Apart from just an alternate way to pay and settle immediate cash transactions, DeFi unlocks the potential of digital currencies by allowing them to be morphed into financial instruments. DeFi represents a concerted, crowdsourced effort to put cryptocurrencies to work, offering people financial reasons to hold crypto beyond merely speculating on price movements
The blockchain technology allows for instant recognition of the exact size of the block by all transacting parties in the chain since the block is simultaneously updated on all their individual databases (or distributed ledgers, as the blockchain calls them), and has unique security features that do not allow tampering with the definition of the block.
By Siddharth Pai
Decentralised Finance (or DeFi, as it’s commonly called in the tech industry) is gaining prominence. DeFi allows apps that can create financial instruments using cryptocurrencies such as bitcoin and ethereum. These cryptocurrencies rely on a piece of internet technology called the blockchain, which has uses both in the financial sector and outside of it.
At the risk of boring some of you, I will provide a short explanation of how the blockchain works. Blockchain is the formalisation (through internet technology) of a process that most Indians intuitively understand—the promissory note—and its dark side, the hawala system. If I issue a promissory note to pay the bearer a sum of, say, Rs 50,000, then I have no choice but to cough up when the holder of the note demands payment; assuming I want to continue to have a reputation among my business associates and networks that I can be trusted. In a hawala transaction, the same process works, except that the promissory note is notional, and may be converted into different currencies while it passes hands—each of whom trust that the other will deliver on the promise to pass on the same Rs 50,000 until it reaches its final recipient. The Rs 50,000 (or any other amount initially defined) is the defined ‘block’ and the hands it passes through form the ‘chain’; all these hands recognise that the value of the block is Rs 50,000 and not some different amount.
The blockchain technology allows for instant recognition of the exact size of the block by all transacting parties in the chain since the block is simultaneously updated on all their individual databases (or distributed ledgers, as the blockchain calls them), and has unique security features that do not allow tampering with the definition of the block. In addition, each block’s movements across the chain can be verified by all parties in the chain since the block carries with it the digital imprint, or ‘signature’, of wherever it has been. The impact of this is revolutionary. It creates instant trust without having to rely on a series of trustworthy banks to clear cheques or having blind faith in ‘honour among thieves’, i.e. that the various parties transacting in a hawala deal regard their reputation as trustworthy agents as being more important than reneging on it.
A largely unregulated part of the economy, DeFi has exploded in tandem with the demand for cryptocurrencies like bitcoin and ethereum. For now, the ecosystem is populated primarily by people who are comfortable with crypto—with all its risk and legal uncertainty. I say legal uncertainty since countries are not comfortable with private players issuing their own currencies, let alone derivative transactions or other financial instruments based on such digital (crypto) currencies, which is what DeFi apps look to do. But more on this legal uncertainty later.
The DeFi world includes apps that create all sorts of financial instruments—which are not simply a new cryptocurrency. DeFi represents a concerted, crowdsourced effort to put cryptocurrencies to work, offering people financial reasons to hold crypto beyond merely speculating on price movements. Because of the explosion in DeFi apps, crypto is finally not just about a new gold or a new kind of money, it represents a way to structure financial transactions that are far more sophisticated. Each new app debuting in the DeFi world seems to be cooking up pieces of an entire financial system based solely on the crypto world, and not on currencies such as the dollar or the rupee, which the older ones among you and I understand better.
Apart from just an alternate way to pay and settle immediate cash transactions, and to as act as a store of value, DeFi unlocks the potential of digital currencies by allowing them to be morphed into financial instruments. At the first level of abstraction, these can be simple forward contracts on cash settlements, such as letters of credit used in the import/export world.
But this sort of use is simple. In the DeFi world, there are several apps taking shape. Some of the more popular ones include apps such as PoolTogether, which have ‘loss-less’ lotteries using ethereum’s smart contract layer, which allows developers anywhere in the world to publish decentralised applications with limitless functionality. Unsurprisingly, this tool has been quick to provide value to the gambling industry which stands to benefit enormously by removing trust from both the players and middlemen. The best way to describe loss-less lotteries in Indian parlance is to liken it to the kind of chit fund that randomly picks the winner of the pot for the month, rather than by using a monthly auction methodology to determine the taker of the pot. Like chit funds, these apps have formed an alternate banking system for savings and loans, but they are based solely on a cryptocurrency and not the country’s legal tender. And like chit funds, they are not insured by any country’s deposit insurance mechanisms.
If you are a speculator rather than an investor, check out legal DeFi by all means.
But these apps are skating on thin ice. Governments do not like private organisations creating alternate cash. China has recently become yet another country that has outlawed all crypto transactions, just before the current Evergrande crisis broke. This action will certainly put a crimp on capital flight from China. Other countries are mulling similar moves.
The author is a technology consultant and venture capitalist
(By invitation from New York)
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