How DeFi is Revolutionizing the Finance industry

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What started with Bitcoin as the new money has spread to disrupt the entire financial industry and currently what we are witnessing is the rise of a new industry which is expected to be the future of the finance industry- the DeFi- decentralized finance.

Satoshi Nakamoto invented Bitcoin to eliminate the need for financial intermediaries. However, the underlying technology of Bitcoin, i.e., blockchain technology, has found wider use over the last few years. It is being used to offer financial products that the traditional finance sector does, in a much more efficient and superior way. 

In times to come, most financial transactions may use blockchain technology. We will have a whole decentralized finance sector in place of traditional centralized institutions.

What is DeFi?

DeFi, an abbreviation for decentralized finance, is a financial system that functions without a bank or an intermediary. It is a completely transparent and more secure system that is decentralized and democratized. DeFi protocols or DeFi apps connect buyers and sellers, lenders and borrowers, without the need of a central authority.

It relies on peer-to-peer philosophy and uses smart contracts on the blockchain network that removes intermediaries. This mechanism lowers the chances of errors and increases efficiency. DeFi protocols comprise an overlapping ecosystem of decentralized applications (DApps) and smart contracts.

Most decentralized applications run on the Ethereum network, the largest open-source blockchain smart contract platform. There are many other blockchains, such as Solana, Avalanche, that now support decentralized finance applications. The first major DeFi application is MakerDAO, which Rune Christensen founded.

How Defi is changing the financial industry

The Defi revolution is taking place fast and replacing the traditional finance sector. It offers many solutions and seeks to develop further in the coming years to various areas of the financial industry- banks, clearinghouses, payment processors, etc. The main idea of decentralized finance is to remove the intermediaries such as central banks or banks. It is also a solution to the problems faced by traditional banking as it offers accessibility, transparency, and greater security.

One of the most significant advantages of defi economy is that it gives users complete privacy and control over their transactions. Ubiquitous in nature, decentralized finance is accessible anywhere, enabling financial inclusion.

The volume of trading tokens and money in smart contracts in the defi projects has been growing exponentially, proving that DeFi is here to stay. As per defipulse.com, the total value locked in DeFi is over $79 billion as of March 19, 2022.

Last year, the GameStop Saga was clear evidence that traditional finance is a passé, and we’re in for a DeFi revolution.

DeFi Protocol Subcategories/ DeFi Services

  1. Decentralized exchanges, or DEXs (Uniswap, 0x)
  2. Decentralized Lending/borrowing platforms (Compound, Aave)
  3. Savings/Deposit platforms
  4. Derivatives (Synthetix)
  5. Crypto based synthetic assets
  6. Asset management (Mirror, Numeraire)
  7. Insurance (Nexus)
  8. Aggregators (Yearn Finance)
  9. Asset-backed reserves (Olympus Dao)
  10. Automated investing platforms
  11. Open Money Marketplaces

Why DeFi is Better Than Traditional Finances

Over the past many decades, we’ve seen central banks print money to deal with various situations, which ultimately weakens the purchasing power of the consumers. The brunt of frauds and failures of some of the most prominent corporate organizations is ultimately borne by communities. 

Traditional or centralized finance lacks transparency, and security is not robust in centralized finance. This is where decentralized finance comes in with better solutions to these concerns. Excluding banks, clearinghouses, payment gateways, and other mediators from all financial processes make transactions faster, easier, and straight forward for all parties.

Some of the features of the DeFi ecosystem which gets it an edge over traditional finance are as follows:

  1. Smart Contracts- The Single Source of Truth

Smart contracts perform the same function as traditional financial institutions such as banks. Various terms of transactions are encoded in the smart contract, similar to rules and regulations set by the banks. Smart contracts facilitate various financial transactions such as payments, lending, borrowing, insurance, etc. It helps cut down the red tape as the transactions are automatic in this case. 

There is no intermediary and no bulky documents that you have to go through. There is no human interface until your contract expires. Traders can borrow money via smart contracts and need to return funds as per the smart contract terms, or else their collateral will burn.

  1. Transparent Financial Operations

One of the most significant advantages of decentralized finance is that the protocols are open-source. Anybody can see them, bringing transparency. You don’t need to get involved in lengthy and time-consuming Know-Your-Customer (KYC) procedures involved in traditional finance that don’t offer their processing algorithms. 

The transparent mechanism also comes in with speed as you skip banks’ regulatory checks and system faults. Another advantage is that despite the transparency, there is user privacy as you can only see the encrypted IDs of users. It is not possible to deanonymize any user.

  1. Financial Operations Without Borders

The decentralized finance sector is global. You can buy something from China or Russia sitting in the United States and make your payment in Bitcoin seamlessly and in real-time. The whole process is cost-effective as well.

