How decentralized finance is disrupting the global financial system

Editor’s Note: This article was originally published on Sina, and has been translated into English.

It is no question that decentralized finance (DeFi) is thriving these past months. Currently, the industry has over US$12 billion in locked-in value and is still increasing, which shows that DeFi is nowhere near slowing down. This goes to show that this emerging technology has the possibility to disrupt the current financial system we are all familiar with.

For those unfamiliar with decentralized finance, DeFi is an ecosystem of protocols and projects that offers the same services and products as traditional finance, only without a centralized authority. With DeFi, users can now experience a truly decentralized exchange and also allow them to lend, borrow, providing them liquidity to earn interest rates that are difficult to find in the current financial markets.

Since DeFi is open-source, anyone may have access to the code and can build entirely new projects or create ones that can complement existing projects. This is one key reason for the recent DeFi boom -the space is innovating rapidly, thanks to the technological development and boon in blockchain technology. This momentum is currently catching up in Asia, particularly in China, where digital wallets are now being trialed, along with the creation of the digital Yuan.

Apart from digital wallets and currencies, decentralized finance has so much more to offer. Because of its decentralized nature, financial products and services that were once limited to the affluent class can now be accessed by anyone in the world, including the unbanked and underbanked. It can also potentially solve the current challenges the centralized, traditional financial system is facing.

Decentralized finance vs. traditional finance

Unlike traditional finance that uses a centralized authority such as banks and governments, DeFi does not have any governing bodies. “DeFi has six key advantages: programmable, high transparency, immutable, interoperability, accessible to everyone, and self-sovereign assets and data,” says Jun Li, Founder of Ontology, a high-performance public blockchain and distributed collaboration platform.

Since DeFi uses smart contracts, this system’s activities are automatically executed and highly customizable, allowing developers to create new financial tools and digital assets. This cuts out the intermediaries used in centralized financial systems. All transactions made through DeFi are transparent and immutable, which provides more security — one of the things users are looking for in traditional finance.

“DeFi activities do not have a bar for entry. Anyone with an encrypted wallet and Internet connection can participate in DeFi activities, regardless of their geographic locations,” adds Li. This allows more people to access financial products and services previously only available to the wealthier class.

“Generally speaking, apart from advantages like immutability, DeFi erases the status of a centralized organization, eliminates intermediary fees during the processes and removes the barriers in implementing cross-region regulations and financial regulations,” explains Li.

Overcoming barriers of traditional finance with DeFi services

Decentralized finance, in general, can potentially remove the hurdles that traditional finance is facing. But what exactly does DeFi offer that solve these current challenges?

“DeFi solves many of the key problems that exist in traditional finance — whether it is a singular centralized point of failure, exclusion of certain customer groups or tedious paperwork and approval processes. Most of all, DeFi has the potential to fairly distribute incentives among stakeholders instead of middlemen,” explains Felix Mago, Co-Founder of Dash NEXT.

One of the most popular DeFi applications is open lending protocols. Decentralized borrowing and lending have many advantages compared to the traditional credit system. These features include instant transaction settlement and the ability to collateralize digital assets, which no user can access in a centralized credit system.

“Overcollateralization is the foundation of DeFi lending and borrowing — borrowers must typically put up more value in collateral than the value of their loans,” shares Stani Kulechov, CEO of Aave, an open-source and non-custodial protocol for money market creation on Ethereum. But if users need to put more collateral when borrowing, how is it better than the traditional credit system?

“[Overcollateralization] is meant to protect the funds in the protocol, so if a borrower cannot pay back their loan or the value of their collateral falls to the point where their loan is no longer supported, their collateral can get liquidated to reimburse the protocol. This keeps the protocol safe, but it also means you need to have some capital (for your collateral) to take out a loan,” explains Kulechov.

