As the blockchain and cryptocurrency sector continues to develop, Decentralized Finance is quickly rising as a key alternative to traditional financial systems.
What is Decentralized Finance?
A Call for Change: A (Very) Brief History of Decentralization
The Catalyst
Access to traditional banking is a luxury. As of 2018, over 1.7 billion adults worldwide remained unbanked. The key causes stated for this were: a perception of not needing a bank account due to not earning enough cash; having a family member with an existing bank account; not having any banks in close proximity; and/or a general distrust of the banking system.
Though the latter was a rather subjective reason, that sentiment was shared by over 20% of people surveyed. The fact is, even global financial service giants fail. In 2008, for example, Lehman Brothers, a firm with US$639 billion in assets, filed for bankruptcy.
This, along with a series of other irresponsible decisions and gross oversights by banking institutions led to a general feeling of distrust from the public.
These events not only fomented this distrust for these institutions but led to a search for alternative methods of wealth management. Then, in 2008 (as a result of this chaos) a group of programmers worked on proposals for systems that didn’t require central governance.
Among these was a pseudonymous Satoshi Nakamoto, who proposed the creation of a peer-to-peer electronic cash system. He called this new system “Bitcoin”.
The Reaction
This new system eliminated the need for central governance by using an underlying technology known as Blockchain. Through a blockchain, users could hold and transfer their funds without the need for centralized institutions (like banks).
Fast forward to 2015, an additional layer of complexity was added to this system as Vitalik Buterin and Gavin Wood released their own blockchain, Ethereum.
Ethereum allowed for the same function of holding and transferring funds. However, it also implemented an additional transaction protocol known as Smart Contracts.
These automatically executed, controlled, and/or documented legally relevant events or actions according to the terms of a contract or agreement. This added functionality was what made decentralized finance possible.
What does DeFi mean?
DeFi is the acronym for Decentralized Finance, one of the fastest growing sectors in the blockchain and cryptocurrency space. DeFi is an ecosystem of Decentralized Applications (dApps) that provide financial services built on distributed networks with no governing authority.
It represents a movement that seeks to push borderless, censorship-free, and accessible financial products for everyone.
Further, the vast majority of these dApps are built on the Ethereum blockchain, which further facilitates their interconnectivity.
In order to understand how DeFi dApps are shaping the future, however, we must first dive deeper into the current financial system and its inherent flaws.
Traditional Financial Institutions (Centralized Finance or CeFi)
Banks and Banking
As mentioned previously, banks are the leaders of the traditional finance space. These giants facilitate payments, deposits, and offer lines of credit to individuals, businesses, and other financial institutions. Banks even provide liquidity to governments.
Banking institutions are so large, in fact, that the total assets value of the top 10 banks in the world is valued at over US$28 trillion. To put that into perspective, that would be enough to pay off the entire U.S. national debt and still have over US$1 trillion left over.
Banks enable money to move around the world and are a vital part of the financial industry. Nevertheless, they are managed by humans and, as such, are vulnerable to human-related risks like mismanagement of funds and corruption.
As mentioned earlier, the 2008 financial crisis was a direct example of the possible outcome of said risk. The situation was only ameliorated through government intervention in the form of massive bailouts. Without which, the outcome may have been catastrophic to the global economy.
Accessibility
One of the greatest flaws of the current financial system is the lack of accessibility for all people. As mentioned prior, over 1.7 billion people do not own an account at a financial institution.
Whether it be due to poverty, geographical location, or distrust of the current system, these individuals are unable to benefit from financial services such as opening a savings account, taking out a loan, or making investments.
A decentralized financial system, on the other hand, only requires the person to have access to a device with an internet connection.
DeFi, therefore, solves these issues as there is no verification process or minimum cash required to create an account; location is entirely independent; and there are no third-party institutions involved, making it a trustless system.
Payments and Clearance
Remittances through banks are tedious. Transferring payments worldwide typically takes several days and incurs numerous fees throughout the process.
A transfer from the U.S. to France, for example, may incur a currency exchange fee, an international wire outbound fee, and then an international wire inbound fee at the receiving bank. That’s three fees and several days in between the sender and receiver.
In some instances, payments may not even go through at all. The bank may choose to freeze the funds and request further documentation.
This wouldn’t happen with a cryptocurrency transfer. Cryptocurrencies power the DeFi ecosystem and allow the sender to bypass intermediaries.
