- [Narrator] A rapidly growing financial trend is attempting to turn traditional banking on its head. It's called decentralized finance, or DEFI. And it promises to bring digital banking for cryptocurrencies to the masses, but with no middlemen and almost no barriers to entry.
- So in the last 18 months, this idea has really mushroomed within the crypto market. - [Narrator] Estimates vary, but a conservative one says the total value locked in DEFI reached $114 billion in November this year. And while that's just a fraction compared with traditional banking, DEFI is growing quickly.
It has increased more than 1,200% since June, 2020. Here's why some are calling DEFI the Wild West of finance, where investors are entering uncharted territory to take on big risks for the chance of even bigger rewards. When we talk about DEFI, we're not talking about a specific financial product or service.
- DEFI is just the next iteration of this grand experiment in cryptocurrencies, which is basically just to recreate the financial system in a digital online format. - [Narrator] Paul Vigna has been reporting on the equities market for almost 25 years, and has been covering cryptocurrencies since 2013. - Anything you could do at a bank or a brokerage is handled rather than through an individual and a corporation, it's handled through a computer program.
- [Narrator] You can think of the emergence of DEFI like this, a dusty town in the wild American West, where there's no sheriff, no bank, and no cash. Here at the local Trading Post, people can trade and lend goods, and do pretty much anything else normally done at a bank. It isn't owned by a single person or entity.
And unlike traditional finance, trades that happen here are verified out in the open where everyone can see. For example, one type of transaction that takes place at the Trading Post is lending. To ensure the trade, the borrower gives collateral for the loan.
The lender then earns interest off this deal in the same way a bank would. Transactions like this are all recorded on a public ledger that everyone can see. In the world of DEFI, this ledger is called a blockchain, which is a network of computers built to store and record transactions.
- Every computer on that network has an identical copy of that ledger, so that all of the data is open, all of it is public. - [Narrator] This is different from a traditional stock trade, which works like this. - I have a broker, the other party has a broker, the company has an institution that keeps track of the stock itself.
All these different middlemen, all these different intermediaries have their own ledgers, have their own internal databases where they're recording the transactions. A blockchain takes care of all of that and does it in an open way that anybody can track the progress of that trade. - [Narrator] Most DEFI services run on Ethereum's technology, which also hosts the cryptocurrency Ether.
It's one of the most commonly traded cryptos in DEFI, along with stablecoins, digital assets, which are pegged to currencies, like the dollar. The DEFI services run on the blockchain, similar to how apps run on your phone. And the mechanism that allows them to work is called a smart contract.
- Smart contract as an idea have been around for years. It's another app that is focused on a bank-like service. So all it's really doing is taking all the parameters of a trade and sticking them into fields and automating it and then monitoring it.
- [Narrator] Smart contracts are designed to give DEFI transactions more transparency and security. - And because all the parameters were being inputted into a program, ostensibly it's more secure because there shouldn't be any real debate or contradiction about the terms of the service. - [Narrator] Despite this layer of security, decentralized finance carries a lot of risk.
In many cases, the people facilitating DEFI transactions are anonymous. This has caused fraud to become rampant. A poorly created smart contract could have loopholes that allow scammers to steal or other design flaws that affect the value of assets.
Another risk is security. And because most DEFI services aren't insured, if a platform fails or is hacked, millions of dollars can be on the line. - The problem is that you may not know who wrote the program.
You may not know how secure the program itself is. That's a significant, significant risk that you really can't overlook. These DEFI protocols virtually once a week, there is a problem with one of them.
- [Narrator] So far this year, investors have lost about one and a half billion dollars to DEFI attacks, hacks, and cons. And in this Wild West of finance, regulation is still virtually non-existent, though, that could change. Here's the chairman of the Securities and Exchange Commission speaking with The Wall Street Journal about DEFI.
- But if this field is gonna have an ability to move forward, it's gonna be inside some public policy framework and inside some sort of regulatory perimeter. Look, folks have already been hurt in this field. - [Narrator] While decentralized finance is risky, many think the potential benefits are worth it.
- The benefits are an ability to make money. You are either lending out your cryptocurrencies and you're getting interest paid back on that, and that interest can be anywhere from 5% to 20%, even more. You can be a passive investor and earn money on an asset that you were probably storing in a wallet that was doing nothing.
The other benefit is you can borrow against your holdings. A lot of these services are being used as a way for people to get a bigger pool of cryptocurrency to go through a bets out into the derivatives market. So it's a way for you to turbocharge your cryptocurrency gambling habit, essentially.
- [Narrator] If DEFI continues growing, it's likely that regulations will be imposed to smooth out its rough edges and reduce risk for investors, which makes sense. Even in the wildest of Wild West towns, a sheriff eventually showed up to lay down the law.
