Benefits and Risks of DeFi

We discussed the main issues surrounding DeFi and the Metaverse in the previous article of the series. Here, we speak about DeFi in more detail; about the risks and benefits, as well as another area of finance in the Metaverse: investments.

As they are based on the smart contract features enabled by blockchain, DeFi services can be provided without a trusted intermediary such as a bank.

DeFi applications operate on a trusted peer-to-peer basis. The trust is in the code executing the service (as with any blockchain transaction), not the parties to the transaction.

This approach reduces the risk and costs associated with transactions and enables a more direct, unique and bespoke relationship between the parties.

As a result, signing up for a service on DeFi is easy and hassle-free. It does not require any government-issued IDs or other government documents or proof of address.

However, as an emerging sector, DeFi is not without its share of risks and issues. Some applications have suffered from coding errors that have opened the way for malfunction and misuse, including hacking. Smart contracts are immutable once created. To avoid similar issues, they need to be set up correctly.

As with all sectors, users need to research the services they use and the companies that provide them and only invest sums they can afford.

As NFTs are increasingly recognised as assets, they also present a conundrum for the investment community. Only popular NFTs are worth investing in, and popular NFTs are not only scarce, they are also costly. The high price of many NFTs limits the number of people that can invest in them; it also concentrates the risk for those doing so.

One solution is the establishment of funds that own a portfolio of NFTs, in which individual investors can own shares. Another is shared ownership — fractionalisation of NFTs.

Fractionalisation is an ancient practice related to financial securities, which splits the asset into parts with different owners. Buying a share in a company is purchasing a fraction of its ownership. This approach can widen the pool of potential investors, enabling more people to invest a lesser sum. It also can increase the total sum invested by allowing for shares to be traded.

Whilst NFTs are inherently non-fungible and indivisible, it is possible to split the ownership of an NFT. Ownership can be divided using fractionalisation, which can be programmed in the NFT or managed by a third party. Alternatively, by layering, where one party has overall ownership and sells specific aspects or layers of an NFT.

Fractionalisation allows users who have been previously priced out of certain NFTs or artists (such as Beeple) to buy a piece of their work. It also allows the NFT holder to see some liquidity from their asset without selling the entire article.

Another challenge is that as virtual objects, most NFTs have no exchangeable value in the real world. One solution is to use gold, silver, and other commodities to create a tangible value associated with an NFT.

In collaboration with Digix, Bullionix supports the creation of NFTs backed by Digix’s gold tokens (DGX). One DGX token is backed by 1 gram of gold, such that the NFT itself is backed or pegged to its DGX/gold value. Since January 2022, they are working towards reviewing license requirements under the Singapore Payment Services Act.

Giving NFTs tangible value opens the doors to many possibilities. For example, it is easy to envisage tournaments where the winners get gold medals as NFTs backed by gold, as happened during the ‘moonshot’ tournament in Decentraland, which brought 20+ teams to battle it out in a virtual game of football.

A specific and active segment of the DeFi sector is fund management. A growing number of Investment firms have an exclusive or concentrated portfolio of NFTs, including:

Conclusion

Many of these funds blur the lines between investor and builder — often built using the very projects they have invested in. New ways of investment are going to be a building block of the Metaverse. This means that DeFi is not going away anytime soon. Watch this space.

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