Decentralised Finance (DeFi) is likely to have a substantial influence on how banks operate in the future, with the ability to modify the structure of the whole financial system at a macroeconomic level. Before we examine and support this notion, JPIN would want to first introduce the essential idea of DeFi.
DeFi manages financial transactions using cryptocurrencies and blockchain technology. DeFi intends to democratise finance by replacing old, centralised institutions with peer-to-peer connections capable of providing a broad range of financial services, including ordinary banking, loans, and mortgages, as well as complex contractual interactions and asset trading.
The New Way: Decentralised Finance
DeFi challenges this centralised financial system by disempowering middlemen and gatekeepers and empowering everyday people via peer-to-peer exchanges.
“Decentralised finance is an unbundling of traditional finance,” says Rafael Cosman, CEO and co-founder of TrustToken. “DeFi takes the key elements of the work done by banks, exchanges and insurers today—like lending, borrowing and trading—and puts it in the hands of regular people.”
Since 2020, DeFi has grown at an astounding rate, with billions of dollars invested in the ecosystem.
Today, you might put your savings in an online savings account and earn a 0.5% interest rate on your money which the bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, cutting out that 2.5% profit loss and earning a total 3% return on their money.
DeFi is powered by Blockchain
Blockchain and cryptocurrency are the core technologies that enable decentralised finance.
When you make a transaction in your conventional checking account, it’s recorded in a private ledger—your banking transaction history—which is owned and managed by a large financial institution. Blockchain is a decentralised, distributed public ledger where financial transactions are recorded in computer code.
When we say that blockchain is distributed, that means all parties using a DeFi application have an identical copy of the public ledger, which records every transaction in encrypted code. That secures the system by providing users with anonymity, along with verification of payments and a record of asset ownership that’s (nearly) impossible to alter by fraudulent activity.
Advocates of DeFi assert that the decentralised blockchain makes financial transactions secure and more transparent than the private, opaque systems employed in centralised finance.
How DeFi Is Being Used Now
DeFi is making its way into a wide variety of simple and complex financial transactions. It’s powered by decentralised apps called “dapps,” or other programmes called “protocols.” Dapps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).
Dapps and protocols are already being used in several ways, such as:
● Traditional financial transactions: Anything from payments, trading securities and insurance, to lending and borrowing are already happening with DeFi.
● Decentralised exchanges (DEXs): Right now, most cryptocurrency investors use centralised exchanges like Coinbase or Gemini. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.
● E-wallets: DeFi developers are creating digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
● Stable coins: While cryptocurrencies are notoriously volatile, stable coins attempt to stabilise their values by tying them to non-cryptocurrencies, like the U.S. dollar.
● Non-fungible tokens (NFTs): NFTs create digital assets out of typically non-tradable assets, like videos of slam dunks or the first tweet on Twitter. NFTs commodify the previously uncommodifiable.
How DeFi shall outperform traditional financial systems
There are three main reasons why DeFi has the potential to outperform the traditional finance system and gain increasing attention in scientific, economic, and public debates:
1. Speed of growth: DeFi is a highly scalable and global ecosystem. Once DeFi as a whole (or a specific DeFi application) proves its utility, exponential growth is possible.
2. Room for growth: According to Messari, a crypto market analytics firm, the capitalisation of all DeFi applications was just 1.5% of the total crypto market as of July 2020. Therewith, it could be argued that there is a lot of room for growth only by further asset redistributions within the crypto space.
3. New-market segments: According to The World Bank, 1.7 billion adults do not have access to banking services. DeFi is permissionless, meaning that anyone can access those financial services from anywhere in the world. All you need is electricity, an internet connection, and a smartphone.
For the first time in history, a financial system is developing without intermediaries at a large scale. So far, DeFi applications cannot compete in terms of security, speed, and ease of use with traditional financial solutions yet. But DeFi has produced real, working applications that have already managed to attract billions of capital. Those resources will be used to develop more competitive and user-friendly applications in the future.
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