found to be “wrong” may be reverted.

I say “sort-of-permissionless” because, while DeFi is indeed decentralized in theory, we are seeing an increasing number of practical controls put on its operation. Rather than outlawing or restricting these platforms outright, various governments have found it more effective to begin attacking the onramps and offramps between Crypto and Fiat. KYC (Know Your Customer) laws require major providers to validate customer identity prior to making large-value crypto exchanges. Coupled with a fully traceable transaction ledger, it’s now possible to follow transactions back to their actual owner, identifying counterparties, funding sources, and more.

Permissionless and Uncensorable

We’re seeing increasing interest from regulatory bodies regarding Crypto systems, which is both welcome (yay validation!) as well as concerning (don’t kill it!). In the United States, President Joe Biden recently signed an executive order directing the government to further study digital currencies, reflecting increasing awareness of and focus on this nascent industry.

While decentralized systems do provide some resilience to outside intrusion, any major platform will require ongoing maintenance and operation by humans. The human touchpoint is, as always, the weakpoint: it’s effectively impossible to run a major platform at any kind of scale in a completely anonymous manner. If any sufficiently motivated individual or government truly wants to find you, they will.

This means that DeFi teams will need to become intimately familiar with the nuances of operating in a regulated environment. Up to this point the community has gotten away with legal arbitrage by outpacing the understanding and enforcement of the regulatory bodies. But governments are catching up fast and have enacted a host of new restrictions which serve to effectively de-anonymize individuals interacting with the crypto ecosystem. A world of fully-traceable transactions implies that dev teams can no longer claim benign ignorance but are now on the hook for the bad behavior of their users.

This is sobering but not necessarily fatal. Though uncomfortable in the moment, accountability is a necessary step along the path to full adoption. But risk cannot be overlooked either: increased leverage from regulatory bodies is not yet fully understood. We should expect unanticipated and unwelcome “surprises” in the coming years as rules are further refined.

Investing for High Return

While there is undoubtedly investment in web3, a large volume of the activity from individuals should be more accurately classified as Speculation. In the United States we have the Accredited Investor test: if you’re already wealthy, then you can invest in whatever you want. Far from being class warfare, the Accredited Investor test is a clever compromise:

• If you’re Accredited then you probably (1) know what you’re doing (as evidenced by wealth / past success), and (2) if you don’t know what you’re doing, you’re probably not going to lose everything, become destitute, and end up as a drain on society.
• If you’re not an Accredited Investor, then you have limitations. But you’ll probably survive.

This is a societal bargain: casual investors lose access to some of the highest-reward opportunities, but also gain some protection against bankruptcy and retirement thefts by smooth-talking scam artists. In return, society as a whole reduces its liability caring for destitute victims. But if you’ve already hit it big, well… good luck, and Godspeed.

DeFi is missing these protections. Anyone can write and deploy a Smart Contract, drum up popular interest, and collect funds. Some of these opportunities will be scams! Some will be the Next Big Thing. But for today, the early adopters have as much opportunity to score (or go bankrupt!) as a professional hedge fund operator. As these systems move further into the mainstream the system will necessarily change and evolve.

Return on investment is correlated with risk. It’s not perfectly linear, but the two are closely related. So if anyone is offering a bigger return than the banks, it’s likely that return comes with material downsides: illiquid capital, high risk of failure, or (in extreme cases) outright fraud. High Return == High Risk.

So DeFi is Decentralized but not permissionless, fully traceable and censorable, enables individuals to speculate on high-risk/high-return schemes until regulation catches up, and individual token trades often come with eye-wateringly-high execution costs and fees.

And yet, here we are. Pouring billions of dollars into an entirely new financial system.

Finance

Ok then, if we’re only somewhat decentralized, what about the Finance bit? The most active DeFi applications currently break down into several major categories:

1. Currency Exchange
2. Lending
3. Yield Farming (paying a percentage on deposited ETH, providing funds to enable the Lending portion)
4. Speculation

Currency Exchange

Any time an individual wants to exchange one currency token for another, there is a transaction cost involved. The current transaction costs can be shockingly high, in some cases exceeding the value of the swapped tokens (for small-dollar amounts). Yet at the time of this writing in early 2022 token swap contracts like Uniswap account for the majority of activity and paid gas fees (transaction costs) on the Ethereum blockchain. Huge amounts of real-world value is being “destroyed” to change one invisible electronic number into a different one. Surprisingly, this is not wasteful!

When boot-strapping an entirely new financial system, existing in parallel with existing systems, the very first task is the enablement of secure transactions and exchanges. Buying and selling one valuable thing, in exchange for another valuable thing, is the very foundation of a global financial system. And this is not without precedent in our existing structure: The Forex exchange market currently transacts 6.6 Billion Dollar in US Dollars per day against the currencies of the world nations. No goods change hands, it’s the money itself which is bought and sold. This volume isn’t doing Nothing: it is wealth seeking valuable use, funds flowing between nations to lubricate the machinery of commerce. Swapping ETH for DAI on Uniswap may feel like a pointless exercise, but it’s on its way to becoming something much larger: the invisible underpinnings of a future economy.