A Bitcoin or Ethereum transfer, for example, would incur a single, comparatively miniscule, fee and would arrive at the receiving wallet in less than 15 minutes. In some cases, if both the sender and receiver utilize the same crypto wallet platform, the payment may be instantaneous.
Transparency
Transparency is another major issue of centralized institutions. Though they are, more often than not, a secure place to park funds, they are still vulnerable to mismanagement as seen in the case of Lehman Brothers in 2008.
The unfortunate reality is that there is no way for the person depositing into their account to know what the financial institution is doing with their funds. Banks are a business, after all. As such, the money that is deposited in their accounts is rarely kept entirely in the bank.
Banks use these funds to make investments of their own. They are able to do this because they know funds kept in savings accounts are rarely withdrawn in one go. Therefore, they can lend that money out to individuals or businesses and earn profits from the interests.
Meanwhile, individuals are left in the dark as to what their money is being used for, trusting this third-party won’t make any wrong investments that may lead them to bankruptcy.
With DeFi this wouldn’t be an issue. The protocols used in these applications are built on top of public blockchains and in most cases are open-sourced for audit and transparency purposes. Their decentralized governance ensures everyone knows what is happening and there is no misuse of funds.
DeFi protocols are written as lines of code. The codes run exactly as they are programmed to. Any flaws would be detected almost immediately.
Centralized vs. Decentralized
The DeFi movement is geared towards bridging the gap between those fortunate enough to have access to financial products and services and those who are not. The goal is to make finance accessible to everyone.
For an individual to have a method of safe keeping their earnings and use them to build more wealth should not be a privilege but basic human right. Only by eliminating the barrier to entry can we begin to fight the extreme poverty that plagues our world today.
In the following section we’ll go more in depth on the different applications within the decentralized finance ecosystem.
Decentralized Finance (DeFi)
In the preceding section Decentralized Finance or DeFi was defined as an ecosystem of decentralized applications. These dApps allow users within the ecosystem to take advantage of financial services like borrowing, lending, and trading without relying on centralized institutions like banks.
As such, DeFi is not a single application but rather a set of products and services. The dApps that make up the DeFi ecosystem act as replacements or alternatives for services like banking, insurance, and money markets. DeFi dApps allow their users to not only use the services but combine them to create more opportunities.
These DeFi dApps are often referred to as money LEGOs due to their interoperability and composability. There are numerous categories that these LEGOs fall into and we’ll refer to a few here. However, we’ll keep the explanations very brief and will delve deeper into each individual one in Part 2 of this article.
Also, it’s important to note that this new decentralized financial sector is in its nascent stage and as such is vulnerable to risk. It is still in its experimental or trial phase and will require time to evolve into full-fledged financial instruments. Still, projects are rapidly improving daily. Here are a few examples of what categories are currently in development:
Stablecoin
The prices of different cryptocurrencies are subject to high volatility. To lessen the risk of such volatility, some coins (like USDT, USDC, or DAI) are pegged to a global currency, like the U.S. dollar. However, centralized stablecoins ask the users to trust they have the amount of cash as coins they issue. A decentralized stablecoin would be transparent and could guarantee that collateral.
Lending and Borrowing
Borrowing from traditional institutions comes with a number of restrictions such as having a good credit score and sufficient collateral. With DeFi, anyone can collateralize their own assets to obtain a loan. One can also earn a yield on their assets by contributing to lending pools (like Uniswap or TRAMS DEX) and earning interest.
Exchanges (DEX)
Centralized exchanges maintain control of the assets deposited within them. With a decentralized exchange (DEX), the investor would keep custody of their assets without the need for a third-party custodian.
Fund Management
Funds oversee assets and manage the cash flow to generate a return on investments. The transparency of DeFi allows users to see how their funds are being managed and understand the costs incurred.
Lottery
Using a smart contract on the Ethereum blockchain would eliminate the need for a custodianship of pooled capital in lotteries. Thus, users could still participate but there would be no unnecessary additional fees incurred.
Payments
Though we already explored the concept of value transfer with Bitcoin and Ethereum, payments also refers to recurring payments. A smart contract could help an employer automate the payment of employee salaries, for example.
