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From TradFi to DeFi

Christoph - Jul 14, 2022 | 7 minutes read

Decentralized Finance, or short: DeFi, is slowly expanding its reach into the mainstream (financial) world – time to learn what it is.

In order to understand DeFi it is best to start with an overview of “TradFi” — a term often used to refer to the regular financial services sector. Afterward, we will look at what blockchain technologies can add to these services before showing the combination of both.

Traditional financial services

Some of the larger segments of the financial services sector are:

  • Exchanges: Exchanges and the broader ecosystem of clearing houses and payment systems allow market participants to trade securities, currencies, or commodities with each other. They are the primary location for price discovery and are charged with running fair and transparent markets.
  • Banking: One of the core businesses of banks is to accept deposits and make loans. In more abstract terms, this means that banks match the supply and demand of differing duration requirements: One client may want to deposit her cash with the bank but be able to daily access it while another client wants to borrow a larger lump sum to buy a house and pay back over several years.
  • Derivatives: The above-mentioned banking services are typically referred to as commercial banking. One of the more complex services offered by banks is the creation and distribution of complex financial products. Generally speaking, these are financial products that provide payoff structures different from simple stocks and bonds. An example is a multi-leg options strategy that lets customers bet on volatility.
  • Investment Management: Banks tend to create products to offer to their clients and through hedging eliminate as much remaining directional exposure as possible (and are therefore referred to as “sell side”). Investment managers (including hedge funds) on the other hand allocate their own or other people’s capital and actively take risks (these firms are referred to as “buy side”).

This list is neither complete nor very granular but it should cover a very large part of the services that financial institutions have offered throughout the centuries.

What holds TradFi together?

So what are some of the important mechanisms that underlie the operation of a financial institution in TradFi?

Centralization is a design strategy commonly utilized (and hence some people use “CeFi” instead of “TradFi”). Centralization simplifies bookkeeping and risk management significantly, which in turn enables simple and capital-efficient solutions. For example, finding every market participant’s balance is easy, and changes only have to be approved by one entity.

This brings us to the second important aspect: Trust (in the central entities). Most assets are held by a small set of custodians and transacted through a small group of intermediaries. The average retail investor has no way to audit these entities. That trust is supported by a plethora of laws and regulations.

While the above features sound intuitive and necessary when hearing them for the first time, the downsides of such systems become clear very quickly and are a driver of the DeFi revolution: A small set of large and opaque financial institutions control the majority of the global financial system. They control who can buy or sell, who can open an account, or who can move their assets around the world.

The power of DeFi

DeFi’s core mission is to change this — financial services should be available to anyone, they should be transparent and control over transactions and ownership should be given back to the individual. This means that a true DeFi protocol has to be:

  • Decentralized: The protocol’s financial services are implemented using smart contracts on a blockchain that is sufficiently decentralized. This ensures that the system can not be captured by a single large entity.
  • Trustless and transparent: The protocol cannot depend on reputation or other off-chain mechanisms to ensure that market participants follow their obligations. Loan repayment, for example, cannot depend on off-chain law enforcement. All information should be publicly available.
  • Permissionless: Anyone with a wallet can use the protocol as described by the smart contracts. No entity has special powers beyond what is written in the smart contracts.
  • Censorship-free: No off-chain entity can prevent users from becoming a market participant. Anyone with a wallet can interact with the smart contracts and therefore use the financial services provided.

Implementing the above-mentioned popular traditional financial services on a blockchain (as a decentralized application = DApp) is not necessarily straightforward though: For example, a central limit order book that is commonly used by equity trading venues is difficult to be efficiently implemented as a DApp. As a workaround, decentralized exchanges (DEXes) mostly use liquidity pools and automated market makers (AMMs) instead.

Similarly, the difficulty of lending and borrowing in a trustless environment has driven the space towards overcollateralized lending protocols with automated liquidations.

Lastly, creating a digital asset derivative, that is pegged to a global fiat currency like the US Dollar (a so called “stablecoin“) is another large problem the DeFi space had to solve.

A look at the DeFi Pulse Index, a benchmark of the largest DeFi protocols, shows us what types of services have been successful so far in getting traction with users:

Decentralized exchanges: Uniswap is the largest and most prominent DEX and has been on the forefront of improving the capital efficiency of AMMs. Loopring, Sushiswap, Kyber Network and Balancer are other DEXes in the index.

Lending: Aave and Compound are the two leading liquidity markets. Users can deposit assets and borrow other assets against their deposits. Risk management and liquidations are fully automated through smart contracts.

Derivatives: Maker DAO is the protocol behind the stablecoin DAI. Synthetix is a platform that enables derivatives to other crypto or real-world assets. Ren is a protocol that wraps assets to move them across different blockchains, Fei Protocol is another stablecoin protocol, and Badger DAO integrates Bitcoin in DeFi.

Investment management: Yearn and Harvest offer a wide array of automated investment strategies.

While most of the development in this field only started a few years ago, the space has already been through many cycles of creative destruction. The fast-moving and volatile space combined with its adversarial nature can be seen as a disadvantage but it is impossible to deny that this evolutionary pressure has caused a speed of innovation not seen in any other industry.

Scalara, a subsidiary of DeFi Pulse, creates and maintains indices for a decentralized world.

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