By: Lou Grilli, Senior Innovation Strategist, PSCU
The basic concept of decentralized financial services has been around since the beginning of the credit union movement in the early 1900s. Immigrants required loans to buy animals and farm equipment, but banks were not willing to lend to them. If they did, interest rates were crippling. By pooling their money to be used for loans to other members, church parishes could offer members reasonable loan rates without the involvement of banks.
While credit unions originated low-tech Decentralized Finance, the shorthand – DeFi – has become a frequently used buzzword most closely associated with cryptocurrency. It refers to the ability of a global network of cryptocurrency holders to provide peer-to-peer financial services over a public blockchain, without the need for a bank.
As an example, if you need $2,000 and hold bitcoin currently worth $10,000, you would normally have to sell $2,000 worth. With DeFi, however, you can deposit your $10,000 of bitcoin as collateral into a piece of code running on a public blockchain called a smart contract. The smart contract maintains loan terms and automatically executes when conditions of the agreement are met. Then, you can borrow directly against it, with loan proceeds paid out in the form of a stablecoin. These smart contracts can be made from anywhere in the world, any time of day, with no paperwork required.
A more complex example, which shows the potential power of DeFi on a global scale, is the case of a startup business looking for venture capital. A network of cryptocurrency holders, likely unknown to each other, can fund the new venture by pooling their cryptocurrency on an exchange. From there, a smart contract disburses stablecoin to the business owner who can use the stablecoin – either directly or redeemed through the exchange as fiat – to pay employees, buy computer equipment and conduct other business-related transactions.
DeFi, while still very nascent, is growing fast. According to The Wall Street Journal, the total market value of crypto funds “locked” in various DeFi platforms is up more than $100 billion from just a year ago, seeing 100x growth during that time. For comparison, the total of the outstanding loans for credit unions in the U.S. is $1.1 trillion, which has taken over a century to accumulate.
Understanding the Risks
The valuation of cryptocurrency held as collateral can fluctuate, sometimes wildly. To combat this fluctuation, stablecoins – or cryptocurrencies created to decrease the volatility of the coin’s price relative to some “stable” asset or basket of assets – are used for the loan proceeds portion of the DeFi transaction. A stablecoin can be pegged to currency, such as the U.S. dollar, or exchange-traded commodities, like gold.
Even with stablecoins, there is still risk. Stability is typically accomplished by “staking,” or collateralizing, reserves to back the value. However, it is rare for a stablecoin to be fully staked by fiat currency – that is, depositing one dollar for each coin issued is uncommon. Instead, a combination of promissory notes, other cryptocurrencies and fiat currency, along with algorithmic control of expanding and contracting the number of stablecoins issued, are all used in an attempt to maintain the value of the stablecoin. In addition, there is no regulation currently established around stablecoins, including ones being used for DeFi. This makes even stablecoins volatile.
Monitoring its Future
While credit unions may have started the concept of DeFi over a century ago, cryptocurrency and the internet have made it into a potentially fierce competitor to lenders, including credit unions. DeFi is still in its early, experimental stage. There are plenty of risks, but it lowers the barrier to creating and distributing new financial services to anyone, anywhere in the world with a computer. Credit unions must understand that when it comes to lending, competitors now include a global network of autonomous, always-available exchanges and protocols.
Lou Grilli is a senior innovation strategist at PSCU, tasked with building and shaping a superior payment and member experience capability for PSCU and its Owner credit unions. Lou is currently focused on real-time payments and cryptocurrency. Lou participates on the U.S. Faster Payments Council, and is named on a patent for the use of blockchain for loyalty programs. He holds an MBA from Duke University and a master’s degree in Computer Engineering from the University of South Florida.