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DeFi The future of Financial Services

Updated: Apr 7, 2023

DeFi is generally known as an extension of blockchain 1.0, attracting massive attention in recent years. The overall market for Global Investable Assets[1] is $120T, and the crypto market forms $1.5T. Although, DeFi made its debut in 2019, and the total value locked up in DeFi contracts is $43.53B[2]. Today, the bulk of this market is captured by MakerDAO. Decentralized Finance (DeFi), a new field applying blockchain technology to the financial industry, reshapes its existing structure. There has been an exponential growth of associated token value. Over the past year, SNX increased in value by around 2000% and Aave by about 800%. Though majority of today's dApps are niche, future applications could significantly impact day-to-day life. This article provides a deep understanding of how DeFi makes traditional financial markets more resilient, improves financial inclusion, boosts innovations to conventional financial services.



What is DeFi?


DeFi—an abbreviation for decentralized finance—is a blockchain-based financial service. DeFi extends the concept of bitcoin or cryptocurrency from a simple peer-to-peer electronic cash system to a peer-to-peer electronic financial instrument system. It eliminates the dependency on middlemen—intermediaries and centralized institutions—in various applications like mortgages, derivatives, insurance, and more. In other words, DeFi provides an alternative financial infrastructure built on top of a cryptocurrency, typically Ethereum. With the advent of smart contract functionality on Ethereum, it became easier to construct real-world complex financial instruments, making it even more powerful. DeFi uses smart contracts (basically software codes) to create rules that replicate existing financial services in a more robust, transparent, interoperable way. DeFi's architecture is based upon open protocols and decentralized applications. The underlying agreement in a smart contract is enforced by code and executed in a secure and verifiable way. This makes it an immutable and highly interoperable financial system with unprecedented transparency and little need for custodians.


How is DeFi similar to traditional finance?


While traditional finance is built on trust, DeFi is built on trust over software code. During the initial days, the lending business ensured trust by transacting only with friends, acquaintances, or friends of acquaintances. Slowly, as the institutions took shape, credit scores or data analysis (as a measure of trust) were used to perform transactions in the larger ecosystem. DeFi extends the mainstream lending business concept by enforcing trust using smart contracts driven by codes, rules, and procedures.


The traditional financial system depends on the strength of large financial bodies in terms of credibility, authority, and stability. Similarly, DeFi relies on the strength of the blockchain network in terms of its protocols and acceptance. Hence, we can say that DeFi is the next-gen version of traditional finance. The mainstream form of Commercial Banks, Exchanges, and Centra Banks is replicated in the DeFi world via Lending, Decentralized Exchanges, and Stablecoin.


Decentralized Lending/Mortgages

Decentralized lending attempts to free financial services from financial bodies and regulators and achieve a transparent and secure financial lending relationship. Mortgage lending forms the primary form of DeFi lending and has few advantages over the traditional lending business—

1. There is no lower limit for investment;

2. Eligibility is less stringent; and

3. The process is more transparent and cost-effective.

The total value locked in the lending business is $19.3B[1]. Maker, Aave, and Compound are major players capturing 96% of this market. As per Maker's website, "MakerDAO is an open-source project on the Ethereum blockchain and a Decentralized Autonomous Organization created in 2014. The Maker Protocol, built on the Ethereum blockchain, enables users to create currency—Dai. MakerDAO governs the Maker Protocol by deciding on key parameters (e.g., stability fees, collateral types/rates, etc.) through MKR holders' voting power. The Maker Protocol, one of the largest decentralized applications (Dapps) on the Ethereum blockchain, was the first decentralized finance (DeFi) application to earn significant adoption."[2]


Decentralized Exchanges

Decentralized exchanges allow users to trade digital assets such as Bitcoin and Ethereum. Its primary purpose is to solve the problems of artificial manipulation in centralized exchanges. DEXs reduce the risk of price manipulation and hacking, and theft because crypto assets are never in the custody of the exchange itself. It is currently dominated by Curve Finance and Uniswap, with a market capture of 57% of the total $15.75B[3]. Curve facilitates the exchange of stablecoins (like DAI to USDC) with low fees and low slippage. Unlike others, it uses liquidity pools (pools of tokens that sit in smart contracts), making it more popular than others.

[1] Defipulse [2] The Maker Protocol Whitepaper, MakeDAO [3] DEX Market Share, Defipulse


Stablecoin

As popular cryptocurrencies offer high volatility over a short period, it makes them unsuitable for everyday use by the public. Stablecoins[1] are cryptocurrencies that attempt to peg their market value to some external currency like USD or gold. Their primary aim is to provide price stability via collateralization (backing) or algorithmic mechanisms to buy and sell the reference asset or its derivatives. Stablecoin is a blockchain-linked currency with a stable price; it bridges the gap between fiat currency and digital currency.