Insurance
Insurance helps individuals manage risk. When a person purchases insurance, they are protecting themselves financially in case of unfortunate and unpredictable losses. Insurance is commonly purchased before any big purchase like a new vehicle or home, or for unforeseen complications like health or life.
Finally, to conclude Part 1 of this article, below is an explanation of the Ethereum blockchain that is what makes the DeFi ecosystem possible:
The Ethereum Platform
The majority of dApps in the DeFi ecosystem are built on the Ethereum blockchain. Ethereum is an open-sourced platform on which software developers can write smart contracts that control digital assets through a set of pre-programmed conditions. The specific conditions depend on the intended purpose of the contract.
Ether (or ETH) is the native cryptocurrency of the Ethereum blockchain. Similar to Bitcoin, it is like money that can be used in everyday transactions. They can be sent from person to person to purchase goods or services based on the current market value. These transactions are all permanently recorded on the Ethereum blockchain.
Gas on Ethereum is a small fee that is paid with every transaction and creation of a smart contract. This fee is, in more technical terms, the amount of computation effort required to execute these operations. The amount of Gas required depends on the complexity of the operation. These are paid entirely in ETH.
Smart Contracts
Smart contracts are the core function that pushed blockchain technology to the next level. By using smart contracts, developers and average individuals alike are able to eliminate the need for third-party intervention.
A smart contract is essentially a programmable contract that allows two counter-parties to set conditions for a transaction.
For example, in 2017 many emerging projects used smart contracts to create a simple system for crowdfunding. It worked in the following manner:
- A smart contract was created that would issue a given number of tokens.
- It would then stipulate that for every Ether deposited by an investor, said investor would receive a given number of that project’s native token.
- Once the investor transferred X number of Ether into the project’s wallet, the smart contract would immediately release the equivalent value of that project’s tokens into the investor’s wallet.
This smart contract then eliminated the need for any third-party (escrows, lawyers, agents, etc.) intervention. It works on an “if this, then that” principle. When a pre-stipulated condition is met, the contract will carry out the operation as it was programmed.
This made these transactions quick, simple, and transparent, as every transaction made was then permanently recorded into the public ledger (ie: the blockchain).
Now, this particular example was also the source of significant controversy. Countless projects needed little more than a nice website to begin asking investors for funds, regardless of whether or not the project founders intended on carrying out their proposal.
Nevertheless, the system worked. A smart contract issued the tokens and distributed to the investors that chose to participate. No intervention was necessary.
The silver lining on the controversy of this period (the Initial Coin Offering, or ICO, boom of 2017) is that it made numerous governments take notice of the blockchain sector and begin to create regulations around it. Thus, adding credibility and accessibility to the space while also taking steps to prevent scams or fraud in the future.
Decentralized Applications (dApps)
On the Ethereum platform, dApps are interfaces that interact with the blockchain through use of smart contracts. These behave like regular web and mobile applications, with some variability in the backend.
As with anything, dApps have both positive and negative attributes:
Pros
- Immutable: Once information is recorded on the blockchain, it cannot be changed.
- Tamper-Proof: Smart contracts cannot be tampered with. Tampering would immediately alert every participant on the blockchain.
- Transparent: Smart contracts for dApps are openly auditable.
- Availability: dApps built on the Ethereum network will remain active and usable as long as the network does, too.
Cons
- Immutable: Smart contracts are programmed by humans. Human error has the potential of creating an issue that, if overlooked, can compound.
- Transparent: Openly auditable smart contracts are publicly available, thus making it easier for hackers to seek vulnerabilities.
- Scalability: In most cases, the dApp is limited to the bandwidth of the blockchain it resides on.
Resources
- Lau, Darren, et al. “‘How To DeFi’ Book by CoinGecko.” CoinGecko, TeaSpoon Publishing, Mar. 2020, landing.coingecko.com/how-to-defi/.
- “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.
- “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.
- “Bank Rankings — Top Banks in the World.” Accuity, 23 Sept. 2020, accuity.com/resources/bank-rankings-top-banks-in-the-world/.
- U.S. National Debt Clock : Real Time, 2020, www.usdebtclock.org/.
- Glotfelty, Bobby. “How Do Banks Make Money?” Betterment, 28 Apr. 2020, www.betterment.com/resources/how-do-banks-make-money/.
This article is produced by T8 EXCHANGE PTY LTD developer of TRAMS.io
