Decentralized finance is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum. Wikipedia
Our legacy financial infrastructure has both limited growth opportunities and contributed to the inequality of opportunities. Around the world, 1.7 billion are unbanked. Small businesses, even those with a banking relationship, often must rely on high-cost financing, such as credit cards, because traditional banking excludes them. High costs also impact retailers who lose 3% on every credit card sales transaction. These total costs for small businesses are enormous by any metric. The result is less investment and decreased economic growth.
Decentralized finance, or DeFi, poses a challenge to the current system and offers a number of potential solutions to the problems inherent in the traditional financial infrastructure. While there are many fintech initiatives, we argue that the ones that embrace the current banking infrastructure are likely to be fleeting. We argue those initiatives that use decentralized methods — in particular Blockchain Technology — have the best chance to define the future of finance.
Financial institutions today are challenged with meeting consumers’ high expectations for fast and convenient digital banking processes, while also needing to mitigate fraud and comply with increasingly stringent regulatory requirements, as explained in Payments Journal. As such, banks are thinking more carefully than ever about compliant storage of personally identifiable information (PII) as they release more convenient financial products to busy, on-the-go customers.
There’s also a better way to make payments. It’s clear that banks have room to grow when it comes to better servicing consumers: there are inefficiencies in the way payments are made, and many worthy consumers are left without access to loans. Decentralized finance can alleviate the pain point waiting for a corporate entity to complete a transaction while taking a fee in the process. Civic believes there is a new way to make payments as the financial institutions formalize their digital transformation strategies. We believe the future of financial services is decentralized.
We have come full circle. The earliest form of market exchange was peer to peer, also known as barter. Barter was highly inefficient because supply and demand had to be exactly matched between peers. To solve the matching problem, money was introduced as a medium of exchange and store of value. Initial types of money were not centralized. Agents accepted any number of items such as stones or shells in exchange for goods. Eventually, specie money emerged, a form in which the currency had tangible value. Today, we have non-collateralized (fiat) currency controlled by central banks. Whereas the form of money has changed over time, the basic infrastructure of financial institutions has not changed. In this book, we offer a potential solution to five key problems — centralized control, limited access, inefficiency, lack of interoperability, and opacity — that arise from the current system of centralized finance.
Five Key Problems of Centralized Financial Systems
For centuries, we have lived in a world of centralized finance. Central banks control the money supply. Financial trading is largely done via intermediaries. Borrowing and lending is conducted through traditional banking institutions. In the last few years, however, considerable progress has been made on a much different model — decentralized finance or DeFi. In this framework, peers interact with peers via a common ledger that is not controlled by any centralized organization. DeFi offers considerable potential for solving the five key problems associated with centralized finance:
Centralized Control. Centralization has many layers. Most consumers and businesses deal with a single bank. The bank controls rates and fees. Switching is possible, but it can be costly. Further, the US banking system is highly concentrated. The four largest banks have a 44% share of insured deposits compared to 15% in 1984.1 Interestingly, the US banking system is less concentrated than other countries, such as the United Kingdom and Canada. In a centralized banking system, a single centralized entity attempts to set short-term interest rates and to influence the rate of inflation. The centralization phenomenon does not just pertain to the legacy financial sector. Relatively new tech players dominate certain industries, for example, Amazon (retail) and Facebook/Google (digital advertising).
Limited Access. Today, 1.7 billion people are unbanked making it very challenging for them to obtain loans and to operate in the world of internet commerce. Further, many consumers must resort to pay-day lending operations to cover liquidity shortfalls. Being banked, however, does not preclude suffering from limited access. For example, the loan amount a small business needs may be too small to interest a bank, so the bank suggests the business apply for a credit card. The credit card could have a borrowing rate well above 20% per year, a high hurdle rate for finding profitable investment projects.
Inefficiency. A centralized financial system has many inefficiencies. Perhaps the most egregious example is the credit card interchange rate that causes consumers and small businesses to lose up to 3% of a transaction’s value with every swipe. Remittance fees are 5–7%. Another example is the two days it takes to “settle” a stock transaction (officially transfer ownership). In the internet age this seems utterly implausible. Other inefficiencies include: costly (and slow) transfer of funds, direct and indirect brokerage fees, lack of security, and the inability to conduct microtransactions. Many of these inefficiencies are not obvious to users. In the current banking system, deposit interest rates remain very low and loan rates high because banks need to cover their bricks-andmortar costs. A similar issue arises in the insurance industry.
