Gone are the days when wealth automatically meant cash, isn’t it? In modern times, wealth assumes many forms and many types of assets. Earlier, to lock our wealth safely, we all invested in fixed deposits, government bonds, real estate, and gold and explored stock markets. These methods are still valid and favoured by many people, however, we all are familiar with the dazzling growth opportunities offered by new methods of making, storing and transferring wealth. The stories of overnight millionaires are a common theme of many discussions. Most of us want to get on the Crypto bandwagon. Did we miss the bus? Is Bitcoin overvalued? Which is the next hot coin? These questions are on our minds.
The bigger question is – do cryptos just mean digital currency or is there any deeper benefit to the whole crypto ecosystem?
The answer is – the opportunity offered by this invention to truly Decentralize Finance (DeFi) is the real game changer – or should be.
To truly understand the benefits (and risks) of DeFi, we should first discuss the issues and challenges in traditional financial systems. Incomprehensible as it may sound to us, there are more than 1.5 billion people in the world today who have no access to the banking systems. Various social, political and cultural factors are responsible for this. Additionally, for many small businesses, banking is just too expensive. They often must pay higher costs for availing business and the procedures and documentation needed to avail of this finance are too complex. Every time a customer uses a credit card to buy a product or a service from such a business, they end up paying as much as 3% to the credit card issuing bank. For low-margin businesses, this is just too high a cost.
It is a well-established fact that lack of access to finance and easy, cost-effective transaction methods causes economic disparity and prohibits growth.
While the banking industry is highly regulated, we have seen so many examples where influential players have been able to bypass these regulations and commit fraud.
Does DeFi solve any of these issues? If yes, how does it do so?
While Bitcoin was the pioneer of digital cash based on blockchain technology, the concept of DeFi got a real boost after the launch of Ethereum.
Ethereum took the features of Bitcoin and extended them further, one of the most prominent development being the “smart contract”. The digital coin is a store of value, that is transmittable and recorded in a shared, decentralized digital ledger. The computer code written for the coin can operate under a set of conditions that control if and how the transfer of value is completed. This works like a set of rules or “framework” that guarantees to honour a business contract by both parties – i.e. delivery of services/goods from the supplier AND payment for the services/goods by the recipient.
Sounds complicated? Think of the traditional practice of bank guarantees. The customer presents a bank guarantee to the supplier which assures that payment will be made once the supplier fulfils his part of the contract. The bank acts as a trusted intermediatory here.
The concept remains the same in a smart contract – except for one thing – the intermediatory is not a bank but the technology itself, eliminating the fees one had to pay to the bank for issuing the bank guarantee.
WHAT ARE THE DIFFERENTIATORS THEN?
First and foremost is the form – DeFi is digital and can be accessed from anywhere, across borders.
Since it is based on computer code, the features and facilities can be improved by constantly improving the code.
By combining different DeFi products, one can quickly build an entirely new offering, while still being governed by the underlying framework. So DeFi is composable, agile and fast, without compromising on the integrity offered by the smart contracts.
Why do we call them “smart contracts”? A traditional contract generally states a condition, which if met shall produce an outcome. If you send me the money, I shall send you the goods.
The “smart” aspect of these contracts lies in the automation. Smart contracts essentially are programs that automatically carry out an instruction once a certain “trigger” or condition is met. The resultant action can be used to send/receive funds. The underlying network guarantees the execution of the contract once the condition is met.
This automation removes the potential for human error. What’s more, it allows the delivery of existing products as well as the creation of new products in a faster and more efficient manner.
This potential to transform traditional financial services into newer, faster, decentralized, paperless and borderless products is where lies the obvious potential of DeFi.
Traditional financial system depends on a centralized infrastructure, managed by various financial institutions (primary and intermediaries) and overall governance is by central authorities. DeFi on the other hand is based on computer code run on the Ethereum blockchain, which is decentralized.
Crypto assets can be productively deployed via DeFi in ways that simply are not possible to be applied to real-world, physical assets. Products like flash loans, decentralized hedge funds, and DeFi crowdfunding platforms are just a few examples of DeFi use cases.
DeFi uses peer-to-peer networks, eliminating any intermediaries, saving on their transaction fees and cutting down on transaction time. Anyone with an internet connection can trade, invest, borrow or lend money via DeFi. The transactions are recorded in a distributed database that also has verification and tamper-proof mechanisms built in by default.
KEY ADVANTAGES OF DEFI OVER TRADITIONAL FINANCE
Security: The underlying blockchain technology ensures that transaction records cannot be fraudulently modified or deleted.
Ease of Access: There is no geographic restriction on DeFi, basically anyone with internet access can use it.
Low costs: Since there are no intermediaries, the transaction costs are low. The parties can directly negotiate the terms of the contract and conduct the transaction.
Autonomous: There is no dependency on central financial institutions or infrastructure. The transactions are secure yet transparent, as blockchain records of completed transactions can be viewed by anyone without revealing the personal information of the contract participants.
Flexibility and Portability: Since the whole concept is based on code, it is easier to add newer features by improving the code. A high level of automation reduces the chances of human error. Most DeFi platforms can easily integrate as the underlying protocols are designed for interoperability.
Finally, since the funds are stored in your own crypto wallets, you are always in control of your money.
CHALLENGES WITH DEFI
As with all emerging technologies, there are some challenges with DeFi too. The most significant challenge is the lack of regulation. The current legislation was drafted based on traditional financial systems, with each country or region having its own jurisdiction and set of rules. DeFi is essentially borderless, so there is a lack of clarity on how to enforce regulation on such a transaction and who should be responsible for this.
The other major concern about cryptocurrency in general and by extension with DeFi is the carbon footprint of the computing infrastructure. Improvements in the code claim to greatly reduce the computing requirements, however, this is not fully quantified or verified by third parties.
Issues associated with any technology platform, such as stability, hardware capacity issues, upgrades, bugs and vulnerabilities are all relevant to DeFi as well.
For DeFi adoption to increase, it must become less complex for the technologically challenged. High volatility and the recent surge in fake, scam platforms are a cause of concern too.
Regardless of these challenges, the fact remains that a large community of DeFi enthusiasts is actively engaged in constantly innovating, improving and adding new services to the DeFi ecosystem. Billions of dollars are now invested in smart contracts and new use cases are being added every day, every hour. From banking to currency exchanges, from insurance to gaming, from derivative markets to saving instruments, and from payment platforms to stablecoins – DeFi is here to stay and grow. It is in our interest to learn more about this exciting phenomenon and be a participant in the new way of conducting financial transactions.