DeFi: The Future of Finance
The long demanded innovation came through DeFi and has changed the world of finance with a market worth of over $100 billion in less than five years
The Great Financial crisis which lasted from 2007-2009 shook even the strongest economies in the world. Millions of homes, jobs and even lives were lost. This led to a decline in trust for institutions and government.
Fast forward to 2021, problems still plague the services offered by most financial institutions of today.
Some of these problems include lack of access to financial services, breach of privacy, hidden charges, waiting on banking hours, high-interest rates on loans, centralization of power, etc.
In Nigeria, for example, charges are imposed on the citizens for every USSD transaction they make because of a row between telecom firms and banks. They gain the increase while the masses pay the price.
Such has been the norm, until the DeFi revolution.
What is DeFi?
DeFi, which is short for decentralized finance, is a financial system where codes (smart contracts) regulate/facilitates financial services through a blockchain rather than centralized financial institutions.
The logic and terms of a financial service are written in immutable computer codes which self executes when predetermined conditions are met - smart contracts.
This completely reduces the need for an intermediary who assumes much power because it enforces agreement and holds money.
Considering DeFi applications (dApp) run on blockchains, they are decentralized and transparent - anyone can audit the codes and check transaction history, anyone can get access to loans or other banking services regardless of race, age, ethnicity, past mistakes, etc.
All of this is just with an internet connection.
The DeFi Structure
Traditional financial systems of today can operate because of three important components:
Infrastructure
Currency and
Regulations
For a DeFi service to completely replace traditional financial systems, it must have these components in place.
Let's see how DeFi replicates these.
Infrastructure
In most of our financial systems of today, banks and financial institutions act as this infrastructure. Depositors lock up their money in a bank with the hope of interest.
Banks lend this money to borrowers who are to pay it back with interest (of course the borrower leaves collateral).
But the main beneficiaries in this process are the banks. They decide who and when to lend, take ownership of collateral when borrowers are unable to pay, give little or no interest to depositors who provide liquidity.
The only few who can compete with banks are the top wealthy 1%.
DeFi solution
In DeFi, public blockchains replace banks as the infrastructure. The nature of blockchain systems changes the whole process.
As opposed to the use of intermediaries, blockchains enable any individual; rich or poor, black or white, to conduct transactions peer-to-peer in a secured environment.
Lenders and borrowers can transact without the need for trust or approval from anyone.
The smart contract automatically carries out all predetermined conditions when contract terms are met or breached.
Also, depositors can use their money to provide liquidity on decentralized exchanges with interest rates of over 10% annually as opposed to the 1% of most financial institutions.
Some of the top platforms where De-Fi services run are Ethereum, Solana, Binance Smart Chain, and Avalanche.
Currency
All financial service involves the use of money, hence the name finance. The currency used for performing financial transactions has evolved from gold and silver to fiat currencies such as the US dollar or Nigeria naira.
These currencies are used because they are stable. But economical challenges in most countries have seen their fiat currencies become increasingly unstable, especially due to the excess printing of money by central banks.
Most recently, the Nigerian naira traded for #500/$.
DeFi Solution
I'm much more confident with crypto than with banks or fiat currency because I can actually control it, and the money supply is transparent, stated up front
Eric Voorhees
Cryptocurrencies like Bitcoin have helped citizens of most countries live above inflation occurring their country just by holding a small quantity.
But not everyone will welcome the volatility that comes with cryptocurrencies, hence a more stable solution is the use of stable coins.
These stable coins are digital assets pegged to a real word asset like the fiat currency of a country, an example is the US dollar.
With the use of these stable coins, anyone has access to any currency without going through banks or paying high exchange fees, cross-border payments becomes fast, and transparency increases.
Top stable coins include USDT, DAI, USDC, and BUSD.
Note: Stable coins are not central bank digital currencies (CBDCs). They aren't issued or regulated by a central bank.
Regulations
In the traditional financial system, banks and the government are responsible for writing and enforcing the terms of agreement for a financial service.
This is very bad as the government and banks can impose regulations on the masses at any time.
Also, there's little room for innovation as only top financial institutions and their employees are able to introduce new solutions to financial services.
DeFi Solution
DeFi services are regulated by smart contracts and DAOs (Decentralized autonomous organisations).
Smart contracts automatically enforce terms of agreement, while DAOs are responsible for decision making.
Another beauty of De-Fi protocols is that they are open-source. Anyone can innovate on or develop a new financial service and launch it in a blockchain without gaining approval from any central authority.
