The Decentralized Future of Finance (Part 2)

Decentralized Finance is the latest disruptor coming out of the blockchain and cryptocurrency space. DeFi connects decentralized financial tools and makes them available to everyone.

If you haven’t already, make sure to read Part 1 of this article to learn more about decentralization and how it is changing the finance sector.

DeFi Connects dApps like LEGOs

Decentralized Applications (dApps) created to work within the Decentralized Finance (DeFi) space are what make the shift towards DeFi possible. “Money Legos,” or “LEGOs” here for short, are what people in the space call these DeFi dApps.

These Dapps are popularly referred to as LEGOs because their individual functions tend to work together easily. In some cases, they even directly connect with each other to improve the user experience.

How do LEGOs work?

Say, for example, a person wants to keep their savings out of the banks. However, they’re afraid of the market fluctuations associated with holding cryptocurrencies. This person could opt to hold their savings in stablecoins (i.e., coins pegged to the value of an asset like the US dollar).

Therefore, they could potentially choose a stablecoin pegged to the USD and have the reassurance that it will maintain the same dollar value. Their concern for keeping their funds out of a bank are solved. As well as, their concerns for the volatility of cryptocurrencies.

From there, this person could safely store their stablecoins in a digital wallet and even link that wallet to other dApps to participate in various investment opportunities.

They could transfer some funds to a decentralized exchange and trade or provide liquidity for traders to earn a piece of the trading fees. Another portion of their funds could go to lending platforms, where they could earn from the interests. And another portion yet, could be spent in a marketplace or trying their luck in a decentralized lottery.

The swift manner in which these Dapps integrate with each other is why they are compared to blocks that fit together perfectly (LEGOs). Block by block, dApp by dApp, the DeFi ecosystem covers more ground and provides new opportunities for its users.

Below we discuss the different levels of centralization and then go more in-depth on several categories that already form part of DeFi’s LEGOs.

Levels of Centralization

Centralized

Any system or operation that is centralized is controlled by one central authority. Banks, corporations, institutes, and countries all have a central governance.

The issue associated with this is that the participants that don’t hold the power are vulnerable to choices made by their respective central authority.

Banks, for example, can freeze funds or cancel transfers without notice. They also use the funds entrusted to them to make investments of their own at the expense of the savings account holder. The only reassurance is a small interest earned on a yearly basis.

Decentralized

A decentralized system is just the opposite. It shifts the power from a central authority to smaller local authorities or individuals.

Ergo, using the same example, banks are removed as a third-party and account holders are now entirely in control of their assets. They can safely store them in their digital wallet and choose whether they wish to save it or find a way to invest a portion.

Semi-Decentralized

Within decentralized applications and organizations there are levels. A semi-decentralized system has some aspects of decentralization but maintains one or more centralized aspects.

This is very common, as engineers like to have a certain level of control to be able to make changes that benefit the platform. An exchange that is still partially run by a central authority, even if they have no control over the funds, is still partly centralized.

Completely Decentralized

Though the goal of the space is to create a system of dApps that are entirely decentralized, this is easier said than done. There is a lot of work that needs to be done before we can fully decentralize financial instruments.

For the time being, no DeFi protocol is completely decentralized. They all maintain one or more aspects that make them slightly centralized or too vulnerable for mass adoption. Ultimately, the entire space is still in its nascent stages and has a long runway to cover.

However, in the near future we may see a leap in development that may change the way the world interacts with DeFi dApps.

DeFi Categories (LEGOs)

To illustrate a few of the categories that compose DeFi’s LEGOs, below we go a little more in-depth. We explain what they are and why they are an important part of the ecosystem.

Assets Management

The practice of Asset Management can branch out to mean both safekeeping and investing to grow wealth. The first step to joining the DeFi space is to create a wallet in which you can hold your funds.

As the majority of dApps run on the Ethereum platform, you will likely use an Asset Management application, a digital wallet, that supports Ethereum tokens.

It’s worth noting that some of these digital wallets are custodial and others are non-custodial. Wallets like Metamask or MyEtherWallet are non-custodial and the funds are always in the user’s control. The platform itself serves only as a bridge between you and the Ethereum network, so you can check your balance and send and receive transfers.

