The Changing Face of Finance – The Emergence Decentralised Finance as an Alternative Financial System (Part 2)
Olubusola Oyeyosola Diya and Oluwapelumi C. Omoniyi
DeFi, as defined by Dr. Usman W. Chohan, an international economist-academic, is “…an experimental form of financial praxis that is removed from dependence on centralized financial intermediaries, which in this context might include banks, exchanges and brokerages… through the use of a blockchain substitutive architecture.”
Because DeFI purports to disintermediate financial activity from the traditional mechanisms to create an open-source and transparent financial service ecosystem that is available to everyone and operates without any central authority, it is important to consider whether DeFi as an alternative financial infrastructure is complementary or an adversarial to traditional financial and banking systems.
In the first part of this three-part series, we examined how this system works; in this part, we will explore a few DeFi protocols and highlight the most prominent use cases.
Stablecoins are the most popular use cases of DeFi protocols around the world because crypto holders, traders, and even Whales (individuals who own a large amount of a particular cryptocurrency) can hedge against the volatility of the prices of cryptocurrency by buying digital assets that are pegged against fiat currency i.e., money issued by a government and declared as legal tender, or commodities.
Stablecoins are digital assets tied to a stable asset such as fiat currency or a commodity like gold. They tend to stay stable for longer periods of time than those that are non-asset backed e.g., Bitcoin (“BTC”) or Ethereum (“ETH”). The entity issuing the stablecoin usually sets up a “reserve” where it securely stores the asset backing the stablecoin, and theoretically, the holder of the stablecoin can redeem one unit of the stable coin for one unit of the asset that backs it i.e., 1USD Coin (“USDC”) for $1.
There are also some complex forms of stablecoins backed by other stablecoins. For example, the NGN Token (“NGNT”) is a collateral-backed digital currency issued by Token Mint that is pegged to the value of the Naira and is not volatile. In addition to being pegged to the value of the Naira, NGNT is also backed by USDC. USDC is issued by regulated financial institutions in the United States, and backed by fully reserved assets, and redeemable on a 1:1 basis for US Dollars. Therefore, a holder of NGNT, can redeem the USDC equivalent of NGNT he holds and trade it in for US Dollars.
However, criticism of stablecoin as a DeFi product remain. Critics argue that stablecoins are only as stable as the asset backing them; thus, they are still affected by the volatility of the underlying asset. They also believe that there is a counterparty risk that investors need to note as most stablecoin issuers do not specify where they store their ‘reserves’ and how much value is actually stored. In instances where the value of the reserves of the issuer is less than the value of the stablecoin issued, this impacts the ability of investors to redeem their stablecoin for the underlying asset.
Despite these criticisms, stablecoins remain one of the more popular DeFi products and are even being used in countries where their fiat-based currencies are losing value, e.g., in Brazil where hyperinflation, poor economic factors and a host of other issues, has caused a crash in the value of the Brazilian Real. Now, most of its citizens are using Tether Coin, a stablecoin pegged to the Dollar, to carry out transactions and have more stable savings.
Borrowing & Lending
Another popular use of DeFi is borrowing and lending of assets or money. There are two variations of the loan products, either ‘Peer-to-Peer’, meaning a situation where a borrower borrows directly from a specific lender, or ‘Pool-Based’, where lenders provide funds to a pool managed by the Dapp that borrowers can borrow from (this is the most common variant). One of the perks on the borrower’s side when considering a DeFi loan is that there is little to no due diligence or credit checks like you would have when accessing a loan from a traditional financial institution like a bank.
The decentralised lending works without either party having to identify themselves and there are typically no credit checks or investigations into whether the debt profile of a borrower will deter the lender from giving out the loan. So how do the loans work? As mentioned above, Pool-Based loans are the most common variant of DeFi loans because of the incentive it offers to its users.
Simply, a typical Pool-Based loan works by users pooling their assets or cryptocurrency and distributing to borrowers according to the terms of the loan written into the Smart Contract. Typical loan terms written into the Smart Contract include:
- Principal repayments and Interest payments – the underlying Smart Contracts of these loan pools are programmed to distribute the principal deposited plus the interest to each investor. After the agreed term of the loan, the DeFi lending platform is instructed by the Smart Contract to deduct the principal sum and interest from the borrower’s cryptocurrency wallets that have been linked to the Dapp (typically one of the condition precedents to disbursement). The principal repayment and interest payment will then be shared to the lenders by the Dapp pro-rata their contribution to the pool.
- Security – the Smart Contract will require a collateral deposit by the borrower and this collateral may either be required to have more value than the cryptocurrency being granted as a loan from the pool or may be equal to the value of the assets they intend to borrow. Collateral may take the form of cryptocurrency or fiat currency, subject to the terms of the Smart Contract. In the event of default by the borrower, the collateral will be available for use to remedy the default. Borrowers can access DeFi loan platforms by simply visiting any DeFi platform that offers loans. Potential borrowers are advised to read through the Terms and Conditions and the collateral requirements before applying for the loan.