Lending + Yield == Speculation

This isn’t the global financial market yet. Without fractional reserve banking we’re back in the Savings and Loan era for web3. No contract can lend tokens it doesn’t have, so we’ve created a new set of funding contracts which lock up currency at a fixed rate of return and then immediately lend it out to borrowers. This is a classic hack: crypto is verifiably limited and cannot be conjured out of thin air at will, so the currency float needed to maintain credit lines must come directly from depositors. In exchange for locking up value in the contract and assuming counterparty risk, depositors are compensated with yield.

Of course, there are gaps. Depository risk is high when the locked token may crash in value overnight. Borrower credit-worthiness may not be subject to the same level of scrutiny. DeFi contracts are not banks backstopped by a federal government (yet). There’s real risk underlying every investment and even “safe” assets can only exist by concentrating risk elsewhere.

Unlike the old S&Ls which held the risk on their own balance sheets, the modern approach is tranched risk. Synthetic speculative assets offer higher-risk leveraged returns, backstopping stablecoins and creating predictable lower-risk depository yield. New models will likely emerge as well: the crypto-finance system is evolving rapidly.

Follow the Value

So Decentralized Finance is only partially decentralized, and also lacks the maturity of classic financial systems. Squinting a bit, DeFi is neither Decentralized nor Finance. So why bother? Isn’t Finance already solved? Empirically, the answer is a resounding No.

One of the biggest misconceptions I’ve heard in the web3 space is that crypto systems serve no purpose. The collection of tokens, NFTs, and DeFi protocols are nothing more than a huge Ponzi-esque gambling system where suckers spend their cash on worthless computer-coins and then lose them to other gamblers or criminals.

Some of this is true! Which is why it’s so remarkable that the game continues. The operation of a borderless, permissionless financial system is so incredibly valuable that people worldwide are collectively willing to put up with terrible security, an awful user experience, frequent scams, and massively high transaction costs. DeFi contracts provide a lifeline for users in sanctioned or warring countries, and create a payment flow partially insulated against local oppression or broader geopolitical meddling.

The total value locked up in DeFi contracts continues to grow year over year. And while we may ultimately end up in a traditional winner-take­-most scenario, I also believe there will continue to exist underserved niches providing space for smaller players to grow and thrive. We are building an entirely new financial system, with all the fractal market complexity that implies.

The important bit then is: where is the value flowing, and what are the risks?

Traditional PMs will recognize these questions and find them comfortingly familiar. They are the same questions we ask of ourselves and our engineering partners:

1. What does the customer really need?
2. What is possible?
3. What is the cost? (direct costs, risks, long-term maintenance)

The answers are similarly simplistic, though they hide enormous complexity:

1. The customer needs value of all types, and value flows to service providers who remove friction.
2. Anything is possible, if it can be automated.
3. The risk is total: the loss of your lifetime earnings due to a coding error. But with great risk comes great reward!

It’s a Wonderful Bank

There’s a hidden trap here: when looking in from outside, it’s easy to focus on the huge risk (I lost everything!) without understanding the broader context. Remember that this is not a new phenomenon; we’ve been here before!

For a concrete example, consider the classic movie It’s A Wonderful Life. There’s a bank run scene which nearly causes the collapse of the local Savings and Loan. Replay that scene in your mind for a moment… is it scary for you? Do you feel the panic? When this movie was released, Americans were still reeling from the Great Depression and the collapse of the banks was a present and terrifying reality. Conventional wisdom dictated stacks of cash, carefully hidden in attic cigar boxes, under mattresses, or buried in the backyard.

For most of us born in the last 50 years this scene is baffling. There’s no sting. The idea of being unable to withdraw money because your bank ran out of money is so far outside of our reality it almost doesn’t exist. When was the last time you heard about a run on your local bank? When did anyone need to buy groceries, but there weren’t enough pieces of green paper in the vault? But this was recent history, historically speaking! The FDIC has largely solved this particular problem, and that’s the point: it was a solvable problem.

Yes, a bad smart contract can cause you to lose everything. Yes, a clever phishing email can steal your Apes. These are bugs in the system. Over time, we’ve found and purged the worst bugs from traditional banking. DeFi is early in this process. The bugs are visible! They are impactful! People are going broke! But with each failure, our collective knowledge grows.

Not Yet Commoditized

Classic economics teaches us that high-margin opportunities attract competition. Those juicy profits are too good to pass up, and eventually new competitors notice the opportunity and enter the market. Each upstart undercuts the current dominant player, and eventually the margin is thoroughly competed away and accrues to the buyer. This process leaves an efficient (but commoditized) market of mostly non-differentiated providers fighting over scraps.

We can easily forget that mature markets don’t start this way. There’s a classic economics joke along these lines:

Economist #1: Hey, look at that! There’s a $100 bill lying right there on the sidewalk!

Economist #2: No it’s not real. If it was, someone would have already picked it up.

It’s still early days for DeFi. There are $100 bills lying about everywhere and motivated builders scrambling to pick them all up. And so we’re still discovering the limits: What token should we build on? Who knows? How about all of them? Modern DeFi entrepreneurship is agile product development at its finest: fast iteration, and reinvestment into whatever works.

A Beautiful Mess

The point I hope to leave you with is this: Decentralized Finance is a beautiful, chaotic mess. It’s real, evolving at a rapid pace, and providing enough end-user value to attract massive investment despite its flaws. The smart contracts written today will probably look quaint within 5 years. Despite the overhead of uncertainty, lack of trust, and technical limitations, DeFi is here to stay. There’s real opportunity here, and stacks of $100 bills waiting to be picked up. Stay safe out there, experiment, build the future!