September 07, 2021 |James Messi
Since the development of the first barter system, society has developed the system of trading further and further. From the simple trading of one good for another to the more complex assets that consist of signed deals, agreements, and collateral – humanity has indeed made leaps and bounds in terms of development of the financial system. But all these centuries of developments and innovations have been centered on a premise that has been proven to be not without a flaw: a central authority which manages and directs all transactions.
Since the minting and issuance of the first coin, a central authority that presides over all matters pertaining to money has been set up. This central authority governs all transactions and could dictate the flow of commerce. As mentioned earlier, this system of financial management is not a flawless one, as seen in the events leading up to the Great Recession. This, along with the problems posed by the massive amount of paperwork and coordination required by centralized and non-digital financial services, is what Decentralized Finances or DeFi aims to leave behind.
DeFi is the broader term used to describe the various applications and services available built for the cryptocurrency sector or on blockchain platforms. As the name suggests, DeFi aims to disrupt or do away with financial third parties or intermediaries. DeFi took its inspiration from the blockchain technology behind the success of Bitcoin, which allows multiple entities to have a copy of the history of transactions – ensuring that it isn’t controlled by one single, central figure.
In traversing the digital space of financial services, it is inevitable that DeFi would come across new digital assets, like the non-fungible tokens or NFTs. An NFT is a tokenized version of a real-world asset such as an estate, an artwork, or a musical composition. Like the cryptocurrency Bitcoin, NFTs are a storage of value. However, the difference between the value storage of cryptocurrencies and fiat from NFTs is in their fungibility.
Fungibility means being able to be replaced or the interchangeability of one good with another similar good that holds the same value. Take Bitcoin or a hundred dollars for example. One Bitcoin is equal to another Bitcoin and one hundred dollars can buy you the same amount of goods as another hundred-dollar. This is not the case with NFTs. As the name implies, an NFT is non-fungible, which means one NFT is not equal to any other NFTs. This is because the value of an NFT is subjective—its value depends on the person buying it. One NFT, a Nyan cat GIF, sold for a staggering price of nearly $600,000.
How do DeFi and NFT work?
DeFi utilizes modern technology to disintermediate transactions—that is, to remove the use of third parties such as banks in making transactions. By removing these intermediaries, DeFi makes transactions faster and gives more control over their money to users. Despite drawing inspiration from and using blockchain technology, DeFi has expanded its use to more than just a simple value transfer to the more complex applications in financial services.
Various DeFi applications are built on public blockchains, most commonly on the Ethereum platform, the world’s second-leading cryptocurrency platform. Users take advantage of Ethereum’s platform that makes it easier to build decentralized applications that do more than just simple transactions. These more complex uses of the platform for financial transactions were even emphasized by Vitalik Buterin, Ethereum’s creator, in the original white paper of the digital platform.
Ethereum makes it easier for users to create decentralized applications due to the platform’s smart contracts. Smart contracts are algorithms that automatically executes transactions provided that the conditions encoded within them are met. The terms and conditions of a given transaction are also built into the code of a smart contract. For example, the terms of a loan between two persons could be executed by a smart contract. If the terms within the contract are not met, the collateral specified therein could then be liquidated immediately, without the need for intermediaries such as banks.
Going over to NFTs, these tokenized assets work similar to real-world assets. They can be sold, auctioned, lent, or used as collaterals. However, unlike real-world assets, NFTs do not have the backing that the former enjoys, leading many to falsely believe that NFTs do not hold any real value. But NFTs do have value because each NFT represents a unique asset that is rare and secured cryptographically. Furthermore, these assets, being non-fungible, introduce scarcity to the world of digital currencies where one BTC is equal to another BTC, etc. Each NFT gains its value from its rarity.
How Do DeFi and NFTs Tie Up?
As already stated earlier, NFTs can be used as collateral. In the same way that traditional works of art have been used as collaterals for loans, so too can NFTs of artworks be used when making DeFi transactions. DeFi and NFTs collaborate in the work needed to bring value to a certain asset to make the asset viable to be used as collateral against DeFi lending. NFTs also help resolve some of DeFi’s liquidity issues by applying the tokenization of the NFTs. The tokenization helps in the quick preparation of an illiquid asset.
However, the relationship between the two are mutual—NFTs help DeFi and DeFi helps NFTs.
Suppose that a person wanted to purchase goods worth $10,000, and that person has 10 ETH. With the ETH to USD rate of roughly $3,800 today, that person’s Ethereum price is valued at around $38,000. However, the person does not want to part with his ETH, so he turns to DeFi to make a loan. He takes a loan worth 10,000 DAI (1 DAI = $1) and puts his entire ETH holdings as collateral. By doing so, the person was able to procure the amount he needed to purchase the goods he wanted and still keep his ETH holdings, supposing he was able to pay off the loan. It is worth noting though that the borrower over-collateralized his loan to make up for the volatility of ETH.
How Does the Future Look for DeFi and NFTs?
Despite being widely used by users of the various decentralized platforms, DeFi is still a work in progress—still in its early phase of evolution. As of writing, the total value locked in Defi is over $95 billion. While this may sound substantial, it is good to remember that many DeFi tokens lack sufficient liquidity and volume to be able to trade in cryptocurrency markets. Cases of hacking and scams are also still quite common.
There is also the issue of existing financial regulations. In centralized finances, laws are made on the basis of separate financial jurisdictions. However, DeFi’s borderless transactions pose a problem: who would be liable in a financial crime committed across borders, protocols, and DeFi applications?
These are all things that are weighed against the benefits that decentralized finance brings to the table.