Blockchain, Cryptocurrencies & Emergence of DeFi

Blockchain, Cryptocurrencies & Emergence of DeFi

Blockchain & Cryptocurrency (Bitcoin, Ethereum, etc.), digital tokens (e.g., NFTs), and digital cash. These often rely on blockchain technology, which is a distributed ledger technology (DLT) that maintains records on a network of computers but has no central ledger. Blockchain also allows for so-called smart contracts, which utilize code to automatically execute contracts between parties such as buyers and sellers.

Decentralized Finance (DeFi)

For more than a century, the traditional financial system has operated with essentially the same model. It all depends on the same central banks, the same commercial banks, the same exchanges, the same insurance companies, and so on. For all the technological change and related developments, the basic framework has remained static and centralized.

Lately, fintech has caused some disruption and helped reduce transaction costs. But fintech relies on the same centralized financial architecture, which places a limit on how low those costs can go and how much efficiency can be gained.

With decentralized finance, that limit doesn’t exist that’s why the current fintech wave will be fleeting.

Decentralized finance—DeFi—refers to the shift from traditional, centralized financial systems to peer-to-peer finance enabled by decentralized technologies built on Ethereum. Millions are building and participating in this new economic system that is setting new standards for financial access, opportunity, and trust.

But what makes DeFi such an inevitable force for change? Will all that change be for the better?

DeFi uses peer-to-peer networks to conduct transactions without third-party intermediaries. Digital assets, such as cryptocurrencies, take the form of “smart contracts,” which are self-executing algorithms based on blockchain technology. “Tokenization” is an important aspect of DeFi. Virtual and physical assets can be turned into “tokens” that act as stores of value and can be used in financial transactions. Some DeFi DAO also give the holder a vote in the governance of a protocol or platform.

Why will DeFi transform the financial system?

DeFi can solve five inherent problems of the traditional financial system: inefficiency, limited access, opacity, centralized control, and interoperability.

Reducing inefficiency means eliminating fees and intermediaries. In the 19th century, a Western Union wire transfer imposed a 3% fee, and more than a century later, even basic transactions — using a debit card, for example — often involve significant fees. Buying a stock might seem straightforward, but obtaining ownership requires an intermediary and can take considerable time. With DeFi, the execution and settlement of a trade can happen simultaneously.

Limited access to the financial system is a serious global problem. Removing those barriers could connect billions of people to the financial services they need. An estimated 1.7 billion people are unbanked, and even more are underbanked. The obstacle for many in these cohorts is financial friction.

For example, excessive cost of capital — banks limiting access to loans with lower rates and instead providing lines of credit at much higher interest — prevents many small businesses from pursuing projects that could boost economic growth. DeFi can directly address the sources of financial friction.

Since DeFi is based on open-source technology, there is more transparency, not less. With a decentralized exchange, for example, users can see the code, the liquidity, and all the other details. The traditional financial system, by contrast, has numerous blind spots.

When you go to a bank, you basically don’t know how healthy that bank is and rely upon our institutions like the FDIC to reduce our risk. But our institutions have a dubious track record at best, and not going back to 1930s. We can go back to the global financial crisis, where many people were dealing with banks that went under.

Centralized control and concentration are essential parts of the current financial system. “Market power” of commercial banks as a prime example. “That means that savings rates are lower than they should be, borrowing rates are higher than they should be. Maybe people are excluded,” he said. “And in decentralized, finance, by definition, it’s different. It’s highly competitive.”

“There’s no distinction between different actors in the [decentralized] space,” he added. “Everybody is equal.”

Finally, interoperability is an unavoidable structural problem in traditional finance: Various obstacles prevent different platforms and systems from connecting to each other. If someone wants to open an account with an online trading platform, they may have to transfer money from a bank account. The process could take days before the new account is ready to trade.

“In decentralized finance, it’s dramatically different you have a wallet, and you go to an exchange, you connect your wallet, and you’re ready to go. Indeed, this is a feature of the so-called Web 3.0 experience. So, with Web 3.0, there’s no username or password. You connect your wallet and you’re ready to go. You’re ready to buy. You’re ready to borrow or lend receive funds. You’re operational. and Web 3.0 is not possible without decentralized finance.”

New technologies, like machine learning/artificial intelligence (AI), predictive behavioural analytics, and data-driven marketing, will take the guesswork and habit out of financial decisions. "Learning" apps will not only learn the habits of users, often hidden to themselves, but will engage users in learning games to make their automatic, unconscious spending and saving decisions better. Fintech is also a keen adaptor of automated customer service technology, utilizing chatbots and AI interfaces to assist customers with basic tasks and keep down staffing costs. Fintech is also being leveraged to fight fraud by leveraging information about payment history to flag transactions that are outside the norm.