Other wallets like Coinbase, however, choose to maintain control over their users’ funds. It’s understandable that to prevent illegal activity, they would want to maintain access. The only issue is that it also creates the possibility of a hack occuring that could syphon off the funds.

Stablecoins

As mentioned previously, stablecoins are digital coins pegged to the value of existing assets like the US dollar. They were created to help mitigate the volatility associated with cryptocurrencies by creating a more stable, yet still crypto-based, alternative.

While holding Bitcoin and Ethereum may seem risky to new users, they can choose to hold stablecoins instead. A few coins have also pegged their value to commodities like gold and silver. The argument for these coins is that, in theory, there should be actual reserves of the asset equivalent to the amount of tokens in circulation.

Though the certainty of whether or not these assets are accounted for is often unclear, it is evident that users trust stablecoins. The USDT, for example, has already grown to a market cap of over US$15 billion, making it the third largest cryptocurrency in circulation.

Decentralized Exchanges (DEX)

Decentralized Exchanges (DEX) are another necessary investment vehicle within DeFi. Though centralized exchanges provide greater liquidity, they also pose a greater risk. In 2019, over US$290 million worth of cryptocurrencies was stolen from exchanges.

A DEX prevents such losses by allowing the user to connect their own wallet and trade without the need to deposit their tokens into a third-party wallet. These exchanges use smart contracts to perform on-chain transactions and eliminate the need for a third-party intermediary altogether.

Popular DEXs like Uniswap even allow users to participate in liquidity pools. This means they can stake their tokens to provide liquidity for traders.

For example, you could stake an equal amount of ETH (the Ethereum network’s native token) and USDT in the DEX. Therefore, when someone needs to trade ETH for USDT or vice versa, you earn a portion of the fees incurred by the trade.

Successful exchanges like Uniswap have even created forks like TRAMS DEX (TRAMS.io), a project that has created their own DEX and native token. TRAMS allows its token holders to stake their tokens and earn from the platform’s growth, similar to shareholders for a company.

Lending and Borrowing

One major revenue-earner for banks is lending and borrowing. It’s a necessary part of development. People without money will seek to borrow funds to start up their own business and then work to pay it back.

Traditionally, however, it has been very difficult to acquire such a loan from a bank. With a decentralized platform, the process is made easier by eliminating the barrier to entry and creating a system of smart contracts to control the deal.

This led to a system of credit through collateralization. Say, for example, that a person is holding cryptocurrencies. If the market is down and they don’t want to sell at a loss, but need liquidity, they could lock their tokens as collateral and withdraw 75% of their value in cash.

With this method, of course, the individual that wishes to take out the loan would first need to have the collateral. In order to develop these systems to a point where we can issue loans to individuals that have little or no collateral, the space still needs time.

A possible solution is to allow users to build a credit score on the blockchain by starting them off with small loans and building their own profile over time. However, this could simply lead to a person building a strong enough profile until they can take out more money than they need. For this reason, it is not yet a process that can be fully decentralized.

Fund Management

In much the same way as Wall Street funds hold billions of dollars in assets, so too could Fund Management be decentralized. Through a series of smart contracts, the value of an issued token could be pegged to the value of a set of assets.

Several applications have already started building such asset pools for their clients. By utilizing algorithms that analyze the market, a platform could advise a person on how to manage their funds best or the individual could purchase tokens from this platform and participate in their investments.

Like with traditional funds, it is up to the investor to research the asset types that the application allows for investments. Then, choose the one with the investment types that are most alike with the investment interests of the investor.

Lottery

A fun aspect of DeFi is a decentralized lottery. While traditional lotteries earn money through ticket purchases and then use those funds to pay the prizes, decentralized lotteries don’t necessarily need to work the same way.

Applications like PoolTogether use the compound interest earned by holding user deposits (on applications like Compound). They do this so that users can receive their money back if they don’t win.

If you deposit $10 to participate in a lottery, for example, the total funds deposited will gain compound interests. Then, once the winner is picked, all funds will be returned to participants and the winner will receive the interests earned with the funds.

