DeFi or decentralized finance has been getting so popular these days for a really good practical and logical reason. The world is shifting to DeFi as it aims to “bank the unbanked”. This provides equal opportunities for many people to grow and protect their investments. Sadly, in the real world, it’s not how it works. DeFi aims to change this once and for all.
This mainly involves financial services using smart contracts, which are highly automated agreements that do not require intermediaries like a bank, instead it uses the distributed ledger technology.
Starting from 2017, the DeFi market has aroused to a massive height with the rise in the value of tradable tokens that are used for DeFi smart contracts. It’s one of the procedures for disruptive traditional financial technology. Decentralized exchanges are the major systems in which DApps have taken off initially. These are completely the peer to peer platforms without any third party.
What Can We Do with DeFi Services?
- Borrow and lend cryptocurrencies in order to earn interest from the platforms.
- Betting on various outcomes of events.
- Exchange of real-world assets including currencies and precious metals.
- No loss lottery such as all the users get their money back and one lucky user will get the overall interest that has been acquired from the shared pot.
- Buying cryptocurrencies such as the stablecoins that will have a pegged value of a particular fiat currency or commodity.
What Is Decentralized Finance (DeFi)?
Decentralized Finance (DeFi) is a blockchain-based type of finance that uses smart contracts on blockchains, the most common of which is Ethereum based on ERC20 Tokens, to supply traditional financial instruments instead of relying on central financial intermediaries such as banks.
People can use decentralized finance platforms to lend or borrow money from others, trade cryptocurrencies, insure themselves against risks, and earn income in savings accounts.
This financial sector was born in 2009 when bitcoin was created. Then ICOs, which were one of Ethereum’s first major use cases, became popular in 2017.
Since 2018, concepts like “liquidity mining pools” and “automated market makers” were introduced, which made many DeFi initiatives develop new tools like collateralized lending, borrowing, and yield farming, among others.
On the other hand, even though decentralized finance became popular in 2020, making Ethereum the only blockchain that supported DeFi tools, numerous cheaper and faster alternatives have emerged since then (for example, Binance Smart Chain). Nowadays, these two blockchains are the most used networks for developing DeFi initiatives.
However, people worldwide do not have access to this revolutionary technology in the numbers we’d like to.
Decentralized finance is quickly rising as a more secure, more transparent, and more efficient alternative to traditional financial services. By eliminating the need for centralized financial institutions, we create a more open and trustworthy financial system and one that’s far more accessible.
Secured by blockchain technology, decentralized finance will reduce the risks of fraud, corruption, and mismanagement of your assets. It will also make managing finance far more cost-effective and efficient, with no more overdraft fees, no costs for wire transfers, and no waiting on banking hours for a transaction to be verified.
The term decentralized finance, or DeFi for short, describes a financial system that operates without the need for traditional, centralized intermediaries. We’re used to everything going through a bank and other financial institutions like a global exchange, but DeFi creates a system that can function on its own.
Perhaps the most well-known application of decentralized finance is online transactions through DeFi cryptocurrency, but decentralized finance allows us to handle a number of financial applications – like investing, insurances, exchanging, borrowing, and lending in a more efficient and transparent way.
How Does DeFi Work?
Rather than a bank facilitating transactions and services between parties, DeFi uses technology. A number of open-source protocols are being developed alongside public blockchains, forming a framework for decentralized finance to operate on.
There are two core components that allow a finance system to work; it needs an infrastructure to operate on, and a currency to operate with. In a centralized system, banks and financial institutions act as that infrastructure, while fiat money, like the US dollar, acts as currency. Decentralized finance must replace these components in order to offer a full range of financial services.
Ethereum is a platform for writing decentralized programs. Through Ethereum, we’re able to create smart contracts – automated code that can be used to manage financial services. Through smart contracts, you can establish a set of rules for how a financial service will work, and deploy those rules to Ethereum. Once a smart contract has been deployed, it cannot be altered.
Users can build decentralized apps on Ethereum to establish any financial service, and allow smart contracts to manage those services autonomously.
In order to create a reliable, secure decentralized financial system, you need a stable currency. Bitcoin is not compatible with the Ethereum platform, and Ether – Ethereum’s own programmable cryptocurrency – is highly volatile.
A stablecoin is a cryptocurrency that matches its value with a fiat currency. DAI is a decentralized stablecoin that’s pegged against the US dollar – meaning 1 DAI is equal in value to $1 USD. DAI’s value is backed by cryptocurrency collateral, rather than being backed directly by US dollar reserves. Because of its stability, DAI is the ideal currency for decentralized finance.
More Than Just Online Payments
The benefits of a decentralized finance system stretch beyond online payments. Money transfer is just one aspect of the traditionally centralized financial system, but decentralized finance looks to replace every aspect, including exchanges, loans, insurance, and saving plans.
