There is no denying that decentralised finance (DeFi) has been picking up traction around the world as an alternative to traditional financial systems. This has been fueled by stablecoins, composability, and dApps (decentralised apps) with recent estimations showing 3 million users.
Wait, what the hell is DeFi?
DeFi is short for decentralised finance. It’s made up of two parts:
- Decentralised — meaning it is not governed, regulated, or entrusted by a single entity, instead it is governed by all users.
- Finance — basically encompassing a financial system that involves the management, creation, and study of wealth and investments.
You can think of DeFi as an entire financial system made possible by smart contracts, composability, and cryptocurrency. Like traditional finance, it creates a system for currency to keep moving, working, and finding meaningful value through mechanisms such as borrowing and lending. However, unlike traditional finance, it does not require a central authority, such as a bank to play the middle man. This has many advantages but also faces challenges of its own.
This article is intended to remove the technical complexity behind comparing DeFi and Centralised Finance (CeFi) in a practical, real-life way that doesn’t require extensive knowledge of cryptocurrency at all. I will use Anchor Protocol for the DeFi example but know that Anchor Protocol is just 1 of thousands of possible DeFi Applications.
Scenario #1 — An example from the centralised finance world as we know it.
To start, I want to introduce 2 regular Australian people in their late 20’s and 1 Australian bank in a centralised finance world.
Emily, Chris, and National Australia Bank in a traditional finance world
— Emily has a stable job and knows saving money is important if she ever wants financial freedom. She tries to limit her expenses and save at least 30% of her monthly paycheck. She isn’t familiar with investing so she just keeps it simple and stores her money in her NAB iSaver savings account which earns her 0.30% p.a.
— Chris is all about leverage and to grow his wealth he is purchasing an investment property. He doesn’t have $500,000 to purchase this investment property outright, so he takes out a loan, pays interest on that loan, and uses the bank's money to purchase the investment property. Yes, he is paying the bank 4% interest per annum but he believes that the property will appreciate through capital growth greater than 4% p.a so, in the end, he will come out better than if he waited to buy the property outright when he had saved $500,000 in cash.
— National Australian Bank (NAB) is one of the four largest financial institutions in Australia in terms of market capitalisation, earnings, and customers. NAB has taken the money that Emily deposited into her savings account (as well as others) and used it to lend Chris money for his investment property. NAB earns 3.70% p.a profit on this loaned money. This difference is referred to as yield or interest rate spread. While this isn’t the only way NAB makes money, in 2021 NAB reported a statutory net profit of AU$3.2 billion for the 2021 financial half-year. Not a bad business if you ask me.
Scenario #2 — The decentralised finance version of that same world.
Now let’s look at that same situation but with a few small changes:
- Replace NAB with a decentralised savings app built on Terra, called Anchor Protocol. You can think of Anchor as doing two things, a DeFi high-interest savings account and also a way to take out loans. Read about how it works here.
- Replace investment property with a speculative crypto asset, in this case, $LUNA.
- Replace Emily’s Bank account with a Terra Station Wallet (The crypto version of the wallet)
- Replace Australian Dollar (AUD) with the Terra stable coin Australian dollar Terra AUD or AUT. To keep it simple, a stablecoin aims to always be worth what it’s pegged to, in this case, the Australian Dollar so for simplicities sake, think of them as the same thing for now.
Emily, Chris, and Anchor Protocol in a decentralised world
— Emily has a stable job and knows saving money is important if she ever wants financial freedom. She tries to limit her expenses and save at least 30% of her monthly paycheck. She isn’t familiar with investing so she just keeps it simple and converts her Australian dollars into Terra Australian Dollars (1:1) through her Terra Station wallet. She then connects her digital wallet to Anchor protocol’s Earn function to deposit her money and earn her 19% p.a interest with no lock-in period.
— Chris is all about leverage and to grow his wealth he is purchasing a speculative crypto-asset called $LUNA. While he expects the asset to grow in value over time, he also wants to maximise his return through leverage so he uses his $LUNA to take out a loan and receives Terra Australian dollars. He takes out a loan, pays interest on that loan, and uses the loaned money to invest further. Yes, he is paying Anchor protocol 20% interest per annum but he believes that $LUNA will appreciate through capital growth greater than 20% so, in the end, he will come out better than if he just held the asset and did nothing with it. At the time of writing this, 9th August 2021, $LUNA has grown +2,072% (YTD) 2021.
— Anchor Protocol defines a money market between a lender, looking to earn stable interest on their stablecoins, and a borrower, looking to borrow stablecoins using a speculative asset. Anchor has a total locked value (money deposited and collateral provided) of $1,975,365,094 USD [August 9th 2021].
Anchor uses smart contracts to programmatically take the money that Emily deposited into Anchor Earn (as well as others) and lends it to Chris for his further investing. Anchor also programmatically uses Chris’ collateral, $LUNA to earn staking rewards.
Anchor earns 0% p.a profit from this interaction and only charges small transaction fees to ensure the protocol keeps running. In fact, Anchor does not earn any profit nor does it employ people or have traditional business expenses, so unlike NAB it doesn’t need to clip the ticket. This results in a better financial outcome for the individuals participating in this DeFi protocol.
Are you thinking “how is the person lending the money being protected from the borrower investing their loaned money?” or “How does Anchor actually work?” Good questions, I cover them here.
So if it’s that great, why isn’t everyone using DeFi?
In short, given that DeFi is so new, it comes down to the technical knowledge it takes to both understand what’s happening and then put that into action. It might take as long as 3-months of learning until you become comfortable interacting with these protocols.
There are also lots of common misconceptions about DeFi, bad actors trying to con newbies as well as a perception that centralised finance is just the way the world works, and that will never change.
Currently, many individuals and businesses are working to bring the value of DeFi to everyday people. Regulations also haven’t been well-defined yet so it’s up to the government to create policies that will create a technology boom and a strong economy rather than stifle innovation.
That sounds too good, are there any risks facing DeFi?
In no particular order, your main risks are as followed:
- Smart contract failure — Like a bug in the code, however, most protocols have been independently audited by a third party to find and resolve any bugs.
- Hacking — This is always possible, however you can take extra precautions such as investing in a hardware wallet.
- Stablecoin de-pegging — This is if the value of an Australian Dollar and a Terra Australian dollar do not equal each other, this can happen in certain circumstances but if you are worried about it you can take out insurance on this through the protocol.
- Losing your seed phrase — This is like a more complex version of your bank account login details, the only difference is if you lose them you can’t call anyone to get them back. Gone forever.
- The whole Terra ecosystem collapsing — Not very likely but it could happen so I’m flagging it for completeness.
- Government regulation — Governments could take a harsh stance on DeFi and make using it or accessing it very difficult.
- Central bank digital currencies forcing certain DeFi protocols out — A popular theme, which is already happening in China, is governments creating their own government-issued cryptocurrency. If Australia did this, it might not allow these protocols to be used.
Thanks for reading! To finish things off, I need to say that I am not a financial adviser nor is this investment advice. I am just passionate about DeFi and the Terra ecosystem. I would love to hear your thoughts so please leave any questions or comments below.