Lack of interoperability. Consumers and businesses deal with financial institutions in an environment that locks interconnectivity. Our financial system is siloed. Moving money from one institution to another can be unduly lengthy and complicated. A wire transfer can take three days to complete. This problem is well-known and some attempts are being made to mitigate it. A recent example is Visa’s attempted acquisition of Plaid in 2019. Plaid allows any company to plug into a financial institution’s information stack with the user’s permission. This is an example of a corporation operating in the world of centralized finance making an investment designed to mitigate a particular problem but not addressing the fundamental problems with the current financial infrastructure. It was a strategic move to buy time.
Opacity. The current financial system is not transparent. Bank customers have very little information on the financial health of their bank and must place their faith in the limited government protection of FDIC insurance on their deposits. Bank customers seeking a loan find it difficult to determine if the offered rate is competitive. The market for loans is very fragmented, although the consumer insurance industry has made some progress with fintech services that offer to find the “lowest” price. The current list of competing lenders, however, all suffer from the system’s inefficiencies. The result is that the “lowest” still reflects legacy bricks-and-mortar costs as well as bloated back-office costs.
The implications of these five problems are twofold. First, many of these costs lead to lower economic growth. For example, if loan rates are high because of legacy costs, high-quality investment projects may be foregone, as explained previously. An entrepreneur’s high-quality idea may target a 20% rate of return precisely the type of project that accelerates economic growth. If the bank tells the entrepreneur to borrow money on her credit card at 24% per year, this profitable project may never be pursued.
Second, these problems perpetuate and/or exacerbate inequality. Most (across the political spectrum) agree there should be equality of opportunity: a project should be financed based on the quality of the idea and the soundness of the execution plan, and not by other factors. Importantly, inequality also limits growth when good ideas are not financed. While purported to be the “land of opportunity”, the United States has one of the worst records in migrating income from the bottom quartile to the top quartile. 2 Inequality of opportunity arises, in part, from lack of access to the current banking system, relying on alternative financing such as payday lending and the inability to buy or sell in the modern world of e-commerce.
These implications are far-reaching and, by any calculus, this is a long list of serious problems that are endemic to our current system of centralized finance. While we are in the digital era, our financial infrastructure has failed to fully adopt. Decentralized finance offers new opportunities. The technology is nascent but the upside is promising.
Our research has multiple goals. First, we identify the weakness in the current system, including discussion of some early initiatives that challenged the business models of centralized finance. Next, we explore the origins of decentralized finance. We then spend some time discussing a critical component of DeFi: blockchain technology. Next, we explore what solutions DeFi offers and couple this with a deep dive on some leading ideas in this emerging space. We then explore the major risk factors. We conclude by looking to the future and attempt to identify the winners and losers.
Resilience
“Decentralized financial applications can make our financial systems more transparent, more resilient and less fragile,” Salil Deshpande, a partner at Bain Capital Ventures, said.
Incidents such as the 2008 Global Financial Crisis (GFC) and the COVID-19 pandemic illustrate legacy financial systems’ issues and their vulnerability to unforeseen macro-economic events. Blockchain innovators believe that DeFi could identify potential systemic financial risk that legacy capital systems found challenging to identify by providing a distributed framework.
The 2008 GFC is a good example, where the Federal Reserve and American Treasury Department committed an estimated total of US$150 billion to save American International Group inc. (AIG). Thousands of pension funds, hedge funds and mutual funds, were invested or insured by this giant. Systemic risk arose when complex mortgage-backed securities were embedded in ‘safe’ investment products. The interplay of structured products across various asset classes, exchanges, systems, and leverage created contagion potential. A distributed DeFi ecosystem would better allow systemic risk to be mapped across a singular, or many interconnected Blockchain.
Financial Inclusion
“If you want to send, lend or borrow money, you don’t need to join a private network like PayPal or Fedwire or a bank,” Peter Johnson, ex-Morgan Stanley banker and now a partner at fintech venture capital firm Jump Capital, said on DeFi’s advantages.
DeFi includes greater participants, with less friction. According to the World Bank’s data, around 1.7 billion adults are unbanked worldwide. Even in the United States, 1 in 5 adults do not hold a bank account, as surveyed by the American Federal Deposit and Insurance Corporation in 2018. If this is the case in one of the most developed nations globally, one can imagine the sheer volume of unbanked individuals in developing countries. However, most unbanked people do have access to smartphones, allowing them access to digital financial services. Micro-loans, yield, savings and transaction accounts are becoming popular at a micro level, with infinite global access.
