What is Decentralized Finance and What Problems Does It Solve?
Our current banking system has seen decades of technical advancements. The development of accounting computers and punch cards in the 1920s was one of the first initiatives to make finance more efficient. The emergence of mainframe computers, which substantially sped up the financial sector in the 1950s and beyond, followed.
The introduction of ATMs and credit cards, which became ubiquitous in the 1970s, was the next revolution. In the 1970s, another crucial component of the financial system, the stock market, began to undergo changes. Computers and algorithms began to gradually replace manual order entry and noisy trading pits. The computerization of finance was accelerated in the 1990s owing to the use of the internet. All of these processes were now feasible from the convenience of our own homes, including accessing bank accounts, making wire transfers, and purchasing stocks.
Fintech Revolution
Then there’s the FinTech revolution. PayPal, Robinhood, Transferwise, Revolut, and other FinTech start-ups recognized the value of a tech-first strategy and provided frictionless financial services to its consumers. When opposed to the clumsy banking user interfaces, this is an entirely different experience. Despite a century of technological advancements, the financial system is far from flawless.
Financial System — Far From Perfect
1) Stock, bond, and other financial instrument settlements take days to complete and require a large quantity of human resources.
2) A clique of privileged few make key choices that affect millions or billions of people behind closed doors.
3) Multibillion-dollar banking scandals that emerge months, if not years, later, leading to prolonged economic downturns, such as the global financial crisis of 2007–2008.
4) Significant inefficiencies in international banking and remittance services
5) Unequal access to financial services, with billions of individuals throughout the world who are unbanked.
This is precisely why we require something new, something better, capable of resolving some of these issues.
Decentralized Finance (DeFi)
Instead of relying on outdated and inefficient infrastructure, decentralised finance, or DeFi, uses the power of cryptography, decentralisation, and blockchain to create a new financial system that can provide more efficient, fair, and open access to well-known financial services like payments, lending, borrowing, and trading.
Efficient
All activities are settled fairly instantly, regardless of if the counter parties are located in entirely different geographic places with differing laws and regulations. Furthermore, the majority of DeFi protocols can run with little or no human intervention.
Permission-less
DeFi is accessible to everyone with a browser and an internet connection. There is no passport verification, no need to present income statements, and it makes no difference what country or ethnicity you are; everyone is treated equally.
Censorship resistant
Access to DeFi cannot be denied by any party. Even a large number of bad actors will not be able to modify the laws of a sufficiently decentralised system.
Innovative
Anyone can contribute to the ecosystem by creating a new DeFi application. In contrast to traditional banking, new DeFi apps may take advantage of existing protocols and build on top of them.
Transparent
On the blockchain, everything is public and visible, including trade volume, outstanding loans, and overall debt. All of these can be confirmed on the blockchain with confidence, and the numbers cannot be tampered with.
Smart Contracts
A smart contract is a computer program or transaction protocol that automates the execution, control, and recording of legally relevant events and actions in compliance with contract or agreement terms. Ethereum, Fantom, and Solana are examples of blockchains featuring smart contracts that enable the creation of any financial application that formerly required an intermediary.
Growth of DeFi
The field of decentralised finance has lately exploded in popularity. Total value locked in DeFi has increased from over $600 million in January 2020 to over $244 billion in October 2021, representing the value of all tokens locked in various DeFi protocols, such as loan platforms, decentralised exchanges, or derivatives protocols.
Proposition of DeFi
Let’s look at a few typical challenges in conventional finance and see how they might be handled in DeFi to better grasp the value proposition of DeFi.
Source: unsplash.com
Let’s start with the most current stock market issue, the GameStop crisis. After learning that Gamestop stock, GME, was heavily shorted by certain hedge funds, participants of the popular reddit group ‘Wallstreetbets’ began purchasing GME in the hopes of triggering a short squeeze, in which hedge funds would be forced to buy back shorted stock, driving the price upward. At some time, Robinhood and other stockbrokers made the controversial decision to remove the ability to sell GME and a few other stocks off their platforms. On a decentralised exchange like Uniswap, a situation like this would not be possible because there is no one authority making choices on behalf of the users.
Let’s take a look at the interest rates. A group of bankers is debating what the ideal interest rate for millions of individuals is. Interest rates are automatically modified on DeFi based on supply, demand, and risk criteria of specific assets that the protocol configures. Every decision is made public.
Consider paying large fees and waiting days for an overseas bank transfer to settle. In DeFi you can send USD based stable coins for a tiny fraction of cost, that would arrive in a matter of seconds. The counter party risk is drastically decreased when diverse assets are settled in seconds rather than days.
Accounting becomes easier with every record being publicly available on blockchain, which can drastically minimize the amount of human resources required.
In Summary
The importance of DeFi must be considered. It might be the next technical frontier in finance, analogous to the internet, and usher in a revolution. It definitely appears so, based on the massive rise and advantages it brings.
DISCLAIMER: The information contained in this article is for educational purposes only and does not constitute any form of advice or recommendation by Wheatstones, and is not intended to be relied upon by users in making (or refraining from making) any investment decisions.
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