Sep 26, 2021

12 min read

Will Banks Perish or Adapt? The Future of DeFi will Decide.

Banks have been functioning since the 14th century. Through debt/ credit system, they bring economic growth, yet they fail when things go wrong.

The first official bank in human history was established in the 14th century (to be precise, 1401). The Taula de la Ciutat came into existence in 1401 in Barcelona and started working as the national treasury for the Catalonian government.

It’s been 600+ years, since then, governments have evolved, banks have become more organized, and things have speeded up with digital banking. But exactly how fast?

You can send money from your bank account to anyone in your country with just a few simple clicks. Moreover, you can pay for the sandwich at your favorite restaurant by simply scanning a code. Too Fast, right?

Cross Border Payments

Banks, when combined with technology, can achieve great things. But only if they wish to adapt to changing times, and the time is changing faster than ever.

As of now, you can send money directly from your bank account within a country in a matter of seconds. But what about cross-border payments?

Now, according to a featured snippet on google, international payments usually take 2–5 days (I guess that’s the minimum, and it might take longer).

Suppose you’re from India, and your wife had an accident (assumption, she might still be giving you a look for reading this article rather than spending time with her, anyway), and you don’t have enough funds in your bank account to pay for the treatment. The only person who can lend you money lives in the USA.

What are you gonna do? Even if your friend transfers the money in the middle of the night, it’ll still take 3–5 BUSINESS days (give it though why I’ve written business in all caps). I don’t think we have a solution to this problem as of now, do we? We’ll come back to this later in the article. For now, let’s talk about something else; let’s talk about our currency.

What is Money?

Now, not googling things for a while: Money provides you a purchasing power of any good/ service and has an intrinsic value attached to it. For example, the US dollar before 1973.

Before, yes, the US dropped off the gold standard in 1973. Before the aforementioned year, you could have easily swapped your $$$ for real gold, and now, it’s just ink and paper. Let’s not stretch this much longer here; I already spoke about what is money in my previous article.

Now coming to the question…

What happens if the currency is not backed by anything of value?

The answer to the question is, it’s all ink and paper and nothing more. And creating more currency might sound like zooooom zoooom… Further, with the evolution of technology, creating currency out of thin air has become even simpler. A guy at the central bank makes a click, and fresh $1 million is created. Click, another million. Click Click Click, that’s the sound of creating a new currency.

Now, since the government or banks control the currency, it has no value attached to it. So, for example, if right now your lazy a$$ got up the couch and marched into the central bank and asked the bank to exchange all the currency you own with something hard, some commodity like gold, wheat, oil, anything that is useful in the real world.

They’ll kick you out! No ifs, no buts, straight out of the bank. Then why do we use the currency the government tells us to use? The only reason if you ask me: It’s because we use them, that’s the only reason, and the day we stopped using their currency will be the day they lose control of us.

Now, since the central bank is printing all the money, what happens if they print too much? Or what happens if they print too little? Let’s get to them one by one.

Too much? Inflation

As more currency is brought into circulation, its value will start getting less with time. Again, let’s talk about history, this time about Zimbabwe. Around 1990, the President of Zimbabwe kept printing money, and he never stopped. As a result, the ZIM dollar is compared to toilet paper.

Too Less? Deflation

Deflation means falling prices. So falling prices is a good thing, right? No. Imagine the prices of goods start falling so is wage. But at the same time, your debts are not falling; the bank still accepts you to pay the same monthly installment. Therefore, inflation is bad for a country, but deflation is worst!

Sitting on the chair and being given this control to prevent or cause an economic disaster is a huge responsibility. But there is one more way things can go wrong!

The role of banks in Economic disaster

Banks basically work on credit/ dept. So basically, they lend out the money you store in banks at high interest rates and pay you a smaller part of the interests. This is how they maintain stability, and it is the banks that drive innovation, development, and economic growth.

Everything works smoothly; banks are getting interest from borrowers, you’re getting interest for just keeping your money in the bank. It’s all music and parties until the borrowers are able to repay. But what if they aren’t?

The Disaster

The present financial system is entirely dependent on banks. If they fail/ make a mistake such as the one back in 2008, all of us are definitely impacted. You might argue that you wouldn’t be affected by a construction company failing to repay its loan. What has it to do with your money? Your funds are entirely safe in the banks, right? Right?

But are they? Banks lend out your money to people who are willing to borrow money to pay for their colleges, fund start-ups, or gamble in a casino. So now it completely depends on the bank who they lend your money, and whether they are able to get it back or not.

If they do get it back, it's all rainbows and sun; but if the borrowers aren’t able to pay the debt, the disaster hits. To keep it short, the borrowers aren’t able to pay the money back; now, the banks cannot give your money back to you; since they don’t have it, you cannot use your money to get daily goods.

It is quite evident that prices in the market rise or fall because of us, the buyers/ sellers. And the famous scientist Sir Isaac Newton concluded, “I can calculate the motions of the heavenly bodies, but not the madness of people.” Of course, there can be instances when we can justify the crashes, but often, it’s just people making foolish decisions that lead to crashes. And in the crypto market, it happens because of a decent sell-off followed by liquidations in the derivatives market, taking the prices lower.

What do you think happened with Evergrande?

The entire market collapsed in a single day, Evergrande wasn’t able to repay the loan, and hence it affected the entire market, even the crypto market! However, the Chinese government seems to prevent the disaster before it affects the global market.

“It has $300 billion in outstanding debt. There is a contagion issue if China Evergrande is not resolved. I think it will end up having some deep-pocketed state-owned enterprises to take over.” said Jimmy Chang.

