Last week, Twitter CEO Jack Dorsey announced that Square, the financial company he also runs, will be launching a new platform for creating decentralised finance projects using bitcoin. Amid the customary, constant online noise surrounding cryptocurrency – looking at you, Elon Musk – these days, you would be forgiven for not giving Dorsey’s move the time of the day. Still, Square’s project might end up being remembered as a watershed moment – the moment decentralised finance, or “DeFi”, finally entered the mainstream.
In recent years, DeFi has emerged as one of the most consequential developments reshaping the cryptocurrency world. Rather than bitcoin, its ascension has been tightly linked to Ethereum, the world’s second cryptocurrency, whose decentralised network – or blockchain – allows for the provision of services and the execution of more complex tasks than just sending and receiving payments.
Arguably, it all started just after the ICO bubble of 2017, when thousands of entrepreneurs and chancers raised billions by selling cryptocurrency tokens online as if they were stocks in – often non-existing – companies. After the crash, Ethereum started crawling with a host of services – DAPPs, or decentralised applications – offering a wide range of financial operations, from loans, to futures, to exchanges, to algorithmic trading.
The selling point, as usual when it comes to cryptocurrency projects, was disintermediation. Users of these services would be unshackling oneself from real-world financial intermediaries, but also from cryptocurrency-focused institutions that had evolved into gatekeepers – from corporate cryptocurrency exchanges like Bitfinex and Coinbase to Tether, the company behind the stablecoin USDT (a digital asset whose price is theoretically pegged to the dollar). Ethereum’s decentralised financial apps allowed users to trade without undergoing the identity checks, anti- money-laundering regulation and other limitations of centralised alternatives. Plus, it was much more fun.
“The advantages that DeFi has are multifold. Number one: it is in theory up 100 per cent of the time, right? So because Ethereum is always up, so is DeFi,” says Lex Sokolin, the co-head of decentralised protocols at blockchain software firm Consensys. “And then there is composability, the ability to layer.”
That means that, on the blockchain, different applications can be programmed to work in sequence, one after another, in a single transaction – their individual operations arrayed and stacked together like LEGO blocks. One can easily design a program that would automatically borrow cryptocurrency from a lending platform, dump it on a decentralised exchange in the hope of making its price plummet, buy it back and return it, possibly pocketing a short margin – in a matter of seconds. Investing strategies become puzzles, jigsaws of software commands to compose on the fly.
“You can build the portfolio and when you have the portfolio, you can build margin, and when you have margin, you can build interest, and when you have interest, you can build an aggregator of fixed income, and then tokens and so on, and so forth,” Sokolin says. “This accelerates everything, and makes it go really, really fast – I think 50 to 100 times faster than if it were not built on DeFi.”
That is exciting, but not complication-free. “People are building really interesting – but mostly experimental – tools. These are being built mostly by amateurs who do not understand how actual finance works,” says Emin Gün Sirer, an associate professor of computer science at Cornell University. “So some of these ‘LEGO building blocks’ are quite interesting and do things that Wall Street cannot do. But some of them end up interacting in unforeseen ways.”
One of the first and most infamous manifestations of this unpredictability is the “flash loan” incident that sent waves through cryptoland on St Valentine’s Day 2020. On that day an anonymous trader managed to get away with a profit of $350,000 in Ether from lending platform bZx, after deliberately pumping asset prices on the exchange bZx relied upon to get its pricing data. The best bit? The money used in the coup de main had been borrowed from a platform that allowed users to take cryptocurrency loans – for a very short period of time: hence ‘flash loan’ – without providing collateral. The trader had transformed no money into a lot of money. Cue a debate about whether the trader could be labelled “a hacker” or simply someone who had read the fine print, realised that bZx could be gamed and acted accordingly.