Beyond Bitcoin – Decentralised Finance (DeFi)

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Ben Mendelson

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Lessons from Coinbase’s explosive listing

All hail Coinbase! If the cryptocurrency exchange’s $85 billion valuation in April 2021 wasn’t impressive in and of itself, it is significant for a number of other reasons. Firstly and in the most simple terms, it perfectly illustrates the unavoidable truth that more and more people want to buy (or are flirting with the idea of buying) Bitcoin and can very easily and quickly satisfy this hunger by visiting www.coinbase.com.

Just set up an account in minutes and off you go!

But Bitcoin is only the very tip of the iceberg. Coinbase’s immense valuation owes much to the various other cryptocurrency investment options it offers would-be investors with access to. Elad Gil, an early investor in Coinbase, described investing in the company, as effectively making a bet on the entire cryptocurrency sector. In stark contrast to Bitcoin’s hefty price tag, Coinbase provides its customers (in addition to Bitcoin) with a smorgasbord of other affordable cryptocurrencies, including, perhaps most interestingly, a collection of DeFi cryptocurrencies.

So what is DeFi?

DeFi, or Decentralised Finance, refers broadly to a blockchain-based financial system where the traditional middle man (aka the banks, brokers, exchanges etc.) are cut out and tossed aside in favour of participants interacting directly with one another, through the help of decentralised applications and self-executing and immutable smart contracts.

Wow. What a mouthful. Let’s break it down.

Blockchains

Blockchains are the underlying technology behind most cryptocurrencies, but also the underlying technology behind DeFi, smart contracts, Decentralised Autonomous Organisations, Decentralised Applications and NFTs (all, if not some of which, you will have almost certainly have heard being discussed in mainstream media). A blockchain is at its essence, a distributed transaction ledger and provides the global, transparent and immutable digital building blocks with which to create all these exciting new technologies.

Decentralised

The term decentralised in DeFi, refers to there being no central third party pulling the strings. No bank offering a loan, no broker to advise on derivative transactions and no multinational corporation running a trading exchange. Blockchain technology takes the place of these centralised third parties and, more specifically, decentralised applications built (aka coded) onto the blockchain.

Decentralised Applications (DApps)

A DApp is a coded digital application, much like those you use daily on your computer or phone, usually accessed through a simple browser extension. The difference is that where the code used to make the applications you use on your computer and phone are located on a centralised server (eg. Apple’s or Microsoft’s), the code running DApps is located on a distributed blockchain. The code behind the DAPP was created by either a single developer or by a community of them, however none of them will have (or ideally should have) ultimate control over the coding going forward. This means that when participants access a DApp through a browser extension, they are being connected directly with access to a blockchain, rather than to a platform governed by a known or unknown third party pulling the strings.

Now there are infinite possibilities for DApps (much like the applications you’re used to on your mobile). This can be anything from the gaming DApp CryptoKitties (where you buy, sell and breed virtual cats – a bit like a tamagotchi), to the admittedly far less exciting (but perhaps slightly more useful) DeFi DApps which can enable participants to lend, borrow, trade, save, invest, hedge and perform all sorts of other financial activities. Uniswap is an example of a DeFi DApp, providing participants with a full decentralised exchange built upon the Ethereum blockchain and which enables the trading of other cryptocurrencies built on the Ethereum blockchain. Ironically, Uniswap is effectively a competitor to Coinbase itself, in the sense that both are cryptocurrency exchanges, while Coinbase is centralised and Uniswap is not.

Smart Contracts

The question is, how exactly does a DeFi DApp enable participants to achieve all this without a trusted centralised intermediary? The answer is to replace the centralised intermediary with a smart contract! This is a programmed contract, coded onto the blockchain that is designed to automatically self-execute on the happening of a pre-determined trigger event. These are not dissimilar to the contracts we are all used to and come across on a daily basis, only they also benefit from all the conveniences of blockchain technology itself, including immutability, versatility, being borderless and being outside of the control of dodgy lawyers!

Why DeFi is important

In theory (we’ll have to wait a bit to see if this actually happens in practice), DeFi represents a globally inclusive, ‘untampered’, flexible financial system. Barriers to entry are a fraction of what they are under centralised financial systems with endless possibilities for peer to peer interactions. Political, economic and social instability do not wreak havoc in the same way, in fact, if anything, these factors could stimulate the flow of money from fiat currencies like the US Dollar and Pound into cryptocurrencies which in turn can be used in DeFi. Above all, it puts the power back into the hands of the individual, allowing them to determine their own financial freedom.

Not so fast..

If this all sounds too good to be true, it probably is. The increasing mainstream adoption of cryptocurrencies such as Bitcoin and platforms such as Coinbase, has undoubtably cushioned the way for these related technologies to take centre stage. However, there is a very powerful (and very wealthy) community of participants who have reason to be less than thrilled with these new technologies.

In the first instance, DeFi is literally cutting out multi-national institutions such as banks, investment funds and brokerage firms. It goes without saying that these institutions will consider this to be less than ideal for their business and are, therefore, likely to (directly or indirectly) put pressure on the DeFi sector and its participants.

Another consideration, is the fact that DeFi is currently (more or less) operating outside of the traditional regulations that have previously governed the financial sector. That is not to say that some regulations that previously existed are not in part applicable to DeFi, nor does it mean that regulators are not frantically moving to set out a framework for ensuring compliance. However, the disruptive nature of Blockchain-related technologies has left many regulators perplexed as to the most appropriate course of action. This has given rise to an unmistakable “wait and see” approach.

In light of the above, I think it is safe to say that caution on the part of would-be participants is strongly advised. We simply do not yet know how regulators are going to react to DeFi and the types of pressure they may be put under by centralised financial institutions to bring and end to this volcanic disruption to the status quo.

But wait, there’s also CeDeFi!

This might sound like a joke, but believe it or not, it isn’t. In fact, it provides a perfect example of one of greatest tension points in blockchain technology, namely centralisation vs decentralisation.

It doesn’t take much imagination to realise that regulatory authorities are going to be, at the very least, sceptical of a fully decentralised financial system (at least in the short to medium term). Not only are the current rules, regulations and policies they are mandated to enforce, often inapplicable to DeFi, if at all, but the traditional third party participants (i.e. banks, brokers and exchanges) on whom they used to rely to exert their will and control, have been forced out too! Against this backdrop, compliance with regulatory authorities seems to be a tough ask.

So what’s the solution? One of the world’s largest cryptocurrency exchanges, Binance, thinks it has the answer, in the form of its Smart Chain (BSC). This has been heralded as the perfect middle ground (at least in the short term) to fully utilise to extraordinary capabilities of DeFi, while simultaneously ensuring the possibility for participants to comply with relevant regulations and policies, despite them being “centrally enforced”. Now I know what you might be thinking, does this mean that Binance has simply stepped in as the same old centralised intermediary under the guise of being a DeFi saviour? Perhaps.. But it might also be a step in the right direction, encouraging increased adoption without stepping too far into the unknown.

Want to learn more? Get in touch with Chronos Law Associate and Blockchain consultant Ben Mendelson at ben@chronoslaw.co.uk

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