But why did the crypto market crash because of Evergrande?

Do you think there’s a reason? No, there’s not, you might justify it by saying that it was Evergrande, but it was rather just human emotion taking the prices lower by 7% for BTC.

Another reason can be lack of information; people usually buy Bitcoin and other cryptocurrencies because they wish to get rich quickly, and more often tend to bail out when something disturbing happens, Leading to a crash (imagine 2 million traders selling at once?)

The fall of Bitcoin

Let’s talk about something else. Remember 2017? Bitcoin’s price broke all records and hit an all-time high of around $20,000. Everything was going fine; new traders were signing up, people were investing more every day, and everyone wanted to get on the bitcoin train.

However, only until the music stopped playing. The aftermath was disastrous; Bitcoin fell as low as $3,900 in November 2018. And this is what happens with any market, be it stocks, commodities, gold, etc. If the music stops too harshly, people run to get their money out.

In terms of crypto, they sell their HODLings immediately, leading the prices to fall further. But at the same time, someone else would have been buying (at least to meet the demand of sellers). These are investors whose goal is to accumulate enough so they can sell again the next time the music is about to stop.

Why do people sell?

As Kindleberger wrote in his book Manias, Panics, and Crashes, “The decline in the prices of some assets leads to the concern that asset prices will decline further and that the financial system will experience ‘distress.’ The rush to sell these assets before prices decline further becomes self-fulfilling and so precipitous that it becomes panic. The prices of commodities — houses, buildings, land, stocks, bonds — crash to levels that are 30 to 40 percent of their prices at the peak. Bankruptcies surge, economic activity slows, and unemployment increases.”

But when we come to crashes in the crypto market, there is a chance that an asset loses its value by 70%, 90%, or even 97%. Why? Because a tiny fraction of crypto investors are buying because of its fundamentals, and the rest are in for a get-rich-quick scheme.

Now the thing to note here, this has not just happened once. What Kindleberger explained has been happening in almost every market crash. And this is something banks have never been prepared for.

As Gary Gorton, a Yale economist, said, “There is a fundamental, structural feature of banking, which if not guarded against leads to such crises.”

Why do we need the banks?

Two hundred or maybe five hundred years ago, we couldn't carry our lives’ savings everywhere we traveled. We needed someone who could store it for us, who could guard it for us, and hence the banks.

Moreover, banks definitely drive innovation and economic growth, but what do you get by storing your money in the banks? A 2% interest? Let me ask something else, what’s the present inflation rate in your country? 4% or 24%?

So, basically, you’re losing the value of your currency stored in the banks. Obviously, you’re a part of the picture that drives innovation, but at what cost? Your entire life’s savings would be turning worthless in a couple of years. So what would you do about your retirement plan? Are you going to work your whole life? No, right!

What solution do I propose?

It might have been pretty evident by now, no? Bitcoin is our solution.

Cross-border payments using the lightning network? Check
No effect of inflation? Check
Meeting supply and demand? Check
Peer 2 Peer Lending/ Borrowing? Check
No need for a third party to store your assets? Check
All of your lives’ earnings can be stored in a tiny secure device.
Security? Check

Coming Back to Our Story

Now suppose you use Bitcoin for transfer of assets around the globe. Your friend wakes up in the middle of night, opens his phone, and send 1 BTC to your wallet address through the lightning network.

What do you think how much is it gonna take? A couple of seconds? Yes. Recently Twitter enable bitcoin tipping by going in a collaboration with Strike API. Now you can send BTC directly through your Twitter account to anyone across the globe.

Wanna know how? Read my guide to Twitter Tips here.

How can bitcoin be used for lending/ borrowing?

This is where DeFi comes in; the term Decentralized Finance aims to bring all the financial tools in the crypto world. As of now, you can easily use your bitcoin as collateral and get a loan in dollar-backed StableCoins.

This way, you never have to sell your bitcoin and just repay the loan to get your bitcoin back. The borrower would still own their bitcoin, and its price rises over time; they would want to repay the loan get their bitcoins back.

Now, as for lenders, the locked-in bitcoin acts as a security. As if the borrowers aren’t able to pay the loan before the scheduled duration, their bitcoin is liquidated, and funds are returned to the lender. Thus, creating a stable system of lending/ borrowing.

A loan without Collateral

Flash loans, ever heard of them? If you have been in the crypto world for a while, I bet you have. Flash loans allow you to borrow funds without any collateral. As a result, you can borrow as much as you want to, use it to do whatever you wish to, and then return the funds in a smaller time frame.

However, if you aren’t able to return the funds, all the transactions reverse, and the lender doesn’t have to suffer a loss. Sounds exciting, right!

We’d talk about DeFi some other day, and I believe this article has gotten long enough, so let’s conclude.

A Unicorn or a Cake?

Not getting into detail, DeFi is an ever-evolving world. Hence, predicting its future now wouldn’t be the best thing to do. However, it would be pretty interesting to see where things go from here. For example, whether DeFi takes over traditional finance and banks perish, or banks work together with technology and provide modern financial services. I believe the latter is the most prevailing option, but what the future holds for us is out of the scope of this article to predict.

I’d be back with another article next weekend. Till then, hit the follow button to keep reading from me, and if you did have a decent read, show some support by clapping!

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Everything written in this article is what I believe and it is highly likely that your thoughts differ from mine (obviously we’re two different people). Therefore, take this article as a light reading and if you don’t like the content, just forget if you ever read it!

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