DeFi is also innovating mega industries at scale — asset management, payment, derivatives, gaming, insurance, mortgages and real estate. The primary use-cases for these industries are efficiencies and pricing — why have many disparate systems with independent pricing mechanisms, when DeFi can house on interconnected Blockchain.
Innovation
“The cost of transacting in cryptocurrencies is significantly lower for local and international transactions to what regular financial institutions propose,” said Charles Awanda, Chief Knowledge Broker at Songhai Labs, a knowledge broker platform and accelerator of innovations.
As reported by the DeFi database DeFi Pulse, the most popular projects in 2020 are lending and borrowing space. Applications built in DeFi replace the role of financial intermediaries, which eliminates the labour and operational costs charged by banks, allowing for lower borrowing and higher lending rates. The higher interest rate premiums, lower remittance costs and speed in DeFi has introduced competition to traditional payment systems and banks, and are forcing them to innovate.
Thanks to the rapid growth of financial technology in the past decade, applying fintech has become one of the primary approaches to lowering transactional friction and maintaining competitiveness among rivals. By 2017, fintech merger and acquisition (M&A) was still an industry outlier, with only 1 in 10 top American banks acquiring fintech startups. However, during 2019, M&A between fintech and banking companies reached a total of US$44.6 billion in funding, and a record of US$233.8 billion in volume through 989 transactions. M&A is often a precursor to maturation of industries. We see this all occur alongside M&A activity within the digital asset industry, providing vertical consolidation and lateral M&A from traditional firms.
The Bank Merger Act and other related laws that ultimately prevent banks from becoming too big to fail have positioned small banks as the main instigators of substantial acquisitions in the past three years. One example was the merger between BB&T Corp. and SunTrust Banks in 2019 to form Truist Financial Corporation, resulting in the sixth biggest commercial bank in the U.S. by assets. Banks were trying to reach economies of scale through M&A for efficiency and competitiveness against emerging financial services. UBS is considering a merger with Credit Suisse to maintain competitiveness and reduce costs as consumers’ desire to save decreases.
However, the remittance costs in banking services still rank the highest amongst all remittance service providers. And together with other remittance service providers, banks seek more innovations to minimize friction and maintain competitiveness.
Benefits of Decentralized Finance DeFi
Here are the advantages or Benefits of DeFi over the traditional financial system
Permission less
Open-source
Decentralized
No involvement of Central Entity
High Liquidity
Borderless
Provides full control over funds
Time-Saving
Cost-Effective
Restrict the fraudulent activities
These are the advantages of DeFi- The New Decentralized Financial System over the current traditional financial system.
The Potential of DeFi is found and understood by many Fintech industry experts and they have started utilizing DeFi to tackle the inefficiencies in their current system and services.
Regulation
“There are some basic red flags that apply across any purchase or investment no matter whether it is a digital asset or a traditional security,” Peirce Weighs, commissioner of U.S. Securities and Exchange Commission, said.
Relevant regulatory laws on DeFi are not yet fully developed, but the topic of DeFi regulation has grown alongside DeFi’s expansion. 7 of 10 key members in the SEC admitted that lack of clear regulation could challenge DeFi growth. To cope with the red flags that DeFi presented, financial regulators in countries and regions like America, Britain and Europe started drafting new regulation protocols. For example, Europe is considering including DeFi in Markets in Crypto Assets (MiCA) while Britain and America are experimenting with ‘embedded regulation’ wherein regulatory approaches are built into each DeFi project’s design.
It is frequently argued that DeFi cannot be regulated because no central party holds management responsibility. We feel a well-developed legal framework can boost DeFi growth but will not impose additional risks to DeFi users. DeFi project developers are more likely to be the ones who burden the legal risk when regulations are fully developed. The good news is that “DeFi could eventually fall under the scope of global regulators as it grows in scale”, reported by Cipher trace which is a forensic team funded by the U.S. Department of Homeland Security to fight crypto crime.
Undoubtedly, whichever your views on resilience, financial inclusion, innovation, or regulation, DeFi is reshaping the traditional financial system and diversifying markets.
The Future of Finance is Decentralized
Some community members have already dubbed 2020 the year of the “DeFi Renaissance.” Amidst the global health and economic crisis, stablecoins have risen in popularity bringing new institutional and individual players into the market. DeFi token values have surged by 200per cent since the beginning of the year. The opportunities for startups using this technology are endless which is promising for the DeFi ecosystem diversification and growth. New game-changing DeFi applications are going to emerge, built at a lesser cost and primed to cross over into the mass market.
DeFi Solution For Current Pandemic Era
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What you need to know about Daiex DeFi platform?
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