Thus, by eliminating the third-party organizers, users can play as many times as they like and rest assured they will never lose their initial investment. There are no losers!

Payments

While direct payments through BTC or ETH are already possible, making these payments more efficient is another opportunity in the space.

Platforms are working on facilitating payments, particularly recurring payments and conditional payments. Smart contracts could be programmed to release pre-determined payments at a specific time each month, like for remittance payments or salaries.

Similarly, if a person needs to do this for their entire payroll, they could turn to a program that automatically releases the payments to all company employees. Thousands of payments could potentially be automated and any necessary changes could be applied in seconds.

When we talk about payments in DeFi it’s not necessarily about peer-to-peer transactions. It’s more about how we can take an existing process and automate it for users.

Insurance

Though the DeFi space is still far from being able to provide enough liquidity to handle a person’s medical or life insurance, we are making steps in protecting losses incurred through smart contract manipulation.

For example, some risks faced by DeFi users could be:

1. Technical risks — smart contracts could be hacked or bugs exploited
2. Liquidity — protocols like Compound could run out of liquidity
3. Admin Keys — a master private key for a protocol could be compromised

Due to risks like these, people could choose to have their smart contracts audited and then insured in the event of an attack or other mishap. The person looking to be insured would need to establish a Cover Period and Cover Amount.

Once that’s been taken care of, if there is a problem, Claims Assessors would follow assessment protocols to see if the issue is covered. If it is, the Cover Amount would be released to the person filing the claim, much like insurance already works.

Though this area is still in its fundamental development and trial phases, it’s one with a great prospect for the future, as insurance is always in demand.

Marketplaces

On a final note, marketplaces are a huge opportunity for both sellers and buyers. Existing platforms have a very strict hold on their users.

If a marketplace is decentralized, then fees incurred are greatly reduced. Sellers won’t have to give as much as a third of their profits to the platform. Instead, the fees incurred will only help to maintain the platform but the majority of profits will go to the sellers.

Consequently, as there are less costs for sellers, prices can be lowered, and customers will also benefit from the best possible prices. There’s still some discussion over the best way to manage returns, refunds, and other such processes that usually require human intervention.

Nevertheless, this is another pillar aspect of DeFi that will prove to be a massive shift once the technology meets the needs of the market.

The Future of Finance

All in all, what we aim to provide here is an insight into what Decentralized Finance is and how it is revolutionizing the Finance Sector. As this shift towards decentralization grows bigger and bigger, more users will see the benefits in taking control of their assets and choices.

Asset Management and investing will no longer need to be something that only people of a certain affluence have access to. Eventually every person on Earth will have access to creating and growing wealth, requiring nothing more than access to the internet.

With the current state of the world and the rapid growth of technology, we can systematically provide solutions for the unfinanced and eventually move into other sectors to provide greater access in all aspects of life.

Remember to check out Part 1 of this article if you would like to learn more about the history of decentralization and what the Ethereum Network is.

Resources

1. Lau, Darren, et al. “‘How To DeFi’ Book by CoinGecko.” CoinGecko, TeaSpoon Publishing, Mar. 2020, landing.coingecko.com/how-to-defi/.
2. “Financial Inclusion on the Rise, But Gaps Remain, Global Findex Database Shows.” World Bank, 2018, www.worldbank.org/en/news/press-release/2018/04/19/financial-inclusion-on-the-rise-but-gaps-remain-global-findex-database-shows.
3. “Financial Inclusion on the Rise, But Gaps Remain, Global Findex Database Shows.” World Bank, 2018, www.worldbank.org/en/news/press-release/2018/04/19/financial-inclusion-on-the-rise-but-gaps-remain-global-findex-database-shows.
4. “Bank Rankings — Top Banks in the World.” Accuity, 23 Sept. 2020, accuity.com/resources/bank-rankings-top-banks-in-the-world/.
5. U.S. National Debt Clock : Real Time, 2020, www.usdebtclock.org/.
6. Glotfelty, Bobby. “How Do Banks Make Money?” Betterment, 28 Apr. 2020, www.betterment.com/resources/how-do-banks-make-money/.

*** Disclaimers all companies and brands mentioned here are for refernces and does not endorse or promote the companies or products.