Banks and the conventional fiscal structure had been stirring a lot of trouble for decades now. To solve their issues, cryptocurrencies like Bitcoin and Ethereum were invented, but they came with their own chain of complaints. So, as a peace treaty between the traditional centralised financial system and the more disruptive cryptocurrencies, DeFi aka Decentralised Finance, took birth in 2020 and since then, it has only seen an upward trend. So, are we moving towards a ‘bankless’ world?
Data from DeFi Pulse (https://defipulse.com/) shows that the “total value locked” (TVL) in the DeFi market’s combined projects has more than doubled to roughly $40 billion in the first few months of 2021. Investors are increasingly turning to DeFi as a result of these developments, which have coincided with the rapidly surging value of cryptocurrencies in recent months and a record low central bank interest rates around the world. This has created a perfect storm for banks, whose profit margins are being dragged down by lower-for-longer interest rates. So, the question arises, will DeFi devour banks eventually?
The issue with our traditional banking systems
In order to answer this question, we need to see what exactly is happening here in the world of finance. The traditional banking system that we have been familiar with for generations is completely centralised, meaning it is controlled by one central body of power. We use currency issued by a central authority, viz. the government, which oversees everything from its creation and distribution to its storage and investment, along with credits, trading, and interest. While it has its perks like the government protection for our hard-earned money, it has a long list of downsides as well.
Human error
The investment and regulation of your assets are under the totalitarian control of the banks, in association with the government. Banks are run by human beings and we all know, when the decision making power is completely in the hands of human beings, errors occur frequently. There is no shortage of news where many people lost their money or suffered because of a bad economical situation because of judgement mistakes on the parts of the banks, the government, or both.
For example, IMF data shows that the decision of the Venezuelan government to print massive sums of money and a series of other bad monetary policies in response to the collapse in oil prices led to inflation of over 1,000,000 percent. This was almost 20 years ago, and the country’s economy is still on a plummeting trend.
Exclusivity
The current fiscal infrastructure is remarkably exclusive – so much so that a study conducted by the World bank group confirms that as of 2017, 1.7 billion people in the world didn’t even have a bank account. The elaborate and complicated documentation and identification procedures of banks have shown to be the main culprits for this.
This kind of financial exclusion not only affects the unbanked people themselves as they stay unguarded against emergencies like serious illness, recession, etc, along with being more vulnerable to predatory loan sharks; but also hinders a nation’s economic growth
Debits and Credits
The current loan-receiving process is time-consuming, cumbersome, and extremely exclusive in terms of eligibility due to lengthy documentation, verifications, and other procedures. Also, one has to submit valuable assets as collateral for a loan, and therefore, may end up losing big if the loan is not paid on time for whatever reason. This results in a huge part of the world not being able to even acquire a bank loan. Furthermore, middlemen lenders frequently focus more on amplifying their own profits which diminishes the return the borrower could get.
Corruption
One of the biggest problems in today’s fiscal structure is the alarming magnitude of corruption that’s possible since a huge chunk of it arises from the central regulating body itself, in cooperation with a range of wealthy and powerful outsiders. Reports that disclose banks secretly producing more money than they need to invest the surplus and pocket the profits for themselves and their influential allies are quite common these days. There are many more creative ways influential thieves like these adulterate the system and plunder the commoners.
The disparity in investment based on net worth
Even though nowadays the middle class invests a lot in the stock market, there still is an enormous gap between them and the investment made by the wealthy. Rich people of any country own a dominant stake in the majority of lucrative businesses, ensuring that they receive the majority of profit returns, leaving the others with very few options. Not only is the collective share occupancy by the middle class much less, but many also don’t even have an entry into the share market.
Expensive operative commissions
Everything in a centralised system requires a mediator for transactions to be validated and conducted, making the system both inefficient and exorbitant as money trickles out for each such facilitator.
What is DeFi?
DeFi aka Decentralized finance is essentially a liaison between the centralised currencies and the decentralised cryptocurrencies. It is a hybrid of the two in which common financial applications are created on a limited scale at a time using a decentralised network and blockchain technology. The majority of DeFi applications are decentralised apps or dApps.
Most of these dApps use the Ethereum framework as it provides both native cryptocurrency and the option of developing other blockchain applications. There are other blockchain platforms there too which are used for this purpose. However, when the same blockchain framework is used to create many apps, they can be integrated or modified to create more dApps with additional features.
How does DeFi work?
Blockchain is the underlying technology for decentralised banking, and it comes with its own set of security and data privacy features, as well as a peer-to-peer decentralised network that can be utilised to create applications. Millions of computers around the world test the input before adding them to the chain. After the data is entered into the system, they are encrypted in such a fashion that they are immutable and practically unhackable. This iron-clad security makes blockchain technology the perfect one to use for financial purposes.
Besides adding multiple security layers of blockchain technology, the fundamental goal of decentralized currencies actually is to automate most financial processes and eliminate human intermediaries. So the DeFi technology adds some extra features of its own:
- Decentralised algorithm:
Interest rates and currencies are established by decentralised data and algorithms on the blockchain technology platform in this way.
- Minimal human interference:
To work on financial and other types of transactions, DApps use smart contracts instead of human involvement.
- Open source coding:
The basic software engineering of DeFi is largely open-source, which means that anybody can examine and evaluate its features, security, and capabilities. The framework is exceptionally safe and reliable because all users have complete access to all information at all times, ensuring that the apps do not run malicious hidden code in the background or steal data without the users’ awareness.
