Wikipedia offers the following definition of FinTech: “Fintech is a new financial industry that applies technology to improve financial activities.” Perhaps quite tellingly, there’s no Wikipedia entry for DeFi (decentralized finance) at present. So, let’s defer to a definition provided by Jake Brukhman, the founder of crypto-asset investment firm CoinFund.
According to Brukhman, decentralized finance is: “an analog of traditional financial services implemented as services for digital assets on decentralized networks.” So, let’s get this straight: FinTech is about using technology to improve finance and DeFi is a type of FinTech specifically for blockchains.
It’s Not Quite That Simple
To understand the distinction between the two it’s important to understand the different contexts in which they arose and the status quos they came to challenge. If you go far back enough in time, finance used to rely exclusively on paper records. Information traveled at the speed of a telephone call and trading was carried out in person by open outcry in trading pits.
Then the computer revolution came along and changed everything. Consider what an earth-shattering effect the humble spreadsheet must have had when it first started being used. Networking, data storage, programmable transactions, all of these and more were truly game-changing developments that were brought about by information technology.
However, FinTech isn’t just finance + computers. FinTech actually forced finance (a pre-Internet technology) to change and adapt to new ways of doing things. It relies on leveraging information technology and networking so that finance can do things that were previously impossible.
The point to understand here is that FinTech was a reaction to how things were done before the Internet, whereas, as we will see below, DeFi is a reaction to how things are currently done in our present version of the Internet.
FinTech works well with our current server-client model, it relies on it, is powered by it. DeFi, on the other hand, doesn’t play so nicely. In fact DeFi bypasses it completely, using decentralized ledger technology (DLT), a.k.a blockchain, DeFi completely does away with centralized points of failure and works peer-to-peer.
A Perfect Example
The image below is captured from a Governance and Risk Meeting conducted by MakerDAO, one of the most intriguing DeFi projects out there right now with a working product. During a recent crypto conference these public meetings, conducted remotely and shared over YouTube, were likened to: “watching the Fed set interest rate policy.” And that’s just what they are.
Built on the Ethereum blockchain, Dai is an ingenious example of game theory being used to replace trusted third parties. It carefully balances economic incentives to produce a digital token whose value is always at or around $1. Dai can be transferred anywhere in the world, almost for free and without any middlemen, it can be freely traded anywhere there is a market for it, no individual or company controls it and no government could ever shut it down.
What the team behind Dai have achieved was previously impossible. They have essentially produced a digital dollar that can do way more than a regular dollar can, with no one being in control of it other than the owner. Consider that Facebook’s Libra is an attempt to do the same thing minus the decentralization and with a consortium of 100 companies backing it.
Dai is what is known as a stablecoin. However, unlike other stablecoins that achieve their parity with the US dollar through centralized means (company bank accounts holding reserves of fiat currencies, or other assets stored away somewhere by an entity you just have to trust), Dai is able to function without a central point of failure.
To create Dai you have to lock up ether (the native currency of the ethereum blockchain) in a smart contract. It’s essentially a loan. You borrow Dai and use ether as collateral. Then, when you want your ether back, you return your Dai to the smart contract (effectively destroying it) and your ether is released. To date, Maker accounts for around 72% of all the ether that’s locked up in the Ethereum DeFi space, which is currently worth just shy of $600 million.
Owners of a separate Ethereum-based token called Maker (MKR), are essentially stakeholders in the project and are able to vote on all changes to be implemented by the development team. The “DAO” in MakerDAO stands for Decentralized Autonomous Organization, which is basically a company that exists on the blockchain without a centralized chain of command that makes decisions through stakeholder votes.
Some other newcomers include Dharma and Compound, which allow you to earn interest from a variety of cryptocurrency assets. These kinds of services create liquidity pools that individuals, businesses and other liquidity takers can access.
Another interesting feature of decentralized finance is that borrowers are overcollateralized. This means that, unlike traditional finance, users can only borrow a fraction of the value of their collateral. In the case of Dai, the overcollateralization ratio is 150%. For the incumbent financial system such hefty collateral figures make financial products like Dai capital inefficient.
However, consider the following; in 2018 the value of ether went from a high of $1400 to a low of about $80. In that time Dai was able to faithfully track the value of the US dollar, despite the asset it uses as collateral decreasing in value by about 94%.
This is a truly astonishing feat, one that our highly leveraged financial system couldn’t hope to match, and indeed didn’t during the 2008 financial crisis. Even if the creation of Dai is capital inefficient, there are other services out there that can may make it worth your time. Dharma pays 10% interest on Dai deposited with their protocol and Compound pays just over 7%.
It’s Not Just About Loans
Loans and stablecoins are just the tip of the iceberg as far as what this technology can achieve. A host of DeFi alternatives to traditional financial products are coming online and they all leverage blockchain tech. Decentralized exchanges like IDEX and 0x allow you to trade crypto assets with nothing other than your private keys.
