Do you guys remember when we wrote about the history of money?
Ah, yes, good times.
It was nice to write about the past of money, but perhaps the time has come to fully look to the future. Decentralised finance is a nascent blockchain-based industry that has already shown it’s come to stay. How much of our financial dealings will happen via DeFi as opposed to traditional finance in the coming years is impossible to predict. One thing, however, appears clear: it’s here to stay.
So what is DeFi? Is it just a fancy word for using crypto for financial dealings? Is the Utrust payment gateway DeFi? Will DeFi replace Wall Street?
Let’s take a look:
Finance is not the economy
Before we get into DeFi, let us spend a few seconds on Fi. There is a common misconception that anything related to finance is anything related to the economy or economics. This is not the case. The economy is a social phenomenon that encompasses a number of matters that aren’t directly related to money. Economics concerns itself with matters such as labour, or the production, distribution and consumption of goods and services. These things all need to be financed, but they aren’t financial in nature.
Finance is about money.
Finance is about how money is made, where it goes, how, and why. It’s about how money flows through the economy. When we talk about a financial industry, financial systems, etc. we are talking about a sector that works exclusively with money. This can include anything from borrowing and lending money to complex securities operations (such as derivatives).
Why does finance matter so much?
If financial operators create nothing, why does the financial industry weigh so heavy over our entire economy? How can the financial system crash or uplift the entire market?
The simple answer is that financial operations are how the economy decides where money should be at any given time. Let us try and answer a very complex question with a very simple example.
Let’s say you make cork (the material, not the city in Ireland, which is already made).
Cork is a very valuable material. It is used around the world to make anything from the paper-pulling mechanisms in printers, the core of baseballs, cork boards, or, more significantly: wine stoppers.
Almost every quality winery in the world uses stoppers made of cork because they preserve the natural qualities of the wine like nothing else. Thirty six BILLION wine bottles are created a year, so cork is big business, right?
Well… here’s the deal. Cork oaks only start producing cork at 25 years of age. Even then, you can only harvest it every 9 years. And the first couple of harvests aren’t that great either, so you only get the good stuff about 43 years after planting your first trees.
How the hell do you finance your business? Who would ever invest in something like this? Who would buy cork 43 years in advance?
Now, this is an extreme example, but this is where the financial industry comes into play, namely something called futures. If you are a winery, and you have been operating for hundreds of years, then you already know you’re going to need cork in 43 years.
You’re going to be needing it all the time, in fact.
If you feel like the price of cork right now, as presented to you by a new player in this market, is great, but you are scared that it will be much higher in four decades, why not sign a contract right now? The winery commits to buying X amount of cork on a given date, at a price decided now. You now have ensured your first sale, even though your product isn’t ready yet.
This is called a futures contract, and it is often used to invest in commodities such as oil. This kind of contract allows everyone to plan ahead.
There are many other financial instruments such as this one, and we can’t really be going over all of them, but the point of most is the same: to move money to where and when it can be most useful to make more money.
Oh, and by the way, if it feels like there’s a lot of risk involved… it’s because there is. Finance is all about trying to predict where the economy is going to be, much more than it is about dealing with the economy as is. Sometimes you’ll get it right, sometimes you won’t.
Can we get to the tech now, PLEASE?
Yes.
Yes, we can.
A lot of what we call traditional finance is run by financial institutions, such as banks, credit unions, insurance companies, underwriters, etc. They are the ones who mediate and/or broker the transactions that are the lifeblood of a financial system. They provide the money for loans, they invest when they see an opportunity, they ensure contracts are legal and valid, and a number of other things, which usually fall within three categories (depository, contractual, investments).
So the question is: can we get rid of them?
https://www.youtube.com/watch?v=wM6exo00T5I
What they do, at the end of the day, is serve as intermediaries to financial markets. As Matthew McConaughey’s character in the Wolf of Wall Street eloquently put it, they “don’t make anything”, but they take home “cold hard cash”.
Now let’s look back at our example. If a winery wants to agree to a futures contract with a cork maker, they would traditionally need to have someone broker that contract. That broker will be paid a handsome fee.
When the payment is made, let’s say via wire transfer, the winery’s bank makes a fee, and the cork farmer’s bank makes a fee. These fees alone can ruin a business’s margins. This is where crypto comes into play. With Utrust, these businesses could be making payments up to 90% cheaper.
But what about the financial part? What about the futures contract, and the brokerage? Are we stuck with this?
Nope. That’s where DeFi comes in.
Smart contracts are clever
DeFi uses the power of the blockchain to ensure that every kind of financial contract and agreement in traditional finance can now be achieved without intermediation. Whether you’re talking about lending, borrowing, derivatives, securities, futures, options, swaps, you name it, it can all be done without one of these institutions looking over your shoulder and taking a hefty cut.
What we are doing for payments, DeFi is doing for finance.
Remove the middleman, lower the cost.
So how does it work?
Blockchains that came after Bitcoin, such as Ethereum, have become a little more sophisticated. They allow for use cases of increasing complexity, and one of the more significant is smart contracts. Smart contracts are essentially programs. They work with instructions and data, and, since they run on a blockchain, they can send transactions over the network.
This, by the way, is what a contract is. A set of instructions (sell cork) and data (on a given date, for a fixed price) that necessitate a financial transaction (pay for cork).
Smart contracts can be programmed to include pretty much any conditions the signatories agree to, and they will execute exactly as programmed. Much like cryptocurrencies (and that’s what decentralised implies), no one has control over the network. Its information is spread out across the entire blockchain, so once a contract is signed, it’s pretty much impossible to renege on it. To invalidate a smart contract, the conditions of cancellation that were agreed upon in the beginning must be met.
Otherwise, the tech will ensure that everything goes according to plan. Not only that, but… this is the blockchain, remember? Everything is public. Transparency is guaranteed.
Let’s say the winery lost faith in your business over the 43 years elapsed since, and they found another supplier. They want to break their contract. With traditional finance, what could you do?
Sue them.
But you don’t have the money or the time to fight that legal battle, so… what’s left? Will the bank or the broker give you the money? Spoiler: they will not.
With DeFi, do you know what happens? You get paid. Because the winery doesn’t have the capacity to stop the payment. Once the conditions of the contract are met, the deal happens.
We also made a video about this article, so if you enjoyed reading it, why not check it out as well?
Next time: PROS AND CONS
Does this sound better than traditional finance, where malfeasance and trickery abound?
Well, we’ll be looking at pros and cons next time!
In the meantime, if your cork business is interested in accepting payments with cryptocurrencies, or even issuing invoices, have you considered Utrust?
We don’t just make nice articles, you know?
