• Anthony Garcia

I Keep Hearing the Term "DeFi"--What Is It?

A conceptual overview and comparison to modern-day "centralized" finance.

Blockchain and cryptocurrency are here to stay, and people who don't understand (or refuse to learn) the basic concepts are at risk of being left far behind in the near future as adoption of the technology reaches the mainstream. An even more cutting edge aspect of the crypto phenomenon you may have heard about recently is known as "De-Fi." De-Fi is short for "decentralized finance," an idea which crypto enthusiasts assert is opposed to the traditional way of conducting finance, which they now term "centralized finance" (i.e. Ce-Fi). To understand De-Fi it may help to first explain how our current system of centralized finance works, identify the problem areas that De-Fi aims to help solve, and review some concerns that have arisen from the potential rise of De-Fi.

Let's say you wanted to buy 100 shares of Apple stock, but Apple is not directly offering any of its shares for sale. Traditionally, you would then turn to the secondary market and seek to connect with others who want to sell their Apple shares at a price that you are willing to purchase. For most people, that is accomplished by turning to a recognized and licensed stock exchange, such as the NASDAQ, where sellers and buyers each post their offers for Apple stock in an "order book." Trades are made when the price a seller is willing to sell matches the price a buyer is willing to buy. Traders have their own jargon and lexicon making their jobs seem mystical and opaque, but on a fundamental level, it really is that simple. This same mechanic occurs on all traditional Ce-Fi, including Forex (exchanges where different international fiat currencies are traded), cryptocurrency exchanges, commodities and futures exchanges, and so-on.

The reason this form of trading is considered "centralized" is because a third-party typically acts as an intermediary to connect buyers and sellers and facilitate the swap (i.e. the exchange). In that way, it is said that one party to a trade cannot be duped, double-crossed, or defrauded by the other party because the intermediary is handling the transaction for them. However, because the intermediaries are handling many, many trades, the intermediaries themselves become a central point of failure and a central point of regulation that affects the multitudes of persons using the intermediary to conduct trades.

For example, in the modern day, in order to utilize an exchange's online trading platform one must deposit the sum of fiat money one wishes to trade with the exchange. The trades happen between users of the exchange's trading platform, and all of the money that is being traded remains in the exchange's custody until a user opts to withdraw monies from the platform. The result is that the exchanges end up holding enormous sums of monies on behalf of their users, and users have to place their full trust in the integrity of the exchanges and their internal security measures. Unscrupulous black-hat hackers drool at the thought of being able to crack the security of these repositories of wealth, and exchanges expend untold amounts of their own money to ensure the viability of their internal security protocols. Operators of disreputable cryptocurrency exchanges, though becoming less and less common as regulation increases, have even been known to abscond with millions of dollars worth of users' deposited funds, leaving users with no way of recovering the funds they deposited.

Centralized cryptocurrency exchanges can also force their users to identify themselves before being able to utilize their platforms, which depending on your stance in the ongoing privacy debate, can be a good or a bad thing. These requirements, known as "KYC" regulations (i.e. Know Your Customer rules), are employed by many exchanges to comply with anti-money laundering laws and can sometimes even be enforced by banks who may refuse to allow wire transfer deposits to exchanges without minimum KYC requirements in place. Exchanges are even able to freeze the assets in a user's account and prevent that person from withdrawing funds if ordered to do so by a government authority.

And here enters De-Fi. Decentralized finance is a novel spin on the traditional trading model that leverages the "smart-contract" capability of certain blockchain networks to allow the conduct of trades without having a central intermediary (and without regulatory oversight). Without getting too far into the weeds, smart-contracts are self-executing snippets of code on the blockchain network that automatically perform certain functions when certain pre-determined conditions are met. In effect, this allows users to trust the integrity of the blockchain network's programming to conduct peer-to-peer trades, eliminating the need for a third-party intermediary. Reputable De-Fi networks make their code open-source so that the tech-savvy among us can inspect and audit the code for security flaws and ensure that the code is safe to use.

Further, De-Fi networks running a decentralized exchange (known in the community as a DEX) do not use the traditional order book method for conducting trades. Rather, the networks themselves establish various "liquidity pools" where owners of cryptocurrencies can "stake" (which term in this context is more akin to loaning) specified crypto assets into a pool that is then used as the source of liquidity for making trades with the pool. In return for staking their assets for the benefit of others, the networks' programming automatically issues reward tokens to the liquidity provider, which reward tokens themselves have value and which can ultimately yield quite lucrative returns for those who do participate (in the neighborhood of hundreds of percent APY in some cases). Again, without getting too far into the weeds because so much can be written about these topics, the networks gather price data of the traded assets in real-time from outside exchanges using a computer process called an "Oracle" and algorithmically establish prices for trades. A number of different De-Fi networks have attempted to streamline the oracle process to differentiate themselves because the more accurate real-time price data can be in the liquidity pools, the less opportunity for persons to exploit arbitrage.

In short, the geeks that created De-Fi have bestowed a great gift upon us, and in time I do believe many of us will transition from the traditional ways of conducting finance to the De-Fi model. However, the benefits of decentralized and peer-to-peer trading is not without cost. I will be addressing the downsides of De-Fi in a future article, but as a short preview I briefly present to you some of the main concerns in the space.

You may have noticed that the De-Fi model is resistant not just to hackers, but to government intervention and regulation as well. There is presently no KYC that I am aware of that is enforced in order to utilize a De-Fi network. One simply downloads the applicable De-Fi application onto a phone or computer, creates an account, and deposits crypto to begin trading. Thus, it is likely that severe restrictions on interacting with De-Fi are on the horizon unless the on-ramps can be more closely monitored by governments to prevent money laundering.

Similarly, there is no regulation for market manipulation of which I am aware. If a Game Stop-style rebellion happened on a De-Fi platform there would be no help from a Robinhood central authority to bail out the privileged among us. By the same token, because these De-Fi markets are still very illiquid in comparison to Ce-Fi, traders with heavy bags of capital poured into a De-Fi platform can significantly manipulate the market to their advantage. To my knowledge, there is no means to prevent this.

There will also be no, or very little, recourse if something goes wrong with the De-Fi platform. If you are hacked, or if the De-Fi network itself is breached somehow, there will not be many options for you to recover your lost assets. Customer service as we now know it is effectively non-existent in the De-Fi space.

These are just a few of the creeping concerns facing the De-Fi community, but this area of cryptocurrency is rapidly expanding and innovating. De-Fi is certainly something to keep on your radar! Contact me today at agarcia@agarcialegal.com if you have a legal matter related to cryptocurrency you wish to discuss or if you want to create a digital estate plan to protect your assets during your succession.

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