Understanding Decentralized Finance

Opportunity and risk reside in the world of decentralized finance (DeFi), the financial systems, tools, applications, and businesses that are built on blockchain technology. The blockchain can provide access to financial tools that once required layers of third parties to guarantee transactions or ensure security of funds.

Blockchain technology has been used within banking, finance, legal systems, and other areas once considered critical to the way money flows and companies provide and collect on services. Companies have just begun to understand, explore, and incorporate the technology and the tools but the size of the DeFi sector has gone from $4 billion to $93 billion in only three years. Before delving into this nascent market there are layers of risk to consider.

What is decentralized finance?

Companies incorporate financial institutions, lawyers, contracts, and insurance policies often for the very reason that they want to secure transactions if they hold up to their side of a contract. But what if technology could provide a tool that secures the transaction, without the need of third parties?

That’s where DeFi hopes to find a market. It uses the blockchain to build in applications, protocols, or tools that allow people or companies to conduct transactions in a way that reduces the need for other third parties to verify the deal. It creates a peer-to-peer dynamic, where users interact and define parameters based on needs, while software serves as the middleman providing assurance of the terms.

It remains a nascent market, but DeFi designers hope that this concept can avoid the significant risks—like regulation, security, and volatility, to name a few—to provide companies and people with an alternative to traditional contracts or transactions.

Why does decentralized finance matter?

One of the most basic DeFi concepts is the smart contract, first developed by blockchain company Ethereum. A smart contract would be built and agreed upon via the Ethereum blockchain, for example. One side would outline the requirements of the transaction before the customer would pay for the service. The smart contract—commanded by the software within the blockchain—would then oversee the relationship. As the service unfolds and different benchmarks are reached, the contract on the blockchain notes the successes. Once the vendor achieves all the agreed upon benchmarks, then the contract ends, releasing the funds that the client agreed to. The funds transfer via the cryptocurrency Ethereum in this case.

The potential for such design expands beyond simple transactions and allows organizations or individuals to conduct agreements securely. For instance, a company in the US could hire a computer designer in Singapore with a scope of work as a contract developed and approved on the blockchain. The DeFi tool will monitor the process, providing both sides with an ability to confirm when certain goals are reached. Once they finish, then the contract confirms the payment via the cryptocurrency hosted on the DeFi platform.

By going this route, there’s no cost to transfer the cryptocurrency via the blockchain across country lines. While one contract may not make that worthwhile, thousands to millions of contracts conducted in this fashion very well could. The same can work in transferring cryptocurrency instead of using an exchange. The DeFi could process the transaction without the requirement of an exchange to confirm the sale. Even lending among institutions or between individuals could run through a DeFi design, since the blockchain technology could confirm the parameters of a loan and determine if interest and the scheduled payments were made. This process, however, is coupled with significant risks due to volatility of cryptocurrency prices, among other reasons.

The design is why companies like Ethereum have grown in popularity as DeFi has surged. It’s also why public companies like cryptocurrency exchange Coinbase have sought to expand into decentralized finance in a greater way. But many risks with the design also exist, which hold adoption back.

Risk of investing in decentralized finance

For investors, the space remains a new area to explore. But that also leaves many questions yet unanswered about how DeFi will shape moving forward. There are cybersecurity concerns as DeFi offerings include very new and untested tools, technology, and companies. A hack of the software could lead to destruction of a company or the associated blockchain platform overnight. There’s also regulation risk, which could change how DeFi operates if new laws impact the DeFi design, that would be the removal of a middleman from the transaction process. For instance, as larger organizations enter, will there need to be more middlemen for certain transactions to ensure compliance of local laws? If so, how does it impact the network that the blockchain resides on? Will it eliminate the ease that the DeFi tool offers?

Unique aspects of decentralized finance

The DeFi and blockchain sector is a broad space with various terms and nomenclature that will arise. The complexity has occurred because the blockchain is decentralized, meaning no one computer or entity holds the software. Instead, it's hosted on thousands of servers and computers across the world, creating a peer-to-peer design in how users interact on the blockchain and how platforms operate.

As you research further, you’ll even find unusual designs for how organizations and companies are structured. It’s important as you delve further into DeFi to have a sense of common terms in the space, since it will aid in your research and help you differentiate between products that have potential and those simply trying to overwhelm you with lingo. These terms include:

• DeFi protocols – This describes platforms that community members or an organization use to build new services. An organization, for example, can build a crypto exchange on the Ethereum smart contract protocol. These are also the rules that creators must adhere to, which are embedded within the blockchain software. Each platform will have its own set of protocols that a creator will have to adhere to.
• Total Value Locked (TVL) – It’s important for you as an investor to know how well a DeFi platform has done in attracting users. One way is with TVL, which describes the total amount of money that the platform has helped transfer or the amount of business that has been conducted with that platform or tool.
• Decentralized Autonomous Organizations (DAO) – Instead of operating with managers and a board, DAOs are a community whose investors determine the pathway for the organization. Performing tasks to improve the organization leads to rewards in the form of tokens (a type of cryptocurrency). Decisions of the company are made by the vote of the DAO participants, as opposed to a CEO or board of directors.

Santander Investment Services can help you understand the potential impact of investing in this sector on your portfolio. With that help, you can weigh new options that best fit your risk tolerance.