Can Decentralized Finance Create a More Efficient Financial System

During last year and the continuation of this year, the term DeFi has generated significant excitement in the crypto community. Many believe that DeFi, or decentralized finance, can completely turn the global economy upside down, making the financial sector transparent and easily accessible. The DeFi movement utilizes decentralized networks to transform traditional financial products into reliable and transparent protocols that operate without intermediaries.

Currently, there are 1.7 billion people in the world without access to basic financial services. However, with a simple internet connection, anyone can access smart contracts and experience significant financial growth and security with DeFi.

The Problem of Traditional Finance

During the crisis caused by the coronavirus in 2020, the Federal Reserve, the U.S. central banking system, made headlines stating that it would inject a substantial trillion-dollar amount into the market to prevent ‘unusual disruptions’ and rescue banks under immense financial pressure. However, that money is not free, and someone ultimately has to pay for it. In 2020 alone, more than $3 trillion was created, meaning that nearly 20 percent of all existing dollars in circulation were created last year.

In addition to being slow and expensive for their clients, centralized financial systems are also vulnerable to hacking attacks, data privacy breaches, and security failures.

Traditional financial systems are also inaccessible to millions of people who do not meet the criteria for opening a bank account. This may sound strange to those in developed countries or wealthy regions, but insufficient identification and access to capital, geographical isolation, and government oppression limit millions worldwide from accessing traditional financial services.

What is DeFi?

Decentralized finance is a new paradigm of the financial system that operates independently and does not rely on centralized financial intermediaries such as banks, credit unions, or insurance funds. Instead, users have the ability to transfer, trade, invest, and transfer between peer users using cryptocurrencies and digital assets through automated smart contracts, eliminating the need for those slow and expensive intermediaries.

More specifically, the term decentralized finance can refer to a movement aimed at creating an open-source, permissionless ecosystem of financial services that are transparent and available to everyone, operating without any central authority. Users would retain full control over their assets and interact with this ecosystem through peer-to-peer (P2P) decentralized applications (dapps).

The primary benefit of DeFi is easy access to financial services, especially for those who are isolated from the current financial system. Another potential advantage of DeFi is the modular framework on which it is built. Interoperable DeFi applications on public blockchains can potentially create entirely new financial markets, products, and services.

Smart Contracts

Most existing and potential applications of decentralized finance involve the creation and execution of smart contracts. While a traditional contract uses legal terminology to define the terms of the relationship between the parties entering into the contract, a smart contract uses computer code.

Since the terms are written in computer code, smart contracts have a unique ability to enforce those terms through computer code, allowing for reliable execution and automation of a large number of business processes that currently require manual oversight.

Using smart contracts is faster, easier, and reduces risk for both parties. On the other hand, smart contracts also introduce new types of risks. Since computer code is prone to bugs and vulnerabilities, the value and confidential information locked in smart contracts are at risk.

In other words, a smart contract is a protocol that allows parties to interact directly with each other without a third-party overseer.

Since Ethereum capitalized on smart contracts to become the first development platform for decentralized applications, it has become the blockchain of choice for many companies looking to build their financial products. After all, not only is the majority of DeFi applications built on Ethereum, but also the largest portion of innovation occurs on that blockchain.

Thus, smart contracts are predominantly executed on the Ethereum blockchain and can be executed automatically without human intervention when the right conditions are met. And it is these smart contracts that allow developers to simplify the once cumbersome boundaries of simply sending and receiving cryptocurrencies.

Characteristics and Advantages of DeFi

The primary features that distinguish blockchain systems from private networks used by traditional financial institutions are:

• developers can program dapps that provide cheap financial services
• transactions can be securely verified without the use of central parties
• free access – anyone can create and use DeFi dapps
• records are not stored on a single server or central network
• transactions are public so that anyone can monitor them
• censorship resistance – a central party or authority cannot invalidate transactions

Problems that DeFi Solves

• Limited access to global financial services – Global access to financial services already exists, but it comes with a range of barriers. Owning a computer or mobile phone with internet access is all that is needed to interact with DeFi.
• Lack of privacy and security – Centralized institutions can inadvertently compromise the wealth and private data of their clients. In DeFi, users control their money and do not need a central authority.
• High fees for international payments – DeFi aims to reduce global remittance fees (which hover around 7 percent) by more than half. By simply eliminating unnecessary fees imposed by intermediaries, cross-border payments can be significantly optimized. 
• As we transition into a ‘dystopian’ age of social media, political censorship can also mean financial censorship. DeFi offers immutable and final transactions that central authorities like governments cannot prevent. While transactions can be publicly audited, the identity of users remains anonymous.
• Developers create user interfaces to make them look more appealing and easier for everyday use. And simplicity will help the masses migrate from traditional, complex, centralized systems.

