This weekend we explore real use cases of the emerging decentralised finance world. In the same way our current financial system possesses core financial primitives such as the ability to pay, exchange, lend, borrow, and hedge, so does the decentralised world. Without exchanges, it would be impossible for businesses to gain access to public funding at scale; without commercial banks, it would be impossible to develop money markets at scale, and without derivatives, it would be impossible to hedge risks.
ight now, we are witnessing the development of new financial primitives that don’t require centralised coordination to operate. These new building blocks will become the infrastructure of an emerging decentralised world. At their most basic, every building block we discuss in this article is a program; these programs are known as smart contracts. Smart contracts are simply basic conditional agreements; if this happens, then this must happen; when this happens, then that must happen. They represent business logic that can be codified and self-executed as conditions of an agreement are met.
The majority of projects we will discuss in this article are built on Ethereum. Ethereum isn’t some new fintech solution; it’s more akin to an accounting system. Every Ethereum user has a public and private key, and the Ethereum ledger records what and how much of any asset they own. As long as a user has access to an internet connection, they can submit transaction requests to the Ethereum virtual machine; these requests will then be processed, executed and settled not by one person or one entity but rather by the entire network.
Not only can users submit requests to move money from one public key to another, but they can also request to use smart contracts. For example, a user can request to take out a loan on Aave, a prominent lending protocol. For their request to be successful, they will need to meet the criteria stipulated in Aave smart contracts, such as posting collateral and borrowing an approved asset at a certain collateral ratio. As long as their request meets these criteria, they will be able to use the smart contract with no permission required.
Once a user is happy with the loan agreement, they sign their intent using their private key, which is similar to a password or signature. In order for Ethereum validators to process, execute and settle this request, they require a transaction fee to be paid in ETH, which we call gas fees. This is all that is necessary when interacting with smart contracts.
So what is DeFi useful for today?
Over the last couple of weeks, we have noticed a surge in interest from small businesses looking to leverage DeFi to establish competitive advantages over their peers or solve some internal problems they have been working on for a while. Whilst DeFi is still in its infancy, there are real things you can do with it today.
Use Case 1: Yield
If there was one macro theme that has persisted over the last 10 years, it would be a movement from risk-free yield to an environment of yield free risk. This is great for those looking to borrow money as central banks have manipulated the cost of capital down to the bone, but it’s not great for those sitting on cash. While having cash on hand is still fortunate, many businesses that find themselves in this position find it challenging to achieve rates of return that allow their treasuries to grow over time or, at the least, keep up with real inflation.
DeFi offers an alternative. Our core view is that the interest rates we see in DeFi protocols are a fairer reflection of the true cost of capital compared to traditional markets. We have come to this assertion due to the free market dynamics of these lending protocols. Interest rates are determined algorithmically based on supply and demand for any given money as opposed to being determined by central bankers. We choose to back mathematics over bureaucracy, free markets over manipulation and decentralised governance over centralised decision making.
If you are one of those fortunate companies with a large treasury of cash, then DeFi might be able to help you out. The way we see it is that you have two options when seeking yield in DeFi.
The easiest option is using large, well-established lending protocols such as Aave or Compound. All you would need to do is obtain USDC, which is a stablecoin. You can read more about Stablecoins here. USDC is a market favourite because it has the least chance of depegging for long periods of time as it is backed 1:1 with the US dollar held in reserves by its parent company Circle. Circle is even in the process of trying to open a direct account with the Fed; this would make USDC indistinguishable from traditional commercial bank money barring its clear technological advantages.
Once you have converted your treasury to USDC, you can now put it to work in Aave or Compound. Both options provide only variable rates to lenders, but the rates you can obtain are in most cases 3x to 10x what you would get in a normal USD savings account. These savings accounts have no minimum fixed duration, and your capital is accessible at the stroke of a keyboard, interest also accrues to you in near real-time on a block by block basis (every 15 seconds or so).
This option might not be for everyone, but it’s worth considering. It carries additional technology risks as it is a more complex approach to obtaining yield. Yield aggregators such as yearn.finance, Rari Capital or Alpha Finance act as conduits that attempt to optimise yields by moving in and out of opportunities discussed in option 1.
Think about it this way, imagine if there was an app on your phone that you could save money with. Every day, it checks the various interest rates available at Standard Bank, Absa, FNB and Investec and automatically allocates to the best available opportunity, shifting in and out of these accounts frictionlessly. That’s what yield aggregators can do for you. You may be able to achieve superior returns using these types of services.
An important note on both options is that the borrowers on the other side of this money market have to remain over collateralised at all points in time. What’s great about DeFi is that it’s a lot more transparent than our traditional money markets, and you can for yourself ascertain whether a network is, in fact, solvent or not.
Use Case 2: Fundraising and Liquidity
On Ethereum, liquidity is king. It moves seamlessly, like water jumping from opportunity to opportunity. Unlike its TradFi big brother, these liquidity networks are global by design and the added benefits of tokenising and fractionalising assets means the potential pool of capital you can attract can come from almost anyone. Whether it is a small investor looking to invest $100 or a big player coming with $100 million, Ethereum doesn’t care; it provides fair and equal opportunity to anyone who wishes to use it.
Whether you are looking to raise equity or debt for your venture, you can probably do so on Ethereum. Adding further to this point, if you already own a whole portfolio of assets and you are seeking liquidity, you could carve out a portion of your portfolio, fractionalise it and allow people to take ownership. Using tokens instead of piles on piles of legal paperwork, administrative staff, and traditional payment rails, you could even increase the efficiencies in distributions of dividends, rent or interest.
Tokens have an additional benefit in that they can be listed and traded on decentralised exchanges; this will mean that you don’t have to get the permission of an exchange to allow shareholders to find buyers and sellers, further increasing the liquidity such a use case can offer.
It would be remiss of us to not mention the regulatory challenges of fundraising in this way. So, before you get excited about how Ethereum can help you fundraise, it’s probably wise to have a conversion with a forward-thinking lawyer and accountant first.
Use Case 3: Rewarding Loyalty
This use case is very different to what has been discussed in the previous use cases. Ethereum as a ledger has two core types of tokens (there’s many more, but we will focus on the basics here). On Ethereum, assets are represented as tokens, financial assets require tokens to be fungible (ERC-20), and e-commerce or media assets require non-fungible tokens (ERC-721).
Non-fungible tokens (NFT’s) can be used in a similar way to how loyalty points are used today. All of the Woolworths cards, Clicks cards and vitality points are inefficient examples of what’s possible with NFT’s. NFT’s can create a direct channel between company and customer. You can use NFT’s to push discounts to loyal shoppers, provide special privileges to early adopters or even distribute value flows generated by your company.
NFT’s in this particular use case will reduce the administration of facilitating such loyalty programs and increase the reach of what’s possible with company-customer interaction.
There is something for everyone on Ethereum. Our view is that due to Ethereum’s utility and flexibility, we will continue to uncover either more efficient ways of doing everyday tasks or discover use cases on new frontiers that just weren’t possible before.
DeFi: The future of FinTech
Give our latest chat with ThavashOnTech a listen.
In this chat we compare Ethereum to Fintech, discuss the implications of DeFi and weigh up benefits and challenges that the industry brings.