Economics 101 and common sense teach us to be sceptical when we hear about numerous financial products (layers) packaged together into one beautiful structured product / wrapper. Such financial products are usually hard to understand, consist of embedded leverage (and therefore credit risk) and may carry excessive fees inside of them.
Is DeFi different?
Code is law
This is the blockchain narrative - if you interact with the software code on blockchain, it will do what it’s supposed to do and nothing more. This means that all the risks should be known in advance and one piece of code interacting with another piece of code shouldn’t be able to lead to unexpected financial result (this also means there is no lender of last resort because “anyone can just read the code and understand the risks they are taking”, but that’s a different point).
Could we phrase this differently though? “Can finance be code”? What if financial products could become codified layers in the tech stack rather than layers of financial payoffs / leverage?
Tech stack applies not only to complex data / IT systems but also to apps we use all the time. Let’s take WeChat as an example - it’s an app that runs on iOS and other operating systems, but it’s not just an app doing one thing - it’s a ‘launchpad’ which allows its users to launch their own mini apps on top of it:
When we pay for ‘an app on top of another app’ we don’t think of this as layered payment tiers, we just think of this as an app that uses someone else’s underlying tech. DeFi is no different.
Money legos
Could we take an operating system (Ethereum), deploy an app there (say a savings account) and then have another app utilise the code deployed by an underlying app? E.g. becoming a market make not just for a stablecoin but for a stablecoin that’s already sitting on a deposit generating income? Or putting your income bearing asset into an NFT?
It takes time to get used to thinking about DeFi products as apps / platforms within a broader open tech ecosystem, but that’s the feature that makes them unique and radically different from traditional finance. It allows to re-envision what’s possible when it comes to financial use cases.
Let’s look at Element - “DeFi’s fixed rate protocol” - as a case study. This recently launched DeFi app allows its users to lock in a fixed interest rate (as most of DeFi operates on variable rates).
The interesting piece is the underlying asset on which generates this interest. We’ve previously covered automated market making (AMM) in DeFi and robo-advisory. Once a standard Ethereum-native token (ERC-20 standard) gets deposited into an AMM it is wrapped into another ERC-20 token. Which in turn can be deposited into a robo-advisory app turning into yet another ERC-20 token. Finally, the wrapped token gets deposited into Element and users can lock in their interest rate if they so desire.
What we have here is a wrapped token consisting of numerous financial layers (with no leverage!) that ends up being used by another app. This flips the business model of finance - these are no longer banks / peer to peer lending apps / trading firms - these are tech layers and platforms which other people can build upon (trickling down the fees of course).
When one accepts that financial products can serve as platform layers allowing for open innovation on top of them, it’s hard not to get excited about DeFi.