Smart contracts on Ethereum are what allow these decentralized services to exist, and what allows them to operate fairly and securely.
Financial Services Backed by DeFi
Decentralized Borrowing and Lending
You could, through decentralized finance, secure a loan in a matter of minutes, without having to go through a complicated or restrictive application process.
Compound is an Ethereum-based app that facilitates decentralized, peer-to-peer borrowing and lending. Compound automatically connects lenders with borrowers, and autonomously manages loans using smart contracts. This has led to a rise in popularity of what is known as ‘yield farming’, as anyone is able to lend their crypto assets and earn interest in the process.
You can also use Compound to deposit your cryptocurrency as collateral and borrow fiat money against it.
Decentralized Exchange (DEX)
The decentralized exchange (DEX) allows us to buy, sell, and trade cryptocurrencies on the Ethereum platform, without having to go through an exchange operator; without the need for sign-ups or ID verification; and without any fees for withdrawing funds. Furthermore, exchanging with DEX doesn’t require any initial deposit, unlike centralized exchanges.
Trades are executed autonomously, with the terms and processes guided by smart contracts.
Smart contracts in the decentralized finance system make peer-to-peer, decentralized insurance possible too.
In a decentralized finance system, you can connect with anyone around the world who is willing to insure your assets, and on the other end, you can insure other people’s assets at a premium, without ever having to go through an insurance company or agent. Everything happens autonomously, with smart contracts ensuring a fair, secure, and trustworthy process.
Why is there a Sudden Craze for DeFi?
The first reason for the DeFi Boom was that the regulators were behind the curve and the DeFi was able to grow up in this vacuum. If we consider traditional lending, it’s a form of unsecured process, and the legal requirement that lenders and borrowers know each other is another factor, which is not needed in DeFi. Instead, mutual trust and privacy is the major attractive feature of DeFi.
The Second reason includes the surge in the mainstream players who are getting involved in it. As many high-street financial institutions are beginning to adapt DeFi and still many are seeking multiple ways to participate in it, it’s speeding up the DeFi success.
The third reason include the effect of COVID-19, the pandemic has caused the global interest rates to be lower. But, the DeFi has been offering an annualized interest rate of 6.75% for those who save with stablecoin Tether. The users will get interest for it and will also receive Comp tokens, which becomes an added attraction. With two-thirds of people without bank accounts, DeFi also has the potential to reach them easily.
The Final reason for the users investing in DeFi tokens is to avoid begin left out of their explosive market growth in the future. Tokens that are currently worth nothing now is believed to have a future value. This causes the rise in the new financial system that is more liberalized and decentralized than ever before. The main question will be how best its development can be carried out with checks and balances that minimize the risks and spread the potential benefits to the users.
Is DeFi the New Bank?
Maybe or a possibility! It’s a given fact that most people don’t have bank accounts. Not having access to this fundamental financial instrument is the main factor that stops them from realizing certain everyday functions. However, decentralized finance (DeFi) was created to meet all the requirements and demands of traditional banking — security, privacy, and accessibility — in a new way.
By transferring financial operations onto the blockchain, people will only need a smartphone or portable PC and a stable Internet connection to access the global financial system 24/7. How’s that for a step in the right direction?
Financial Inclusion for Everyone!
Finally! Everyone is aiming for financial inclusion and it’s happening with DeFi. Individuals and enterprises who are financially included have access to financial goods and services that fit their requirements — transactions, payments, savings, credit, and insurance — offered by big institutions with all their benefits and drawbacks.
Access to a bank account in the current financial system is the first step toward economic development since it allows people to store their money safely. However, a bank account’s most crucial function is to be the portal to other financial services.
For nations where 80% or more of the population has bank accounts, the next phase is to transition from account access to account usage (China, Kenya, India, and Thailand). These nations depended on reforms, private-sector innovation, and a drive to build low-cost accounts, including mobile and digital payments.
DeFi platforms provide an alternative system, not simply a plug-in to existing banks. Their decentralized nature means transaction onboarding and market-based risk assessments are much easier to scale across a business’ wider system because access to relevant information is not dependent on centralized processing or a prior relationship.
Prior to DeFi, a business would have to complete anti-money laundering and “know your customer” checks for every source of capital and convince their counterparts to onboard to the same transaction banking programmes. They also would not be able to present evidence of performance on their debt or payables outside of financial statements.
DeFi allows for the exchange of trustable data across a system, mitigating these barriers to business financial services. Until now, however, most companies did not seriously consider DeFi as a viable alternative to their bank’s services because of the volatility of crypto-assets, regulatory uncertainty, and the immature technology involved.