In addition, where the collateral is a cryptocurrency, one of the terms set include that where the market value of the cryptocurrency drops below a certain price point set by the pool, it will be liquidated and shared among the individuals that deposited into the pool and the borrower may keep the borrowed asset as a result.
For example, if you want to take a loan of 1 BTC from a pool, you have to deposit the cash equivalent of 1BTC or another cryptocurrency, or asset, as collateral into a cryptocurrency wallet and link it to the DeFi platform built on the same blockchain technology as the Smart Contract. Once the collateral is deposited, the borrower receives 1 BTC, and after a few months, in accordance with the terms of the Smart Contract, the borrower returns the 1BTC with interest and the Smart Contract releases the collateral to the borrower. The interest is shared among the investors and the loan transaction has ended. On the other end, where the borrower defaults on its payment obligations, the collateral deposited in the vault – the equivalent of 1 BTC – is released and used to remedy the default – also executed automatically by the Smart Contract.
One distinct attraction of DeFi is limited obligations imposed on the borrower, as may be gleaned from the above. For example, there are no obligations limiting the borrower from accessing further loans as you would find in traditional loans with banks, there are no required financial covenants to be maintained by corporate borrowers, nor are their clauses limiting its business, such as, material change and change of control clauses.
DeFi loans are also experimenting with a concept called ‘Flash Loans’. Flash loans work on the basis that the loan is taken out and paid back in the same transaction. Creators of flash loans highlight how the cryptocurrency borrowed may be sold on an exchange or platform that has attached a higher price to it so that the borrower of the flash loan makes an instant profit. If the loan cannot be paid back within minutes, the funds revert to the lender or pool. For example, if Mr A gets 1 ETH from a pool that values it at USD$200 (Two Hundred Dollars) and sells it on an exchange for USD$220 (Two Hundred and Twenty Dollars) or trades the asset on a P2P Platform for USD$220, Mr A makes a $20 profit and can pay back the value of the loan (USD$200) to the pool, or can buy 1ETH at USD$200 and give it back to the pool. If the transaction is not completed within the short time frame, it fails. To curtail the risk of the flash loan failing within the short time frame, the cryptocurrency usually stays in the lenders wallet until the borrower has completed the terms of the flash loan. There is no collateral deposited during a flash loan transaction and flash loan enthusiasts hope that it can be developed to have more use cases for short sellers and arbitrage traders.
One of the criticisms of cryptocurrency as an investment class is that it does not yield interest as it sits in a wallet. However, the soaring prices of cryptocurrency meant holders were not particularly bothered about this. That was until the ‘Dip’ happened. With Bitcoin crashing from an all-time high of USD$65,000 (Sixty-Five Thousand Dollars) to USD$37,000 (Thirty-Seven Thousand Dollars), and other coins following suit (Ethereum dipped by half of its market price), traders and holders of cryptocurrency are looking to hedge against the volatility of cryptocurrencies and gain interest on their investment while holding their cryptocurrencies despite the price movements (‘HODLing’ – Hold on for Dear Life-ing – as popularly termed).
DeFi products are offering them an opportunity for passive returns on their assets through yields – “Yield Farming”. By depositing stablecoins (defined below) into a pool administered by the Dapp, investors will be rewarded for their deposits with annual returns called Annual Percentage Yields (“APY”). Another interesting factor to Yield Farming is that in addition to the expected APY, some DeFi protocols offer a new Token as an additional incentive. If the new token received by the investors begins to gain traction in the market, they can sell it and make more profit.
As peculiar as it sounds, the incentive creates a positive growth loop for the DeFi protocols and its investors. Getting more people to use the protocol will increase the value of the native token the protocol offers, and investors may be attracted to use the protocol and “farm” to get the token.
However, Yield Farming has been criticised by stakeholders as a “pump-and-dump” scheme as the coins can easily lose their value if people decide to stop using the DeFi protocol it is attached to. There is also a possibility that Whales can use it to manipulate the price of the tokens they own by lending some to a pool, and then using another account to borrow the cryptocurrency, artificially driving up demand, which will in turn affect the price of the token.
In the final part of our article, we will look at the disadvantages and advantages of DeFi and whether it has a role to play in the future of finance.
Ælex is a full service Commercial & Dispute resolution law firm with offices in Nigeria and Ghana. Contact us: www.aelex.com; @aelexpartners on LinkedIn, Twitter, Instagram and Facebook; [email protected]
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Olubusola Oyeyosola Diya and Oluwapelumi C. Omoniyi are Associates at the Firm.