Market Cap for stablecoins stands at around $48B[2], out of which USDT captured 70% of the market. Other significant players are USDC, DAI, and BUSD.


DeFi’s Future

Integrate with the mainstream

For DeFi to scale, it is imperative to integrate the mainstream and next-gen financial systems. Blockchain is one of the hot technology being adopted by the Fintech industry, especially by disruptive startups. Rather than competing against established infrastructure, these initiatives are aiding the traditional financial system to become more secure, transparent, and affordable. Further, it adds stability and provides a risk-mitigation approach by improving the quality and bringing credibility. DeFi's underlying assumption is that all assets can be tokenized in the future, which is nothing but today's world of asset digitization. This is consistent with the recent trends in the policy of governments and global institutions[1]. After the assets being digitized, they can theoretically be traded and circulated globally. Hence, digital assets and DeFi are similar in many aspects; the only difference lies in networking (alliance chain VS public chain).


Compliance

In traditional finance, compliance around anti-money laundering (AML) and countering-the-financing-of-terrorism (CFT) relies on know-your-customer (KYC) guidelines. In the DeFi space, Ethereum's decentralized infrastructure enables next-generation compliance analysis around the behavior of participating addresses rather than participant identity. These know-your-transaction (KYT) mechanisms help assess risk in real-time and protect against fraud and financial crimes. For example, in mortgage lending, if we lift regional restrictions and do cross-border capital asset docking (such as inflow of foreign funds), then it will theoretically be a DeFi form that adheres to regulations and compliance and fully integrated with traditional financial services.


Cross Border Financial Service

A trusted distributed computing network can allows DeFi to build financial services on a globally auditable digital ledger. The business logic is immediately executed on the contract code automatically. These features can improve the level of risk management and supervision capacity, hugely beneficial to global financial business development. Cross-border risk control measures and consensus rules can better integrate financial services across regions and promote more efficient, transparent, and flexible systems, and this is the essence of DeFi.


Resilience

As per Salil Deshpande, a partner at Bain Capital Ventures, "Decentralized financial applications can make our financial systems more transparent, more resilient and less fragile."[2] Global pandemics like COVID-19 or the 2008 Financial Crisis have exposed the

vulnerabilities of our traditional system. Visionaries believe that DeFi's distributed system can find global financial risks to prepare us better in front of macro-economic events.

In 2008, the US government bailed out big financial institutions by aiding them with billions of dollars. These institutions embedded complex mortgaged-backed securities (deemed to be risky) into their 'Safe' investment offerings. A distributed DeFi system could have highlighted such risks by tracking across single or multiple blockchains. Also, DeFi potentially offers much higher returns to savers than high-street institutions. For example, Compound has been offering an annualized interest rate of 6.75% for those who save with stablecoins Tether.


Financial Inclusion

According to a 2017 survey by the FDIC, 25 percent of US households are unbanked or under banked.[1] Another report from World Bank Group mentions as many as 1.7 billion adults are unbanked globally.[2] That's roughly one-fourth of the global population. DeFi provides a platform with greater participation and less friction. As smartphones make digital financial services (like microloans) accessible to a larger population, many disparate systems with independent pricing mechanisms (like derivatives, gaming, or insurance) can be brought together using DeFi on interconnected blockchains.


Innovation

The higher interest rate premiums, lower remittance costs, and speed in DeFi have introduced competition to traditional payment systems and banks and are forcing them to innovate. As a result, there is a rapid growth of Fintech M&A with conventional banks. Whether it is MasterCard’s $825 million acquisition of Finicity[1] or Amex's acquisition of Kabbage[2] (to take over Kabbage's employees, technology, and financial data), the trend clearly shows banking institutes' interest in new emerging startups. Also, many established financial institutions are seeking ways to participate in the DeFi ecosystem. For example, world's biggest banks are piloting blockchain technology[3] to speed up payments as part of the INN (Interbank Information Network), spearheaded by JP Morgan, ANZ, and Royal Bank of Canada.


Conclusion

After a couple of years of development, DeFi is very likely to witness explosive growth in the next few years. We are heading towards a next-gen financial system that is more liberalized and decentralized, the world has ever seen. The critical question is how best to guide its development with checks and balances that minimize the risks and spread the potential benefits as widely as possible. That is the challenge for the next few years.



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