representations of various cryptocurrencies in coin form sitting on a laptop

What is decentralised finance and what should investors know about this space in Australia? Find out here.

DeFi, short for "decentralised finance," is a promising component of our brave new crypto world. The DeFi sector in Australia is here to stay, but what should investors know about this space?

DeFi offers an alternative to traditional financial services and institutions by bypassing banks, brokers, exchanges and other "middlemen" that serve as financial intermediaries that regulate the markets. In effect, DeFi is evolving into a parallel financial framework that facilitates and records transactions involving financial instruments and payment mechanisms chiefly related to trading and lending operations.

The DeFi market is currently expanding at an explosive rate. According to figures released by DeFi Llama, cryptocurrency investors have put up US$250 billion worth of assets as collateral in various DeFi projects, funds which are then lent out in the form of cryptocurrency loans. As more and more institutional investors enter the DeFi sector, the market is expected to expand to US$800 billion by the end of 2022.


Bitcoin and Ethereum, the world's two leading cryptocurrencies with market caps of US$882 and US$421 billion, respectively (as of the beginning of April), are digital assets whose ownership is documented in a public transaction ledger known as the blockchain. A traditional financial institution such as a bank, credit card provider or payment facilitator like PayPal maintains its own private records and uses its own servers to process transactions. Cryptocurrency transactions, by contrast, are processed on the computers of a global network of users and recorded publicly (though pseudonymously) for the entire network to see.

As currently constituted, the emerging DeFi sector provides holders of cryptocurrency the ability to bypass the world's traditional network of bank and other financial gatekeepers by means of independent, self-regulating computer programs that rely on blockchain technology.

These decentralised applications (DApps) of blockchain technology offer a more efficient and streamlined mechanism to access financial services by creating an alternative ledger system known as "distributed ledger technology" (DLT) as opposed to VISA, PayPal or other legacy digital payment services. By harnessing the power of blockchain, a new global ledger system has taken shape that relies on a global web of interconnected computers to record and tracks all transactions. Not only does DLT store such transaction data but it also identifes the parties involved in any transaction.

This allows anyone with a crypto wallet and an internet connection unlimited access to DeFi services. Users can trade currencies and move assets whenever and wherever they want and avoid antiquated and cumbersome bank transfer protocols and related fees. DeFi users are, however, required to pay "gas fee" charges for crypto transactions in many cases.

DeFi is thereby expanding the fundamental premise of digital money — bitcoin and other cryptocurrencies — by allowing individuals and companies alike to execute financial transactions by means of a new and fully transparent system.

DeFi Applications

Lending platforms

The DeFi market is currently expanding at an explosive rate. According to figures released by DeFi Llama, cryptocurrency investors have put up US$250 billion worth of assets as collateral in various DeFi projects, funds which are then lent out in the form of cryptocurrency loans.

Parallel to the expansion of the cryptocurrency market, DeFi will become increasingly able to provide loans via the various lending platforms that are popping up around the world. In effect, DeFi lending platforms are digital banks, taking money from cryptocurrency depositors and lending it out to borrowers.

Instead of traditional bank loans, the DeFi platforms rely on "smart contracts" — primarily the Ethereum blockchain — which uses computer code to authorize, execute and verify transactions.

Lending markets serve as one of the most intriguing and promising applications of DeFi by connecting borrowers to lenders of cryptocurrencies by means of platforms that enable individuals or companies to either borrow cryptocurrencies or provide crypto loans.

In order to obtain a loan, borrowers must put up collateral — usually ether, the crypto currency issued by Ethereum, the principal system on which all cryptocurrency applications are based. Borrowers tend to receive loans in the form of stablecoins pegged to traditional currencies like the dollar.

Alternatively, borrowers can post collateral in the form of bitcoin, which then gets deposited in a crypto pool that is overseen by a smart contract. Should the price of bitcoin take a precipitous fall, the smart contract automatically liquidates the collateral to protect depositors who have provided the loan funds in the form of stablecoins. Meanwhile, lenders earn money from the interest rate the platforms charge for lending out their funds.

Decentralised exchanges

Decentralised exchanges use smart contracts to enable traders to execute orders without an intermediary. Users trade directly from their wallets by exchanging one currency for another, for example Bitcoin for US dollars or euros for Ether, by means of the smart contracts behind the trading platform. Traders are solely responsible for managing and securing their funds and risk losing their holdings if they lose their private keys or send funds to the wrong addresses. The advantage of bypassing financial intermediaries and preserving anonymity is offset to a degree by the lack of security a bank or a centralized exchange provides.

Stablecoins

A stablecoin is a cryptocurrency pegged to the value of a non-crypto asset (i.e. the US dollar) that offers price stability, which in turn provides greater security for DeFi collateralized lending. Tether is one of the leading stablecoins.

Australia: Making a splash in DeFi

Australia currently ranks 12th out of 154 countries according to the Global DeFi Adoption Index published by Chainanalysis. This index uses three metrics in its assessment of DeFi adoption: on-chain cryptocurrency value received by DeFi platforms weighted by public private partnership (PPP) per capital, total retail value received by DeFi platforms and individual deposits to DeFi platforms.

Australia's DeFi sector is currently experiencing a boom led by various companies such as Synthetix (SNX), which hopes to become a decentralised version of derivatives exchange BitMEX; Maple Finance (MPL), which offers loans for crypto institutions; and newly launched tiiik, which offers a digital wallet that allows investors to earn interest on DeFi products. Other new Australian DeFi players include Thorchain, Ren and mSTABLE.

While the DeFi sector is currently in its first developmental phase much like Bitcoin in its early days, individual investors have three main ways of investing in this evolving industry. First, one can obtain cryptocurrency-based loans; second, one can earn interest by lending (staking) their crypto holds, looking to invest in DeFi coins. Block Earner, for example, is an Australian fintech outfit that provides a DeFi online savings platform, which pays 7 percent interest on deposits. Third, investors can simply invest in DeFi coins in the same way that one can purchase cryptocurrencies.

Evolving market

Investors willing to take a plunge in DeFi should be aware that the underlying volatility of the cryptocurrency markets can rattle the DeFi sector in the event of sharp declines in bitcoin, Ethereum and other cryptos. There is also the added spectre of rug pulls, a relatively rare but catastrophic form of fraud.

Rug pulls see unscrupulous DeFi developers create a new token, pair it to a leading cryptocurrency such as tether, set up a liquidity pool, and then use secret back doors encoded into the coin's smart contract to mint millions of new coins before liquidation. This was the case in 2020 when SushiSwap developer Chef Nomi cashed in his SUSHI tokens after raising over $1 billion in collateral finance, which caused the price of SUSHI to crash to near zero.

Don’t forget to follow us @INN_Australia for real-time updates!

Securities Disclosure: I, Harold Von Kursk, hold no direct investment interest in any company mentioned in this article.

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