Decentralized Finance (DeFi) — Friend or Foe?
Imagine not having to deal with your banks to borrow money? Well, some people may argue that it is how it works anyway with peer-to-peer (P2P) model, however, P2P lending still requires you to connect your bank account to the P2P platform. In other words, you do still involve banks even under P2P model!
DeFi Eliminates the Role of Intermediaries in Finance
We have lived in a world of Centralized Finance (CeFi) where financial transactions are controlled by some institution from Central Banks to Financial Intermediaries. This mode raises five key problems with CeFi; (1) Centralized Control, causing interest rate to be highly controlled by central banks (2) Limited Access to financing, limiting smaller businesses to get more loans from banks (3) Inefficiency, causing costly and slow transfer of funds (4) Lack of Interoperability across banks causing delays in wire transfers between different banks (5) Lack of transparency, limiting customers’ access to the financial condition of their banks.
DeFi creates a solution by offering a peer-to-peer system that runs on blockchain technology, such as Ethereum, via smart contract that is not controlled by any centralized institution. Key goals are to democratize finance, increase efficiency, and eventually lower the cost. For example, in centralized finance, banks pay very low savings rate of nearly 0.50% p.a. but can lend at over 2.5% and profit nearly 2.0% p.a for a customer. DeFi gives anyone the opportunity to lend their own savings to others and earn the 2.5% return instead in a transaction that is fast and secure.
Strong growth in the past year, with the emergence of Decentralized Apps (dApps)
According to DeFi Pulse, the dollar value of all the tokens locked in the DeFi’s smart contract (Total Value Locked) has been growing 50x in the past year, from approximately $1B in early May 2020 to $50B in April 2021. Similarly, the outstanding loan in DeFi Lending has reached approximately $10B in April 2021.
This strong trend is primarily supported by the rise of dApps and Protocols in DeFi ecosystem. According to the State of the DApps, up to 450 new Finance dApps created per month.
DApp is a decentralized application that allows direct interactions between peers (i.e., removing the central clearing). These applications are the actual products that customers and developers interact with, such as Uniswap and Compound.
DeFi is at a nascent stage and the upside is promising
Snapshot below highlights how Compound dApp allows us to connect our crypto wallet and lend and borrow money directly to/from others with dynamic pricing (interest rate) based on loan supply and demand. This is just one example how DeFi can significantly optimize the process and lower the cost.
In addition to lending/borrowing, DeFi also offers a wide range of financial services, such as payments (e.g., Celer Network), exchanges (e.g., Uniswap), derivatives trading (e.g., Synthetix), asset management (e.g., Metamax) and insurance (e.g., Nexus Mutual).
DeFi does not come without risks
The great advantages that DeFi can offer does not come for free. There are some potential risks that we must be aware of.
- Scalability
DeFi has not been proven to work well in a larger scale. As Nasdaq reported in Q4 2020, the fast-growing DeFi has caused congestion in the Ethereum blockchain which led to elevated fees
2. Consumer protection
DeFi has soared in the absence of rules and regulations. This could be a double-edged sword as this would also mean that users have no protection in case the transaction goes wrong.
3. Security
Over the past decade, crypto-focused products, primarily exchanges, have repeatedly been hacked, which shows that software is uniquely vulnerable to hacks and developer malpractice.
What’s next?
DeFi has shown an outstanding growth in the past couple of years and is expected to grow even more in the future. This could generate a significant threat to all the traditional financial institutions. These institutions should start adopting and integrating their services with Crypto and DeFi.
According to research by Crypto.com and BCG, 86% of traditional financial institutions have started to assess services on DeFi framework. The services with the top focus were asset management and payment processing. Another interesting perspective is that larger financial institutions are more likely to adopt DeFi and realize first mover advantages because they can afford more risk. 39% of those companies also mentioned that they are planning to implement DeFi by collaborating with an existing consortium, platform, application, or services.
Looking ahead DeFi protocols are building a future that can tower long standing financial institutions as their legacy systems create ongoing deficiencies in Finance, Banking and Lending services. DeFi’s global reach, market structure and value capture will be increasingly more relevant to customers and investors than the current offering we see today. This begs the question: Why roll the dice when you can always win?
#CBSDigitalLiteracy
References:
- https://corpgov.law.harvard.edu/2021/01/14/defi-and-the-future-of-finance/
- https://defipulse.com/defi-lending
- https://corpgov.law.harvard.edu/2021/01/14/defi-and-the-future-of-finance/
- https://www.stateofthedapps.com/stats/category/finance#new
- https://www.nasdaq.com/articles/as-defi-deflates-ethereum-users-get-reprieve-from-soaring-fees-congestion-2020-10-07
- https://blog.crypto.com/the-sudden-rise-of-defi-survey-findings/