A bank will generally have several restrictions on cross-border transactions due to the issue of traceability, national security, taxation, etc. However, traditional financial institutions are slowly catching up and adapting to the cryptocurrency ecosystem. For instance, VISA now accepts transactions with USD Coins (USDC) on the Ethereum network.

  1. Financial Services Accessible for Everyone

Decentralized finance is enabling financial inclusion across the world. as it is not restricted by factors such as age, caste, income, location, etc. Borrowing is easier on the DeFi systems as it is based on your crypto holdings and not your credit rating.

Operationally as well, DeFi platforms are much simpler. You avoid intermediaries, bankers, and tons of paperwork. You have to create a crypto wallet and be on a crypto exchange. The flow of digital money is seamless, that too without the need of a bank account and other formalities!

  1. Data Safety

The data security concern curses traditional finance. We’ve seen massive data leaks in Web 2.0 by some leading organizations, such as Facebook. Banks and payment gateways are prone to cyber-attacks that make a user’s information vulnerable and risk potential fraud.

On the other hand, decentralized finance is built on blockchain technology, which makes it less vulnerable. Infiltrating the defi platforms is difficult because the system is supported by thousands of nodes and validators who approve the transactions.

Moreover, defi protocols are generally safe as blockchain developers spend a lot of money on fixing bugs. However, fraudsters can still use various methods such as social engineering, phishing, etc., to hack the users’ wallets.

We’ve already seen how the DeFi ecosystem has several advantages over the centralized system. Still, the sector is in its nascent phase. While the investor money has started flowing in, there’s still a long way to go.

Benefits of DeFi for Small and Mid-Sized Businesses

It’s not just the individual customers who stand to benefit from the decentralized finance, but small and medium enterprises (SMEs) as well. It is well known that SMEs often face difficulty in accessing formal finance and don’t usually get it at lucrative interest rates.

However, this is made possible by DeFi, which comes in handy for SMEs. SMEs can use Defi in the following cases-

  1. Decentralized Lending and Borrowing

As funding is the biggest hurdle for startups and small enterprises, DeFi is helpful in these cases. Entrepreneurs can borrow funds from the DeFi platforms against collateral and payback once the project takes off or as per the terms of the engagement. Defi products such as flash loans, liquidity pools, are interesting concepts in which one can make money.

  1. Staying on Top of Trends

As cryptocurrencies are the future of money ahead, individuals, investors, and organizations worldwide are moving towards it, slowly but surely. Even some of the governments have also started to accept it. So it makes sense for the small enterprises to accept it early to stay on top of the trend and be a differentiator in the defi market. It will also help them in acquiring new customers across various locations.

  1. Stablecoins

A significant problem that DeFi solves is currency volatility. Cryptos are immune to central banks’ interventions and external influences. Also, if Bitcoin looks too volatile, one can deal with Stablecoins, which are tokens pegged to some real-world commodity or currency. For instance, USDC is pegged to the US dollar.

4. Innovative Savings

One of the most lucrative aspects of DeFi is investments and savings. It has opened up a whole new world for investors looking for better yields and passive income. You can stake your coins to earn attractive yields, be a liquidity provider in liquidity pools to earn handsome returns. The entire concept of yield farming has made the sector highly attractive.

Legal Risks and DeFi

As DeFi is free from financial intermediaries and regulators, it brings complexities of its own. Governments worldwide are scrambling their heads around how to deal with this new world and put a leash on it. Some accept it with their arms open, while some are outrightly banning it.

How DeFi finds peace with traditional banking and the regulators will determine many things in years to come. We’re already seeing many countries imposing taxes on crypto assets. As we progress and innovate further in the sector, we may see more legalities and regulations.

The noteworthy part is that some individuals or organizations lead several crypto projects. For instance, Vitalik Buterin enjoys influence over Ethereum even though he’s not associated with it anymore.

Some DeFi applications do not have the old system licenses to operate lending protocols. For instance, Compound and Aave don’t have banking licenses in the United States. Nexus Mutual, a crypto-insurance product, doesn’t have an insurance license in most countries where it offers its services. DeFi tools like yearn finance can be said to be running unlicensed investing funds.

The major areas that may need attention and could be of concern to the regulators are:

  • Custody — of users’ cryptocurrency collateral.
  • Governance — who oversees users as they use a platform’s functions and how the corrective action is taken.
  • Compliance — The biggest advantage of decentralized finance- privacy- is a concern for the regulators as it makes KYC difficult.
  • Profit model — Who decides the profitability model and the distribution of profit.

The need for legal regulations may only grow going forward to lend protection to users, developers, and investors.

Conclusion

The need for truly democratized and decentralized financial platforms are increasing every day as traditional financial institutions continue to fail the commoner’s trust.

Decentralized finance replaces many of the current outdated processes by offering greater transparency and more robust security.

The DeFi ecosystem has many advantages over traditional finance. It has emerged as highly lucrative for entrepreneurs, individuals, organizations, and investors.

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