The quantum of investment in building the digital infrastructure underpinning DeFi is mind blowing.
The idea for banks began almost 4,000 years ago in ancient Babylon, when money lenders made loans to people and began charging interest.
The concept of banking is relatively simple: an intermediary takes money deposited by one entity and then lends it to someone else for a fee – interest.
The bank, or the middleman, takes their cut of the interest paid and the entity who lent the money in the first place gets the rest.
This system worked for thousands of years.
Until the proliferation of blockchain technology started to threaten the supremacy of the middlemen.
With blockchain technology, a network of computers verifies transactions, doing away with the need for the central authority figure to manage the ledger.
With the ledger becoming decentralised – the big, powerful authority in the middle is no longer required.
With the middleman out of the way, decentralised finance, or DeFi, emerged.
Money without the middleman
DeFi is an umbrella term for a variety of financial applications in cryptocurrency, or blockchain, geared toward disrupting financial intermediaries.
The DeFi concept has libertarian undertones, and resonates with society’s underdogs who’ve for centuries been oppressed by the political and financial elite.
It’s therefore hardly surprising that DeFi spread like wildfire throughout the crypto community.
2020 onwards saw a huge build out of yield-based, unregulated DeFi and crypto “shadow banks”.
While DeFi terminology is different to traditional banking, in the most basic use case, the user locks-in their crypto tokens into a smart contract and earns a return from the DeFi platform for doing so.
In decentralised finance, this is known as “DeFi staking”. In traditional banking it’s called a bank fixed deposit.
During the boom, one of the biggest DeFi lenders, Celsius, were offering users yields of 18% for depositing their crypto with the firm.
US banks during the same period were offering rates less than 1%.
But like most things in finance, the higher the return, the higher the risk.
The crypto equivalent of a run on the banks
Cryptocurrencies have suffered a savage meltdown this year. Bitcoin has lost almost 60% of its value since the beginning of 2022.
Warren Buffett famously once said: “only when the tide goes out do you discover who’s been swimming naked”.
And in June, Celsius were caught out in the changing crypto tide.
The company told users that it was pausing all withdrawals, swaps and transfers due to extreme market conditions.
Celsius managed $11.8 billion in assets as of May 17, according to the company’s website.
And just like the Global Financial Crisis of 2008, the contagion spread throughout the markets. Only this time, there was no government bailout.
The future of DeFi and what it means for traditional banks
The big question is whether DeFi can recover from its 2022 crisis of confidence.
Idealism only stretches so far when people have lost money.
Certainly the quantum of investment in building the digital infrastructure underpinning DeFi is mind blowing.
As of mid-August, the total value locked in decentralised finance projects was about $62 billion, though that’s down from a peak of $250 billion in December 2022.
It’s estimated that transaction costs for DeFi are anywhere from 5-30% cheaper than traditional payment methods, due to super-fast digital architecture.
This type of value doesn’t simply evaporate.
But for DeFi to survive, it’s going to need to offer more than being an unregulated, digital version of traditional banks.
And there are probably some good lessons forged over thousands of years such as the importance of protecting and preserving customers’ capital.
There’s certainly cause for traditional banks to be nervous, the quantum leaps in technology, the rate of customer adoption and the speed of transactions should have old-school banks shaking in their boots.
But there’s one big problem for DeFi still to solve – programming Adam Smith’s “invisible hand” with a dead man’s brake before the bullet train goes over the cliff.
Heidi is the CEO of finance data and media platform Grafa. She consults to a range of companies from ASX Top 200 to fast growing startups and cryptocurrency companies.