A recent spurt in investment activity and dizzying yields have brought decentralized finance, or “DeFi,” to mainstream attention. DeFi is an umbrella term for reconfiguring financial services so they can be built on the foundation of distributed ledgers.

Put simply, DeFi projects spur users to shift away from centralized service providers, like banks, to instead use software protocols to store, borrow and lend money. These protocols use digital assets, like Bitcoin, Ethereum and stablecoins, combined with smart contracts. These contracts are essentially computer programs set to execute automatically when conditions associated with an agreement are met.

DeFi has existed for about six years now, but the recent activity and yields — as compared to regular savings accounts — have also drawn users willing to experiment with the nascent field.

The most common metric used to determine growth in the DeFi ecosystem is total value locked (TVL). At its core, TVL represents the dollar value of digital assets locked into a smart contract. Put another way, TVL is the value of total deposits pledged as collateral with a DeFi protocol.

In July 2020, TVL for all DeFi projects tracked by data provider DeFi Pulse stood at $1.9 billion. Today, it stands at a little more than $55 billion. Chief among those projects are Aave and Instadapp, both lending protocols that allow users to deposit digital assets and take out loans against them.

Yields drive mainstream interest

Much like a regular bank in centralized finance, Aave also offers users yield, or interest, on their deposits. Depositing USDC, the U.S. dollar stablecoin issued by Circle, earns users an annual yield of 2%. A savings account from JPMorgan Chase on the other hand, offers an annual interest rate of 0.01%.

However, deposits with JPM are insured by the Federal Deposit Insurance Corporation (FDIC) and those with Aave are not.

“From a retail perspective, speculative interest is certainly the primary driver in investment. The lack of regulation and transparency makes it easy to offer enticing returns,” Simon Zais, a consultant at consultancy firm Capco, told Bank Automation News. “As the cycle moves into the next stage, we expect to see institutional players get involved who will leverage DeFi to lower settlement costs, increase efficiency, and deliver new features.”

Hoping to capture some of the growing interest in DeFi, digital payments provider WireX rolled out a feature labeled “X-accounts,” which allows customers to earn interest on both fiat and crypto funds by depositing them with DeFi protocols like UniSwap, Aave, MakerDAO and 1Inch.

“We’ve always been about being a bridge right between the old infrastructure, or the traditional financial infrastructure, and the new one,” Georgy Sokolov, co-founder of Wirex, told BAN. He added that while trading and investment use cases dominate DeFi right now, the protocols could later expand to retail users who would want to borrow or lend money without relying on traditional institutions with a central point of failure.

Governing DeFi and protecting customers

While traditional financial institutions are heavily regulated industries, DeFi is much closer to a financial Wild West at its current stage. Decentralized services may be provided through a controlling entity, but many rely on a decentralized autonomous organization (DAO). A DAO is a group of people involved with a project organized in a non-profit entity in which rights and obligations are specified in smart contracts.

Regulating DeFi appropriately might take some time given the nascent nature of the technology, but protecting consumer interest has also popped on the radar with the proliferation of attacks against DeFi protocols that can lead to the loss of customer funds. Even in the absence of attacks, certain projects can be hit by panic selling, and their tokens can lose value within hours.

Investor Mark Cuban was recently on the receiving end of one such event when a token from Iron Finance called Titan ended up crashing to zero from $60 in one day. In a blog post, Iron Finance clarified that the token lost its value due to a “large scale crypto bank-run.”

“Crypto lending platforms and so-called decentralized finance (“DeFi”) platforms raise a number of challenges for investors and the SEC staff trying to protect them,” Gary Gensler, chairman of the U.S. Securities and Exchange Commission, said in his May testimony before the U.S. Subcommittee on Financial Services and General Government.

“[Know-your-customer] and [anti-money laundering] features remain inefficient for both DeFi and traditional finance shops,” said Capco’s Zais, adding that regulatory opacity could preclude major investment and mainstream adoption of DeFi. “Stablecoins backed by mainstream institutions or CBDCs are necessary to bring regulated and transparent liquidity to the DeFi ecosystem,” he said.

While sky-high yields may not be sustainable in the long run, what DeFi offers at its core is an alternative to the financial pipelines with which people are familiar. Whether it will succeed in the long run is likely to depend on how the projects deal with, “ease-of-use, rewards and benefits, and a strong record with respect to security,” Zais said.