Banking for the unbanked remains the biggest challenge for the developing economies across the world. The complexities of the traditional system pose obstacles for people who need access to finance at the right amounts and at the right time. Read on to know how a revolutionary concept called decentralised finance is on the path to disrupting financial services as we know them today!
The current financial system is based on third party centralised institutions that use outdated technology. The slow-paced nature of age-old methods along with the limited accessibility to the existing financial intermediaries hinders borrowing, saving, investing and trading that is not on par with the fast-paced age of the internet. Presently with over USD 43 billion worth of total locked value, decentralised finance may just hold the solutions that the beneficiaries of today need.
DEMYSTIFYING DECENTRALISED FINANCE
Decentralised finance, better known as DeFi, is a developing fintech opportunity that leverages secure distributed ledgers based on cryptocurrency and blockchain technologies to carry out financial transactions. The aim of DeFi is to facilitate financial democratisation by substituting traditional centralised financial hubs with peer-to-peer solutions that can offer a wide range of financial offerings. As such, DeFi presents an alternative system that eradicates the central control that banks and other legacy institutions have on financial transactions, products and services.
Financial services on the DeFi concept are built on public blockchains like Bitcoin and Ethereum. However, by the end of 2021, a research note by bank JPMorgan Chase found that the majority of DeFi applications based on Ethereum was nearly 70%.
BASED ON BLOCKCHAIN
The core technologies that run DeFi are Blockchain and cryptocurrency. In a conventional checking account, the transaction is recorded in a private ledger such as your banking transaction history. This, in turn, is owned and managed by a large financial institution.
Alternatively, Blockchain is a distributed public ledger where financial transactions are databases in computer code. The blockchain is said to be decentralised as there is no middleman or gatekeeper managing the system.
The transactions are established and documented by parties that utilise the same blockchain, via a process of solving complex maths problems and accumulating new blocks of transactions to the chain.
A DeFi smart contract replaces the financial institution in the transaction that can hold money and can send/refund them based on fixed conditions. It cannot be altered after it becomes live.
The slow-paced nature of age-old methods along with the limited accessibility to the existing financial intermediaries hinders borrowing, saving, investing and trading that is not on par with the fast-paced age of the internet.
Currently, almost all financing and trading aspects are governed by centralised systems, overseen by gatekeepers and middlemen who regular consumers need to deal with to get access to desired services. Financial corporations presently guarantee transactions giving them enormous power because the common person’s money flows through them.
Moreover, billions in need aren’t even fortunate to be given access to set up bank accounts or use other financial services. For those that are lucky to have the opportunity, money transfers can sometimes take days due to internal human and technical processes. Additionally, there are limited opportunities for beneficiaries to access capital and financial services directly from banks, exchanges and lenders who gain premiums with fees from every financial and banking transaction. Also, you do not have access to banking services if you are travelling.
While trading hours are often limited to business hours, centralised institutions can close down markets at will. Moreover, the hidden cost of financial services is your personal data. As such, this lack of access to finance can be an obstacle to people from being employed and also block an individual from getting remunerated.
DEFI WHAT’S POSSIBLE
On the other hand, DeFi presents a decentralised global alternative to the current financial system. It is built around open-source technology that anyone can program with and opens up financial offerings to everyone with an internet connection. Moreover, DeFi products are largely owned and maintained by their users as well. DeFi challenges this centralised financial system by cutting out legacy middlemen and gatekeepers. It unbundles traditional finance via peer-to-peer exchanges and puts it in the hands of regular people.
With DeFi, people offer their savings as loans directly to others, cutting out that x% profit loss held by intermediaries and earning the full x% return on their wealth. This ensures you hold control of where your money goes and how it is spent. This pseudonymous process of preserving your online security is swift and transactions happen in minutes in markets that are always open. Most importantly, the process is transparent as anyone can look at a product’s information and verify how the system functions.
Consequently, DeFi gives you control and visibility over your finances. It gives users exposure to global markets and alternatives to your local currency or banking options. DeFi products open up financial services to anyone with an internet connection and they’re largely owned and maintained by their users. There are no more centralised authorities who can block payments or obstruct your access to your financial needs. Previous slow services with the risk of human error are safely automated and handled by code.