Use Cases and Products

Decentralized Money Markets

Open lending protocols are among the most popular types of applications that are part of the DeFi ecosystem. Open, decentralized borrowing and lending have many advantages over the traditional credit system. This includes instant settlement of transactions, the ability to collateralize digital assets, no credit checks, and potential standardization in the future.

Since these lending services are based on blockchain, they minimize the required amount of trust and have the assurance of cryptographic verification methods. Lending on the blockchain reduces the risk of the other contracting party and makes borrowing and lending cheaper, faster, and accessible to a larger number of people.

Decentralized Markets

This category of applications can be challenging to assess, as it is precisely the segment of DeFi that allows the most room for financial innovation.

Undoubtedly, some of the most important DeFi applications are decentralized crypto exchanges (DEX). These platforms allow users to trade digital assets without the need for a trusted intermediary to hold their funds. The exchange occurs directly between users’ wallets with the help of smart contracts.

Since they require much less maintenance work, decentralized exchanges typically have lower trading fees than centralized exchanges.

Blockchain technology can be used to issue and enable ownership of a wide range of conventional financial instruments.

Token issuance platforms, for example, can provide issuers with tools and resources to launch tokenized securities on the blockchain with customizable parameters. 

Other projects may enable the creation of derivatives, synthetic assets, decentralized prediction markets, and much more.

Monetary Banking Services

Since DeFi applications are by definition financial applications, monetary banking services are an obvious use case for them. This can include issuing stablecoins, mortgages, and insurance.

As the blockchain industry matures, there has been an increased focus on creating stablecoins. They are a type of cryptocurrency that is typically pegged to real assets but can be sent digitally with relative ease. Since cryptocurrency prices can sometimes fluctuate rapidly, decentralized stablecoins could be adopted for everyday use as digital money that is not issued or monitored by a central authority.

Primarily due to the number of intermediaries that need to be involved, the process of obtaining a mortgage is expensive and time-consuming. By using smart contracts, contracting and legal fees can be significantly reduced.

Insurance on the blockchain could eliminate the need for intermediaries and allow for risk distribution among many participants, which could result in lower premiums with the same quality of service.

Risks and Challenges

One of the greatest advantages, and at the same time the biggest challenge in DeFi, is the characteristic that allows individuals to take control of their assets. However, with great power comes great responsibility.

• Poor performance – Blockchains are inherently slower than centralized systems, which translates to applications built on them. DeFi application developers must take these limitations into account and optimize their products accordingly.
• High risk of user error – DeFi applications shift responsibility from intermediaries to users. This can be a negative aspect for many. Designing products that minimize the risk of user error is particularly challenging when products are implemented on top of immutable blockchain systems.
• Poor user experience – Currently, using DeFi applications requires additional effort on the user’s part. For DeFi applications to be a fundamental element of the global financial system, they must provide tangible benefits that encourage users to switch from the traditional system.
• Crowded ecosystem – It can be a daunting task to find the application that is most suitable for a specific use case, and users must have the ability to find the best options. The challenge is not only building applications but also thinking about how they fit into the broader DeFi ecosystem.

The DeFi movement is one of the most promising trends in the crypto space. Not only is the technology intriguing, but it truly has a unique opportunity to revolutionize the global financial landscape.

Decentralized finance is focused on building financial services separate from traditional financial and political systems, thereby enabling a more open financial system and potentially preventing precedents of censorship and discrimination worldwide.

Although it is an appealing idea, decentralization does not represent a one-size-fits-all solution. Finding use cases that are most suitable for the characteristics of blockchain is crucial for building useful and open financial products.

If successful, DeFi will take power away from large centralized organizations and place it in the hands of the open-source community and individuals. Whether this will create a more efficient financial system remains to be seen when DeFi is ready for mass adoption.

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