10 Aug 2020

DeFi for Blockchain and Digital Assets

What is DeFi?

DeFi stands for “Decentralized Finance”, which aims to recreate the traditional financial system by taking out a lot of red tape of middlemen. Many traditional actions in the finance markets such as lending, borrowing, structuring derivative products, and the buying and selling of securities, can now be done through a decentralized open-source network. The vast majority of these applications are currently created on Ethereum, but other platforms with smart contract capabilities are starting to find a potential market here. 

The Cayman Islands has been one of the best offshore jurisdictions for assisting technology companies with the structuring of their digital asset projects. IMS has been involved in the digital asset industry from the early stages of the ICO phase of this industry in Cayman, through the IEO transitions of capital raising and now assisting clients with the latest DeFi projects. Our corporate governance experts in the digital asset arena can assist you with your investment funds looking to participate in this asset class or on your private companies seeking to launch new and innovative products.

What functionalities does DeFi have?

Firstly, DeFi would not exist without a particular type of cryptocurrency called “stablecoins”. These are different from the typical cryptocurrencies like Bitcoin, which are known for their volatility, in that a stablecoin is pegged to a fiat currency (for example the US Dollar). Because the volatile nature of some financial digital assets makes lending contracts based off of these impractical, most DeFi contracts incorporate stablecoins within their offering. Some popular stablecoins markets today include USDT, USDC, PAXOS and Dai. It is estimated that there is as much as US$7.5 billion held within DeFi smart contracts globally.

Financing through lending and borrowing

DeFi allows a participant or customer to, digitally and algorithmically, take out a loan without any need for a complex application process and most of these do not require the participant to have a bank account. Some DeFi products allows for the borrower to obtain loans without the need to find a lender, in the traditional sense. Instead, the lender is the digital smart contract itself and the coupons or interest rates are calculated algorithmically based on supply and demand within that smart contract. In other applications, a fixed interest rate is guaranteed in exchange for loaning your digital asset to the contract.

DeFi allows borrowers to stake their digital assets as collateral, which are locked within a smart contract until the loan is repaid. Examples of DeFi lending platforms are operations such as Maker.

Decentralized Exchanges

Trading of digital assets is typically done through platforms run by a third party. What the new established DeFi exchanges are attempting to create is a more equitable exchange by removing the third party through the use of smart contracts and which in turn can act as a custodian of funds and digital assets in a peer-to-peer exchange without interference from a third party.

Asset Bridges done Synthetically

Digital assets like Bitcoin are good for a potential store of value, but sometime are more challenging to be used as collateral. Recent products that have been created now allow for a digital representation to the underlying cryptocurrency to be created which allows for its use in financial contracts. We are seeing increased popularity with these platforms and they are gaining momentum, in use from well-established and successful clients. An example of these platforms acting as synthetic bridges is BitGo (which also provides custody services).

Future in this space?

In traditional unsecured lending, there is a legal requirement that lenders and borrowers know one another’s identities and that the lender reviews the borrower’s ability to repay the debt. In DeFi, there are, at present, no such requirements. Instead, it operates on the basis of mutual trust and the operation of privacy. That being said, regulators will now have to weigh the balance between stifling innovation and failing to protect individuals from potential risks here (and this is of course a delicate balance) - individuals may be placing their funds into something new and unregulated. However, it seems more reasonable to encourage innovation and change, and this seems to be taking place. In July 2020, the US Securities and Exchange Commission took some significant steps towards acknowledging and allowing for DeFi by approving an Ethereum-based fund, Arca, for the first time. Hopefully the trend continues, and good disruption of the established norms takes place.

About the Author
Sean Inggs is an independent fund director at IMS in the Cayman Islands and can be contacted at: singgs@ims.ky.

IMS is one of the longest established company management firms in the Cayman Islands. IMS is licensed by the Cayman Islands Monetary Authority to provide independent directors, company management and incorporation, mutual fund administration, captive insurance and trust services. For more information about our services, please contact us.

Disclaimer: this publication does not constitute legal or professional advice and should not be relied on as such.