THE MONEY PROGRAM
By programming logic into money, we get programmable money. It allows us to get the control and security of cryptocurrencies like bitcoin and Ethereum and lending, borrowing, scheduling payments, etc.
For example, a smart contract that’s devised to hand out a fixed amount as per an escrow agreement could be programmed to send money from Account X to Account Y every month. No extra recipient may be added. It will only commence as long as Account A has the required funds, eliminating the scope to embezzle funds. As contracts are also public, bad contracts will often come under community inspection pretty quickly.
LET’S GET IT STARTED
Getting a crypto wallet such as Metamask would be a great base to start and fund with Ethereum. Do remember to save your public and private keys or you will be locked out of the wallet. You can then trade digital assets on decentralised exchanges to understand which assets and platforms are the best to invest in.
USE CASE UTOPIA
The market use cases for DeFi are far and many. They include:
Asset management: Buying, selling and transferring crypto, as well as paying interest in digital assets with crypto wallets.
Compliance and KYT: Know-your-transaction (KYT helps assess risk in real-time and protect against fraud and financial crimes) against compliance issues based on anti-money laundering (AML) and know-your-customer (KYC) in traditional finance.
DAOs: DAOs are decentralised autonomous organisations that cooperate according to transparent rules encoded on the Ethereum blockchain, removing the need for a centralised, administrative entity.
Data and analytics: DeFi protocols facilitate merits for data discovery, analysis, and decision-making over financial opportunities and risk management.
Derivatives: DeFi derivatives can characterise real-world assets such as fiat currencies, bonds, commodities and cryptocurrencies.
DEXs: Decentralised exchanges (DEXs) are cryptocurrency exchanges that operate without a central authority or listing fees and thus help reduce the risk of price manipulation, hacking and stealing.
Insurance: DeFi is still a growing arena with attendant risks based on smart contract bugs and breaches.
Lending and borrowing: Peer-to-peer lending and borrowing protocols happen to be some of the most widely used apps in DeFi. Flash loans can quickly be utilised to help savers earn income.
Margin trading: DeFi margin trading is powered by decentralised, non-custodial lending protocols automating traditional brokerage activity.
Marketplaces: DeFi protocols are making way to facilitate diverse online marketplaces from freelance coding gigs to digital collectables and physical commodities.
Savings: Numerous DeFi apps offer interest-bearing accounts that can earn significantly more than traditional savings accounts, depending on the dynamic interest.
BUMPS ON THE RISKY ROAD
As DeFi is an emerging concept there are a few risks associated with it. Since 100% collateral is required for transactions to be carried out this excludes many beneficiaries from qualifying. DeFi’s open and distributed nature might also contribute to problems with governmental and cross border financial regulations. Further questions are raised on who would be the enforcing authority. Moreover, according to calculations by blockchain data platform Chainalysis, USD 14 billion in cryptocurrency was transferred to illicit addresses in 2021, which was double the figure seen in 2020. While the analysis suggests cybercriminals raked in USD 7.8 billion in cryptocurrency from victims, about USD 2.8 billion of that figure came from scams, where developers create seemingly genuine cryptocurrency projects before stealing investor funds and absconding. Alarmingly, hackers continue to be a threat and about USD 2.2 billion was outright stolen from DeFi protocols in 2021.
DEFI AND THE FUTURE
While just in the beginning stages of its growth trajectory, DeFi has aimed to get rid of third parties, reduce transaction times and increase access to financial services. With the onset of the metaverse, DeFi can play a big role in the trading of NFTs and other offerings in the digital space. In conjunction, it has the opportunity to commodify the big data sector. However, while it takes control away from third parties, decentralised finance does not deliver full anonymity. Moreover, as it’s still an unregulated arena, it is still prone to infrastructural bumps, hacks, and scams. Additionally, issues such as technical maintenance, system stability, energy usage and more still need to be contemplated. If DeFi succeeds further, traditional financial institutions will also want to get in to have a piece of the pie. With the development of and debate around the infrastructure of DeFi, the opportunity to reach decentralised finance’s full potential lies in the task of educating the people about its promise.