DeFi is booming - Banking to be a thing of the past?

Sep 09, 2020
4 min read
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Imagine a future where cryptocurrency and decentralized finance become the norm, and banks become an option. Although this isn't happening anytime soon, DeFi is catching like wildfire. The total value locked in DeFi increased five-fold in just six months and stands at over 4 billion dollars. I agree that this is a drop in the ocean compared to the trillion-dollar traditional banking industry. Still, given the pace at which DeFi is moving, it'll engulf the banking industry.

But what exactly is DeFi?

DeFi stands for Decentralized Finance and is often referred to as the Open Finance Movement. Decentralized finance is built over smart contracts, protocols, digital assets and are accessed using a dApp (Decentralized application). Consider it a futuristic system of every traditional financial service you use today - loans, trading, insurance, and more. It runs on a trustless, permissionless, and open blockchain where the control is not under any individual entity. The majority of DeFi applications now are based on lending and borrowing with impressive interest rates that sometimes touch double-digit figures (Sounds way better than the negligible interest rates banks provide, doesn't it?)

These applications run on smart contracts that are programs that execute when certain conditions are met. The code is written and released, and from then on, there is no central power handling your assets. Everything is automated with almost no human intervention (although developers deploy upgrades or bug fixes). Most of the DeFi applications are run over the Ethereum network. Even though there is still a scalability problem, it is expected to improve vastly with the release of Ethereum 2.0 as it is moving to the Proof-of-Stake system from the current Proof-of-work mechanism.

Traditional Finance vs. Decentralized Finance

The most 'in-your-face' difference is that an organization runs banks, and they are responsible for the money you deposit in the bank. They lend it out as loans, or they charge you for their services. DeFi is fighting against this to bring about a decentralized system where people would no longer need to rely on a third party, like banks, for their financial needs. With DeFi, people can transfer money across countries (depends upon the regulations). This is what DeFi is aiming at, a globalized peer-to-peer financial system. People that aren't in the crypto space often assume cryptocurrency is volatile and highly unstable, and it is not safe enough to use them as a global currency. This is where stablecoins step in. Stablecoins are a cryptocurrency too, but they are pegged to the value of the US dollar. Such coins are protected against the instability of the cryptocurrency market. Tether (USDT) and MakerDAO (DAI) coins are some of the critical stablecoins.

Customer data must be protected at all costs, and that is something legacy finance cannot entirely guarantee since it is prone to hacks due to its centralized nature. In a blockchain, all the data is encrypted and is publicly available to validation. This does not mean that your data is out in the wild. Unlike banks, DeFi does not require you to identify yourself. The entire system supports anonymity and yet provides security as no one will be able to alter data. In 2019, Capital One fell prey to a hacking attack that exposed over 100 million customers' personal information. Since DeFi is entirely transparent and anonymous, customers will feel much safer here. The anonymity might also open doors for money-laundering, so it will be challenging to come up with regulations.

The Venezuela Hyperinflation is something so devastating that it almost rendered the currency worthless. A steep drop in oil prices and poor government policies led to the mass printing of new currency, which destroyed the economy and shot up inflation to over 1,000,000%. This was entirely caused by humans. Blockchain came to the rescue when people from Venezuela started sending funds as cryptocurrency to their friends and relatives in other countries. Such a problem can never occur in DeFi since new coins are minted based on the protocol and not by choice.

MakerDAO is currently the darling of the DeFi world and has 1.09 billion dollars locked in its system. MakerDAO is a decentralized organization that allows the lending and borrowing of cryptocurrency and is built over the Ethereum network. It locks ETH as collateral in Collateralized Debt Position(CDP) and lends the DAI stablecoin with an attractive interest rate with complete security since a smart contract manages all this instead of a central authority. It is smart and also dangerous in a way that, in order to maintain the stable value of the DAI token, the collateral must always be at least equal to the amount of DAI borrowed. If the collateral value falls below 150%, a liquidation process is automatically initiated by the smart contract, and anyone in the network acquires the power to repay the debt. These people aren't so kind as to repay someone else's debt. They get 13% of the total debt taken from the initial borrower's locked funds. All this can be avoided by the borrower controlling the loan amount and the regularity of repayments. The liquidation is solely done to maintain the stable value of the DAI token. This way, it can remain a global currency that anyone can send and receive around the world. A lot of other players are catching up in this space, including Compound and Synthetix.

What's next for DeFi?

DeFi will not replace traditional finance overnight, it's just taking its baby steps, and we have to wait until it can run. It might either overthrow traditional finance or coexist with it. The future where these two switch roles and traditional finance is looked upon as a mere option is inevitable.

One of the significant challenges DeFi will face is regulation, and it's interesting to see how it will tackle this problem. COVID has turned the world upside down, and DeFi has taken advantage of it. The past few months have seen a surge in the adoption of Decentralized Finance. Mainstream companies are paying attention to DeFi and are working hard to tackle it, but DeFi seems to be growing strong.

Cryptocurrencies are already being accepted as forms of payment in various stores and organizations around the world. DeFi should earn the trust of users to enter mainstream adoption. The tech has developed significantly, and developers are working on providing a better user interface to allow even grandmas to use it. The crypto community has dubbed 2020 the year of the "DeFi Renaissance." The topic of decentralization is, itself, pretty restricted to the tech community, and it has to cross that border for mass adoption. DeFi isn't going to take over the world in the next 4 or 5 years, but it's taking one step at a time, and each step is a giant one.