- Inclusive and borderless:
Being open-source platforms, dApps are truly inclusive and allow the user access to anyone with a computer and an internet connection, with no restrictions, not even the ones imposed by geographical borders. DeFi’s ultimate goal is to establish a completely borderless economy.
- Permissionless:
The development or the use of a DeFi app needs no one’s approval, facilitating avoidance of the inexclusive and exhausting bureaucratic proceedings of the traditional banking systems. DeFi is often known as “open finance” for being so transparent and adaptable.
- Amenable development procedure:
DApps permit safe integration of third-party apps for expansion of the functionalities, offering developers additional flexibility. What’s more intriguing is that users can even create their own interfaces if they believe the current options to be insufficient.
How can DeFi solve the issues with our financial systems?
According to Peter Wall, the CEO of a global crypto mining company, Argo Blockchain, the necessity for an open, transparent, and secure system has grown as centralised corporations and banks continue to fail individuals who desire financial independence. DeFi can be an exemplary solution as it gives the power back to people with true decentralisation and impenetrable data ledger resulting from blockchain technology.
On top of the basic upsides of using a blockchain application, there are several more ways DeFi simplifies the banking structure, along with making them more accessible to a much greater section of the population, eventually solving the majority of problems that arise from the traditional banking systems.
Tokenizing assets:
All of your assets in a decentralised financial system can have a digital worth assigned to them, or they can be “tokenized.” These assets can be whatever someone else in the particular blockchain network of the dApp considers valuable, such as real estate, jewellery, clothes, collectibles, etc. The native currencies of the elemental blockchain framework (e.g., ETH for the Ethereum platform) are most commonly used as reward tokens for this operation. Anyone with access to the DeFi system can use these tokens to trade, sell, or invest. This not only simplifies the entire investment routine, but it also diminishes the risk of market manipulation, data secrecy, discrimination, and other sorts of corruption.
Liquidating non-cash assets:
In the current centralised financial arrangement, cash is the sole liquid asset, meaning it is the only thing that can be used to save, sell, or buy new stuff. In a DeFi world however, the aforementioned concept of tokenization of physical assets makes sure that every possession of yours can be liquidated by adding a digital value to them.
This means that properties can now be utilised in fractions for borrowing, selling, and investments. As a result, common people can use any of their belongings as collateral for investment as well as make smaller investments, which will, in turn, shorten the gap between the upper and the middle-class in terms of investment. Besides, lenders will be able to access a larger pool of borrowers as more people from various backgrounds become active in the investing market, which will only improve their business.
Enhancing the flexibility of financial services:
All assets in a DeFi system can be standardised with a single digital value, as described above. Consequently, substantially more interoperability of financial services across multiple providers and platforms will be possible. This will lessen the friction that currently exists as a result of the centralised system’s rigidity.
Eliminating biases:
The automated nature of the decentralised finance system as well as above mentioned tokenization of assets ensures neutrality of the system. It treats everyone in the system fairly, with no favouritism based on their financial situation, colour, language, national border, or anything else for that matter.
Making transactions speedier and low-cost:
The underlying blockchain technology of DeFi basically erases all middlemen from the system. As a result, the transaction, verification, investment, loan application, and consultancy expenses for a range of different applications become minimal to non-existent.
Making lending protocols open:
Decentralised finance makes lending protocols open, which means it eradicates the human involvement in lending. You will be depositing money and receiving a return just like you do in banks now, but the proceedings, decision-making, authentication, linking the lender and the borrower – all is performed by the smart contract, in an automated manner. Therefore, you acquire the entire sum of the profit, without losing any for the broker. Moreover, the interest rates for everyone become the same as no credit checks are included in the eligibility criteria for a loan.
The co-founder at Quadency, Manish Kataria, agrees, “Every step of the way, fees are taken by middlemen, leaving you to earn at best 1-2% short-term in current market conditions. But if you remove all those middlemen and safely connect the lender and borrower directly, suddenly you can earn rates closer to 8%”.
Making marketplaces decentralised:
A DeFi marketplace requires no separate item registration, user authentication, or withdrawal costs. People can easily join a DeFi network and conduct an anonymous yet secure peer-to-peer transaction using a blockchain-powered smart contract. The tokenization opportunity of anything valuable along with this opens the marketplaces up for everyone around the world with a computer and an internet connection. Any objects like electronic and electrical equipment, research papers, collectibles, games – pretty much anything that one person has and another wants, can be exchanged between them, in less time and with much less effort.
So, are we looking at a bankless future?
As we can see, decentralised finance offers a wide range of advantages over the conventional banking system, it is one of the fastest-growing fields in decentralised services with over 40,000 monthly users and an increasing number of startup ventures. Having said that, as of now, there are still some areas of this technology that require improvement and at the same time, its implementation also requires legal support. Also, in terms of awareness, it is currently limited to crypto enthusiasts and presumably will still take some time to gain mass adoption.
All things considered, the decentralised platforms don’t exactly reject the banking infrastructure altogether. The functioning of them resembles banks to a great extent, except for the parts where banks pose challenges to the society and DeFi works to resolve them.
So, overall, it is fair to say that decentralised finance will probably not eradicate banks altogether, but it will rather redefine the traditional form of banking. Even many banks are starting to realise the scope of this technology and incorporate its features into their already existing structure. With the high rate at which it is being embraced by the financial community, we are hopeful that we will see a new age of decentralised banking very soon in the future.
Author: Ralph Kalsi, CEO and Founder Blockchain Australia™
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