Through collateralizing assets, users are assured that the asset they lent will be paid back in all circumstances. Apart from lending and borrowing, DeFi also transforms the current exchanges we have. Decentralized exchanges (DEXs) allow users to trade digital assets without the need for a centralized entity as an intermediary to hold their funds.

“DEXs by nature are decentralized, meaning they don’t ask for KYC and provide constant liquidity regardless of the number of players in the market. This is in contrast to the traditional order-book model, which often suffers from a chronic lack of liquidity for smaller tokens due to low trade volume/market size,” shares Rebecca Mqamelo, Head of Growth at Zerion, a DeFi platform that allows users to build and manage their portfolios.

The advantages of decentralized exchanges over centralized ones outweigh its drawbacks. Exchanges owned by centralized companies — even those who trade cryptocurrencies — are vulnerable to hacks. Just recently, a cryptocurrency exchange was hacked for over US$150 billion.

“DEXs result in increased user-security, given their non-custodial nature. Centralized exchanges have proven time and time again that they are vulnerable to hacks, which often results in lost funds for users,” says Corey Miller, Growth Department of dYdX, a decentralized exchange for spot, margin, and perpetual trades.

“In addition to security, DEXs are typically available to anyone, as well as have the ability to list new assets faster than centralized exchanges. Additionally, many DEXs are set up in such a way that their users are rewarded as the platform succeeds, thereby aligning interests and creating a positive feedback loop,” Miller added.

The future of DeFi

With all the benefits that decentralized finance can provide, it can potentially transform the current financial system. But to achieve the full transformation, DeFi should be fully embraced globally to continue to thrive. While it has been booming in the West, Asia has still yet to fully grasp this concept. But if with the support it has been getting recently, we can see DeFi transforming our current financial system.

Image credit: Pixabay

Featured in the story

Jun Li

Jun Li is the founder of Ontology (ont.io) & Co-founder of Onchain (Blockchain Technology). He is a senior blockchain architect and blockchain solutions professional with 16 years’ work experience in IT and fintech. Li previously provided technical architecture, management, and planning support for top international IT firms and major Chinese financial exchanges.

He has taken part in the architecture design and technical management of many major systems, and has built up multiple technical teams and systems from scratch. Li also has a profound knowledge of the finance industry, excelling at internal management and external communication.

Stani Kulechov

Stani Kulechov is the founder and CEO of Aave and ETHLend. He is a seasoned entrepreneur with extensive experience developing technology in the crypto, blockchain, and fintech space. Stani is also a mentor to many founders and advisors of ICOs and blockchain projects and has spoken at numerous FinTech, Blockchain and cryptocurrency events, particularly on topics related to Ethereum Smart Contracts.

Felix Mago

As Co-Founder of Dash NEXT & Dash Thailand, Felix is pioneering to enable and scale crypto payments on all verticals with a cooperative approach, involving partners all over the world. Felix is the Author of the “Bitcoin Handbook” and Co-Founder of FUTERIO, a Southeast Asia based gateway to Blockchain and Co-Founder of the German Blocktech Institute, helping startups and corporations from all sectors finding and implementing their Blockchain potentials.

Corey Miller

Corey joined dYdX in 2020 to run growth initiatives for the decentralized (DeFi) borrowing and lending platform based on Ethereum. Previously, Corey was an investor at BlockTower Capital and Scout Ventures. Corey graduated Cum Laude from the University of Pennsylvania, earning his Bachelors of Arts in Science, Technology, and Society with a concentration in Information Technologies and Organizations.

Rebecca Mqamelo

Rebecca currently is the Head of Growth at Zerion, the world’s most intuitive DeFi interface. Previously, Rebecca worked on blockchain-based currency development programmes in Kenya. With a background in Economics and Data Science, her focus is on redesigning money for the 21st century — which means leveraging alternative currencies to facilitate more inclusive, resilient and sustainable local economies. She believes we ought to recognize the “fintech revolution” for what it is: a nice UI update to the same financial operating system. It’s time to shift gears with decentralized finance.