Decentralized swaps are another interesting application. They allow users to instantly convert one type of crypto token into another at the best available exchange rate. Imagine a future in which everything is tokenized, from your public transport credits and supermarket loyalty points to your air miles. Now imagine those points, which used to be stuck on the servers of those individual businesses, being freed so that they can be part of a broader economy.
Loyalty credits represent real world value that you can only currently redeem in one place. Blockchain and DeFi promises to make these things fungible, so you can convert your loyalty points into dollars, or your air miles for bitcoin, at the press of a button. Uniswap is currently one of the largest of these Swap DEX protocols with over $19 million worth of crypto assets locked up and daily volumes in excess of $1 million.
Then you have decentralized prediction markets like Augur, which allow anyone, anywhere to create a market on the outcome of anything. From whether President Trump will win the next election to whether it’s going to rain on your wedding day next month.
A great deal of economic activity takes place on Augur, such as making markets, placing bets and receiving fees for reporting on outcomes. But beyond that, Augur is a decentralised information aggregator and oracle. It’s a way for the machine world to have a trustless way of reliably knowing what took place in the “real” world. This information ,where relevant, can then be fed into other decentralized systems, such decentralized insurance.
The Real Differences Between FinTech and DeFi
Earlier we briefly touched upon the fact that Fintech and DeFi rely on completely different infrastructures. FinTech depends on the client/server model, whereas DeFi is all about cutting out the middleman and doing things peer-to-peer. These differences inform just about everything else about these two approaches to financial technology.
For instance, FinTech systems are proprietary and as a result fragmented. There do exist protocols like FIX, which allow intercommunication for specific purposes, like trading, but they still involve counterparty risk. This calls for costly and time consuming legal, accounting and insurance requirements.
DeFi comes with none of this bureaucracy. Crypto assets eliminate counterparty risk because there is almost no risk and no cost of transferring crypto assets between parties. This is regardless of whether that asset is worth $1, or $100,000,000. Half the reason for the bloated financial system we have today is that it has to keep track of who owns what and insure against the risk of transferring this or that asset between parties. Crypto tokens are essentially bearer instruments. No-one needs to hold them for anyone else, no-one needs to prove that they actually own them. Your private keys the proof that you own them. And those same private keys are also essentially the asset itself.
|High throughput||Low throughput|
|Bureaucratic||Code is law|
|Counterparty risk||No counterparty risk|
Can’t we all just get along?
So is DeFi the evolution of FinTech? Probably. Is it here replace the existing financial system? Almost certainly not. At least not for a very long time to come. DeFi is very much a cottage industry and the volumes it generates are still tiny by FinTech’s standards. It can accomplish many incredible things that haven’t been possible until now, but the technologies it relies on are still new, not very well-understood by most people and are currently difficult to scale.
But what DeFi has going for it is that you don’t need permission to use it and start building on it. You can build it today and worry about the bureaucracy tomorrow. In FinTech it works the other way around.
You have to go through a lengthy and expensive bureaucratic process first, then get to the business of building. It’s the difference between asking for permission in advance or for forgiveness after the fact. The latter may be a cheekier approach but it achieves more in the long run. Ultimately it means that much more talent will be attracted to work on DeFi projects, making it difficult to compete with it in terms of innovation.
We forget that there was a time when the iPhone was in direct competition with the Blackberry. It took a little while for us to collectively figure out that that thing we carried around with us was destined to be more like a computer than a telephone. In Q4 of 2016 Gartner Research finally announced that Blackberry’s market share had officially fallen to 0%, with only 207.9 thousand units sold that year.
When Apple transitioned from using IBM PowerPC processors in its laptops to Intel x86 processors in the mid-2000s, it was primarily because Intel’s power per watt and performance roadmap for this metric couldn’t be matched by IBM. Today even Intel’s rivals use the x86 architecture and Intel maintains the lion’s share of that market.
What’s the moral of the story? Get the base layer right, and you’re good. In the first example Apple capitalized on the fact that the future was pocket computers, not cellular phones that do some computer stuff. In the second example, Apple again saw the writing on the wall and jumped ship to the most promising processor architecture at the right moment.
Apple itself, though, is in the process of losing its battle with Android and this is primarily because iOS is a closed, proprietary system, whereas Android is open source. Just like DeFi, over the long run this means more developers, more partnerships and more users. As of June 2019 Android has 76% of the mobile operating system market to iOS’s 22%.
While DeFi and FinTech may not be going head to head in the same manner, the infrastructures they rely on are. And what’s really interesting to note is that even though FinTech is completely incompatible with DeFi. DeFi, on the other hand, is compatible with everything. DLT or blockchain, as a base layer that deals with trust, is a layer that can operate beneath the established client-server model our current Internet relies upon.
It allows anyone, anywhere, including FinTech players themselves, to utilize and build on top of DeFi systems, taking advantage of and leveraging everything from their publicly available data, to their mathematically derived models of trust. In conclusion, DeFi is the new FinTech, but it’s not concerned with dethroning its older sibling, it’s off doing its own thing in its own P2P way.