What is DeFi? Decentralized finance (DeFi) is the first viable alternative to the current financial industry. It utilizes blockchain technology and open distributed ledgers. It removes the need for third-party intermediaries and allows for trustless peer-to-peer transactions.
To better understand DeFi, it is vital to understand what preceded it: traditional finance (TradFi).
Financial institutions that power the modern world such as central banks, commercial banks, hedge funds, and other financial institutions, are all part of TradFi. Services these institutions offer include money management, investment, assets and liabilities, credit, etc. These vital services have helped bolster economic growth globally and pushed the world into a new era of prosperity and interconnectedness.
At the heart of TradFi are centralized institutions. They act as intermediaries and middlemen between two parties, and these intermediaries have facilitated the ability to trade between various unrelated parties for centuries. The two central principles that differentiate TradFi from DeFi are: permissioned access and the custodial approach.
Permissioned Access: This refers to the fact that only individuals vetted by these institutions and who fit some norms set by these institutions can participate in the financial system. It is, at its core, exclusionary. In TradFi, there is an inextricable link between user activity and identity.
Custodial Approach: Assets are entrusted to the institutions for safekeeping and supervision; thus, these institutions are responsible and ultimately in charge of the assets given to them. They possess single points of failure and further enable individual corruption. This is not unique to TradFi and also exists within crypto with what are commonly referred to as Centralised Exchanges (CEXs), such as Binance and Coinbase. Many opt for a non-custodial approach and this birthed the popular term: ‘Not your keys, not your coins.’
Shortcomings of Traditional Finance
TradFi has many shortcomings and is struggling to keep pace with the increased demands of modern commerce and the changing values and ideals of the modern world. Financial institutions face greater scrutiny, and the public demands more accountability and requires greater transparency from institutions that have operated hitherto with little to no liability.
A common criticism is the lack of transparency offered by TradFi, and this lack of accountability has led to reckless and unchecked behavior. One prime example of this is the behavior seen by Banks in 2008, offering loans to market participants without the ability to service the debt, which contributed to the global financial crash.
Financial exclusion is another problem with the current financial model. According to the World Bank, there are 1.7 billion people without a bank account or access to traditional financial services. This predominantly affects lesser economically developed countries. More than one-fifth of the current global population has no bank account.
Money has become highly politicized. Central banks have embarked on quantitative easing when governments want to expand domestic policy and do not have the money to do so. In simple terms, it means printing more money, leading to the currency being devalued. Market participants have their currency depreciated despite not agreeing to the policy. And this highlights a further criticism, which is the level of control these financial institutions have over the monetary supply.
DeFi Is the broad term for all decentralized, open, peer-to-peer financial products that rely on smart contracts that operate on blockchains. DeFi has several characteristics that distinguish it from TradFi: open/ permissionless, peer-to-peer, transparent, and borderless.
Open/Permissionless: This means that anyone can access DeFi. There is no identity requirement or authorisation. And most importantly, no single entity has the power/ authority to block a valid transaction.
Peer-to-peer: Transactions are sent from one party to another without third-party intermediaries. Individual parties can transact with each other, and this is made possible through decentralization as multiple independent network participants perform transaction validations.
Transparent: This means that every transaction is visible and verifiable to everyone. A full copy of the ledger is distributed to every node, and every transaction can be found on Block Explorers. Transactions are also immutable so altering the history of transactions is not possible. The ledger retains a permanent and unalterable record of every transaction made on the network, marking the most significant bookkeeping change since 1494.
Borderless. There are no geographic restrictions to access DeFi; all it requires is an internet connection.
Many different DeFi platforms are actively developing state-of-the-art alternative financial services to compete with and, at times, complement financial services offered by TradFi. MoneySwitch is one such DeFi platform. MoneySwitch allows anyone to participate and provide short-term liquidity to enable more efficient cross-border payments and earn interest on stable assets. This opportunity has, up until now, exclusively been available to banks and financial institutions.
Want to learn more about MoneySwitch and the changing reality of global payments? Please join us here, and for further information on how to help power the cross-border payments of tomorrow whilst earning yield on your stablecoins, visit us here.
DeFi aims to disrupt and decentralize the financial industry and push for more transparency and access. It is still a nascent industry and suffers from unclear regulatory standing and bad actors. But DeFi does, for the first time, offer an alternative financial system for those excluded or fed up with the current system.