DeFi: Crypto’s Financial System of the Future
The future of finance is taking shape on the blockchain in the form of “DeFi”, short for Decentralized Finance. Technologists have coined this term to represent the faction of blockchain-based technologies that are focused on providing financial services such as lending, borrowing, and trading to holders of cryptocurrencies. These protocols are looking to overtake traditional financial institutions by providing fast, cheap, transparent, and auditable applications that enable participants to retake control of their finances. The cryptocurrency market goes far beyond the minting and trading of digital assets; DeFi reimagines how financial services are offered in the digital age.
DeFi applications are mathematical protocols built on top of blockchain infrastructure (a public, decentralized, and cryptographically secure ledger). They rely on ‘smart contracts’ to execute transactions and exchanges. Kevin Lu from Coin Market Cap defines a smart contract as “an automatic and self-executing agreement that operates without the need of a central authority or rent-seeking third party.” Popular DeFi applications such as (Maker DAO, AAVE, Compound and Uniswap) are built by entrepreneurs and supported by developers, but the applications are exceptionally transparent. Their code base, transaction history, interest rates, and liquidity pool volume is all publicly available and updated in real time. This development model is a stark contrast to the black box of private banking that exists today. DeFi seeks to offer financial services that are significantly faster, and more transparent, accurate, secure, and cost effective than legacy banks.
The banking industry was born from the need for a trusted institute to facilitate the secure, collective exchange of money between lenders (savers) and borrowers. To incentivize lenders, banks offer services, security, and interest rates for deposited funds. With this collective pool of funds, banks offer loans to borrowers. Borrowers offer collateral (an asset such as a home or car) to offset the value of the loan and pay the bank an interest rate that is dependent on the risk of default. Banks have flourished under this model for centuries. The top 4 banks in the United States (JPMorgan, Wells Fargo, Bank of America, and Citigroup) collectively reported 2019 Net Revenues of $102 Billion. Modern banking has been a major contributor to economic growth and stability across the globe. However, technological developments in distributed cloud computing, computer processing hardware, and cryptography have given rise to DeFi and a transformative financial infrastructure.
Nearly every industry has experienced significant disruption due to the continued development of technology. Entertainment, commerce, media, travel, and manufacturing, among many others, struggled to transition their business models from physical to digital. The most significant developments in these industries over the last decade have largely come from new market participants who have a product tailor-made for the digital world. Amazon, Netflix, Facebook, Bumble, Spotify, Airbnb, Uber and many more businesses emerged with transformative business models that reinvented an entire industry around a digital product or service. Financial services have transitioned to the digital age with online banking, digital transfer of funds, direct deposit, and auto-pay loans. However, these services are largely a replica of physical interaction and exchange rather than a new, transformative design. Over the past year, there has been exponential growth in DeFi participation. As of May 7th 2021, investors have $78 Billion dollars invested into these technology protocols. The future of finance may already be in motion.
Participants in DeFi are savers and investors like any other, seeking to capture a strong return on their money. It’s been my observation that individuals contributing to DeFi’s rapid growth have done so for one of three primary reasons:
1) They have been turned off by legacy financial institutions and governments due to issues with monetary policy, currency manipulation, excessive surveillance, security of funds, and inefficient financial infrastructure
2) The interest rates on DeFi protocols are better than they would get at a traditional financial service provider
3) They are excited about exploring a new financial frontier
Regardless of the reason for exploring DeFi, the most critical reason for why individuals continue to engage is the freedom and self-sovereignty. By moving away from centralized institutions, savers and borrowers are able to engage in financial activity without the cost of an intermediary. This translates to participants reaping the benefits of a system, rather than the institutions. As society continues its transition to a digital world, legacy financial institutions built for the physical world will be forced to compete with highly efficient and cost-effective digital protocols.
Sources:
A Dive Into Smart Contracts and DeFi | CoinMarketCap
DeFi — The Decentralized Finance Leaderboard at DeFi Pulse
How the Four Biggest US Banks Generate Income and Revenue (mx.com)