DeFi Use Cases
Lending and Borrowing
This has been the example used for the most part of this article.
Getting a loan has been made very easy through DeFi applications. A person can get one within seconds without providing any personal information or government ID.
Borrowers use either NFTs or cryptocurrencies as collateral to borrow from either an individual or a liquidity pool. The lender automatically receives the collateral if the borrower is unable to pay back.
Lenders who provide liquidity for pools gain interest after few days or even hours depending on the pool size.
Popular borrowing and lending platforms include Aave, MakerDAO, and Compound.
Decentralized Exchanges (DEX)
These exchanges give users the ability to trade thousands of tokens directly into their wallets without going through any intermediary.
Unlike most peer-to-peer trading platforms where exchanges act as escrows between individuals, smart contracts fill the gap and take care of the whole process.
People who provide liquidity for these exchanges also earn interest over time.
A few of these exchanges are Uniswap, Synthetix, Pancakeswap, Curve Finance, and SushiSwap.
Payment Solutions
According to the World Bank, over 1.6 billion people in the world are unbanked. And this means they are likely to become poorer without any access to financial services.
However, since the introduction of DeFi applications, anyone, anywhere in the world now has access to financial services.
People can receive payments from anywhere in the world just by having a cryptocurrency wallet on their phones. No cross-border fees charged, no time wasted in bank halls.
Bitcoin, Ether, Binance Coin, Solana, and DOT are currencies those who welcome volatility can use to receive payments.
People who prefer a stable option can receive or make payments using stable coins like USDT, DAI, or USDC which are all pegged to the US dollar.
Crowdfunding
Anyone with a business idea or an app can easily receive funding in small shares from a pool of individuals across the globe through crowdfunding.
But most crowdfunding platforms charge high fees, most investors also overlook projects because of too many scam projects.
DeFi solves this through the use of smart contracts in enforcing contract terms, and decentralized platforms like Binance Smart Chain cut down the fees drastically which most centralized crowdfunding platforms charge.
The two-way benefit is that those small businesses and innovative ideas can easily receive funding via a transparent process without surrendering their business to venture capitalists, and any individual gets the opportunity to own shares of a company or project that might be the next big thing.
Some DeFi applications even limit the number of shares a person can own to democratise the whole process.
DeFi based crowdfunding has been happening in the form of ICO (initial coin offering), but new and better ways are being developed - Gitcoin grant being one of such
Other DeFi Use Cases
Insurance
No loss lotteries
Margin trading
Quadratic funding
Trading and prediction markets and many more
Challenges and Risks
New opportunities also come with new challenges
DeFi may be able to solve many problems our current financial systems face but it also poses new challenges.
The two major issues are technical and user challenges.
Technical Challenges
Although blockchains are extremely or almost impossible to hack, the same can't be said for applications that run on them.
Some DeFi services are susceptible to hacks due to errors in their codes.
DeFi codes being open-source might have solved this problem from the start, but projects that have less attention from developers or ignore concerns raised in their forums fall victim to these hacks.
This is already a red flag to not invest in or use such DeFi platforms.
Recently, Poly network, a DeFi platform, suffered a hack that saw over $600 million stolen.
However, hackers find it extremely hard to spend funds stolen from DeFi platforms because of the transparency of blockchains.
Transaction speed and poor internet access in some countries are other technical challenges.
User Challenges
Moving from centralisation to decentralisation shifts duties from intermediaries to users.
This means users are responsible for every action (correct or incorrect) they take.
The immutable nature of DeFi platforms ensures that once a transaction is performed, it can't be reversed. And humans are prone to making errors, especially with numbers.
People have lost thousands of dollars from inputting too many zeros mistakenly in a transaction.
You have no customer service to call, and transactions are irreversible.
Also, not all users are ready to switch from their centralized services to DeFi, probably because of misconceptions around cryptocurrencies and the poor UI/UX designs of some DeFi platforms.
Conclusion
Our current financial systems are boxed and limits everyone in different ways.
The long demanded innovation came through DeFi and has changed the world of finance with a market worth of over $100 billion in less than five years.
DeFi will surely replace or be integrated into the financial systems of today because it has come to stay. But before that time comes, it must overcome the challenges it currently faces.
And its open-source nature tells us these challenges will not last long as innovations are introduced daily into the world of DeFi.
Leave a comment (questions & your thoughts)
Subscribe never to miss another issue
This really opened my eyes did not know about this before
DeFi has surely come to stay.. But what scares me is it's susceptibility to hacking. What's the solution to that?