What is Decentralized Finance
According to “The Complete Beginner’s Guide to Decentralized Finance (DeFi)” article by Binance Academy:
“Decentralized Finance or DeFI refers to a system of financial software that enables financial products to be made available to the public on decentralized blockchains. A global alternative to current centralized financial systems.”
As we have learned, the term decentralized, and its ramifications, will revolutionize how we interact with each other. These new interactions can have different effects in various sectors. In the financial markets, new interactions will dramatically change the current structure by eliminating the need for intermediaries. Banks, Lending Institutions, Money Managers, Market Analysts, Hedge Fund Managers, and other positions and functions can now be performed using smart contracts. With peer-to-peer decentralized financial instruments, people can pool together resources and lend/borrow from each other. Self-hosted wallets that remove custodial entities controlling your assets, and financial instruments managed by a series of smart contracts that execute programmed trades, financial services are creating an internet-based global financial ecosystem available through your smart phone resulting in an enormous value creation.
According to Grayscale Research | December 2022 DECENTRALIZED FINANCE (DeFi) Internet Banking Beyond Borders
“DeFi’s market cap has risen to $42 billion in three years. DeFi assets are now valued at 1% of the $4.3 trillion market cap of the S&P 500 Financial Services Sector. Yet, at only 0.5% of the $8 trillion global banking industry. DeFi users have grown to 5.3 million and will soon approach the scale of leading banks if this rate of growth can continue. Total value locked in DeFi exceeds $40 billion, which would be 0.2% of all U.S. commercial bank deposits or make DeFi the 50th largest U.S. bank by assets. From these assets, DeFi is on pace to generate ~$900 million in annual revenue.”
Lets discuss why these new system are emerging by looking at some pain points with traditional financial systems.
Lengthy Time Period to Clear Funds
In traditional financial systems verifying and transferring fund can take up to days. Transactions with your credit card that seem to be instantly settled are not transfer at the point of sales. Banks and other financial institutions can spend time and resources on the process of clearing and settling financial transactions.
High Cost in International Transfers
Current systems for moving money across boarder is cumbersome and costly. Fees for international money transfers can be as high as thirty percent of the total transaction amount.
The current state of the traditional financial system is exclusionary and prohibited. The ability to receive services from money managers is directly relate to where you live. A large portion of the world does not have available access to banking systems.
Inefficient System and Workflow
The current banking system hasn’t changed in decades. Processes that should have been updated to reflect modern technical advances are unchanged and inefficient. Siloed information adds to inefficiency in workflows. Financial service providers hold on to data and count on siloed, systems that don’t allow customer to share data and limiting opportunities.
High Barrier to Entry
The barrier to entry and access to financial services leave a great number of people unable to utilizes these services and take advantage of investment vehicles. KYC (know your customer) and AML (anti money laundering) rules make it prohibited for a larger number of the population.
Benefits of Decentralized Finance
With the advent of, decentralized finance system built on blockchain, problems with traditional systems are fixed and new opportunities become available. Decentralized exchanges democratize access to investments creating a fundamental change the way we invest.
No longer does it take days to settle accounts between banks and customer. The time for a transaction to settle on a decentralized financial vehicle is calculated in minutes not days. The time for a block of transactions to be agreed upon and added to the chain, is calculated in minutes and is final. Wait times for funds to become available no longer exist.
No Cost Transfer
In a peer to peer payment system the fees and charges from middlemen are eliminated. Minimal fee can occur with the expense is associated with the computation power of the transaction, but the fees from all intermediaries that charge to move your money are removed.
Access for the Unbanked
New global liquidity pools made available thru DeFi investment vehicles open new investment innovations that have far reaching ramifications. Microloans, smaller loans made from pools of capital, now are available to smart phone users with out waiting for bank approval, granting access to financial vehicles to participants previously excluded.
Benefits of Blockchain Systems
The basic traits of blockchain, transparent, decentralized, and immunity eliminate any need to trust an outside party.
Low Barrier to Entry
To take advantage of an opportunity is as simple as a using a smart phone and sending your crypto asset, there is no need for a bank to grant you permission to invest.
With new technology comes some challenges. Let’s discuss some issues with decentralized finance.
Lack of Regulatory Guidelines
With the ability to conduct business globally, there is no clear authority to police and govern these borderless financial ecosystems. The question of responsibility over these hugely funded crypto projects are at best ambiguous. Do the laws apply in the country you incorporated in, where you store your funds, or where you clients are? The answer to these questions is a developing story.
Smart contract are the backbone for these news systems. Smart contract computer codes can inadvertently leave room for exploitation. Evidence of this type of computer espionage is clear by the DAO hack, as discussed previously, hackers found a vulnerability with the way the code was written and syphoned funds to an unauthorized account. As smart contract become mainstream and vulnerabilities eliminated, tested templates, and experienced developers will have an impact on reducing this disadvantage
As with a new technology, we are finding ways for it to be the most effective. The DOT.com bubble in the 1990’s was a result of new internet technology and entrepreneurs testing new ideas. A lot of these ideas didn’t survive the turn of the century. Blockchain and the new financial pathways it creates, will also take trial and error to discover the best use cases.
Volatility of the Underlying Crypto Asset
As we all have ready cryptocurrencies are very volatile Several companies have destroyed by the swings of the crypto markets. So how are enterprises building financial future on such an unstable currency? One way to minimize this risk is with the use of Stablecoins.