Even Tesla’s purchase of $1.5 billion in bitcoin was motivated by the direct financial value of bitcoin as an asset, not by its transaction banking needs.
While DeFi previously solved the complex requirements around portable digital ID for businesses and has a roadmap for providing access to financial performance track records in transaction banking, it completely lacks two crucial elements: a one-to-one exchange with fiat currency; and interoperability between different blockchains so that counterparties could freely interact with one another.
The former is necessary for cryptocurrency to offer a stable store of value that can be used as currency and to have an easily accessible interface with the traditional financial system. Interoperability is crucial for transactions to occur at scale in the highly fragmented blockchain space.
Two recent developments in DeFi have made significant progress towards plugging these gaps.
- First, availability of stablecoin pegged to the USD, such as USDC, USDT (Tether), BUSD (Binance) and Dai (Maker), is growing. Tools like Curve and robust cryptocurrency exchanges allow for easy conversion from one USD-backed stablecoin to another.
- Second, interoperability protocols, such as the Inter-Blockchain Communication protocol, have been released for both public and private blockchains.
Each of these capabilities means that businesses and financial institutions will have many more options to conduct business independent of the banking system, with the potential to create sizable efficiencies for larger companies and open up liquidity for SMEs.
That is true for each of the major categories of transaction banking services: provision of short-term liquidity and cash management, trade finance, payments, escrow services, and custody of assets.
Non-blockchain fintech platforms already provide the first three without becoming banks, and DeFi adds the features of smart contract-driven workflows (business workflows that are at least partially executed by blockchain-based smart contracts, not by manual intervention or non-blockchain-based automation) and use of cryptocurrencies, a parallel, highly liquid asset class.
As for the last two categories, companies that keep custody of cryptocurrencies, such as Paxos, Anchorage, and Kraken, are increasingly pursuing bank charters from the US Office of the Comptroller of the Currency to serve as a trust bank, offering security and regulatory safety to corporate treasury departments attracted to the cost and ease of blockchain-based services.
DeFi Focuses on Client Relationships
In many ways, DeFi supports the move away from the historic primacy of the client relationship. The business model has relied on the fact that once a corporate client chooses a particular bank for one service and the bank’s relationship manager establishes trust, then the client will use other services as well. This has been changing for some time, however.
DeFi-based transaction banking strengthens the existing trend where services are atomized, and financial management relies more on technology, workflow management, and risk arbitrage for credit opportunities.
The crucial values that DeFi adds to these changes are permissionless access and the greater emphasis on interoperability.
Non-DeFi decentralized systems do not yet have the ease of user onboarding that encourages adoption. Workflow management and credit arbitrage across systems are almost impossible with centralized systems that do not communicate with one another.
Nowhere is that last requirement more urgent than it is for SMEs. While large enterprises seek efficiency in transaction services, SMEs require access to credit for continued business operation and survival.
Banks and fintech platforms have been scrambling to find a way to address that need, but the existing frameworks for servicing businesses are not a great fit. While AI and general digitization platforms seemed to be the best chance for immediate relief, the explosive growth of DeFi has also expedited the impact of blockchain.
The four main reasons why people can’t have a bank account are as follows:
- Lack of access to nearby banks / mobile phone
- Minimum balance fees
- Distrust of the banking system
- No access to government-issued ID
Banking the Unbanked!
These four causes are still valid in developing countries. Most people who need financial tools (a loan, for example) usually get that money from friends or family simply because the bank requirements are unattainable.
The lack of long-term financial system policies that guarantee digital and physical infrastructure to attract telecommunications and banking investments makes opening and maintaining a bank account a script for a fiction movie in developing countries.
Therefore, unbanked people in every country of the world desperately need a much simpler, secure, and private financial alternative. Decentralized finance is establishing itself as the best answer to grant anyone access to a DeFi Wallet24/7.
Why DeFi is So Much Better Than Banks?
These are the top 10 most common bank complaints:
- Excessive / hidden fees
- Poor customer service
- Check/funds essential bouncing
- Expensive debits charged first
- Loyalty is unrewarded
- Mortgage / loan issues
- Huge errors/discrepancies
- Bad branch experiences
- Difficult for small businesses
- Failing to honor their promises.
As you can see, people complain because they want to have minimally fair conditions to manage their money with transparency and security. Unfortunately, however, banks have often failed to provide such guarantees.
On average, compared to others, banked people may be more likely to discover the different decentralized finance platforms that exist right now on the market and therefore be encouraged to use them for their financial transactions despite the UX difficulties that exist nowadays.
In other words, most people who currently use traditional financial services worldwide are not happy with their banks’ financial tools, making them a vital sector that also needs DeFi services to manage their money more securely and privately.