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What is DeFi and why does it matter for accountants?

15 October 2020: In the world of fintech, decentralised finance – better known as DeFi – is the hottest of hot topics right now. But what is all the fuss about? FinTech academic and chartered accountant Gavin Brown explains.

Since the turn of the 21st century, we’ve seen the emergence, disruption and ultimate dominance of ‘platform businesses’. These organisations shake up existing business norms by shrinking supply chains to just two counterparties: namely the producer and the consumer.

Their value proposition is to provide the platform or ecosystem where these two parties can connect. For example, Facebook connects advertisers with consumers of digital content, Amazon links sellers with consumers, Netflix brings media content to viewers, and Airbnb unites property owners with tourists. And the list goes on. Indeed, you may be forgiven for thinking that’s as short as a supply chain can become. But think again…

Power to the collective

Enter the world of decentralised computing. One component of decentralised ledger technology (DLT) is ‘blockchain’ which is the technology that empowers people to bank without a bank through cryptocurrencies, such as Bitcoin.

Decentralised finance (or DeFi) brings decentralised applications (dApps) to the financial sector, intending to remove the need for intermediaries such as exchanges, underwriters, brokers, regulators – and even legal professionals.

The intermediaries still exist, in a fashion. But rather than a single, centralised platform business that extracts economic rent, the DeFi intermediary is instead a near-frictionless codified platform. Often it’s created and maintained by a self-governing community for the benefit of the community. There’s a lot to unpack there. But what we’re talking about is a cooperative or mutual structure that’s been ‘tuned’ by technology.

Pains and potential

DeFi has the potential to speed up commercial processes as well as reduce costs and thereby improve efficiency across most finance operations. However, it’s a nascent technology and is largely unregulated at the moment having experienced growing pains already. For instance, the furore surrounding the reported decision by the creator of the decentralised exchange and market maker SushiSwap to liquidate $14m worth of tokens shortly after its launch.

Another DeFi project example somewhat closer to home would be that of the decentralised no-loss lottery, such as PoolTogether. Put simply, lottery players buy tickets but if they lose they have their stake returned in full, hence ‘no loss’. The winning ticket receives its stake back plus the accrued interest from the aggregate of all stakes held before the draw. The same concept underpins Premium Bonds in the UK. But rather than being run by National Savings and Investments, the decentralised version uses blockchain, smart contracts and cryptocurrencies as its functional currency.

Ready for take-off

There is more than $11bn locked up in smart contracts at the moment. More than 100,000 Bitcoins, representing in excess of 0.5% of all in circulation, are locked into such smart contracts on the Ethereum blockchain. In this context, DeFi is still tiny and not therefore likely to disrupt our established multi-trillion-dollar financial industries soon. However, we as chartered accountants should have it on our radar. But why?

Previous innovations, such as aviation, were not ready to challenge established transportation norms on day one. The Wright brothers’ first powered flights in 1903 only covered distances of hundreds of feet. But a lifetime later, long-distance flight joined the mainstream. Expect the DeFi innovation to ‘stick’. And for my money – if you will excuse the pun – it will likely be incorporated into our industry over a much shorter time frame.

Gavin Brown is an Associate Professor in Financial Technology at The University of Liverpool and Fellow of the ICAEW as a chartered accountant.