The traditional financial structure of the world gives banks control over the worldwide supply of money. As a result, a group of central banks manages the lives of people around the globe. While the Western World seems to have adapted to the game rules, there are still 1.7 billion unbanked adults (as of 2017 World Bank’s statistics) who do not have an opportunity to take advantage of such welfare and so cannot fit into the existing financial structure.
Banks do promote financial inclusion strategies and initiatives in 2020, yet it is still hard to imagine that a poor Cuban who doesn’t have resources to buy a new cupboard will open a bank account; or that a Nigerian with two classes of education on average will get to one of 22 banks in the whole country to participate in the world’s financial system.
There is a wide range of factors and life circumstances that restrict people access to the traditional financial system. As a result, they cannot engage in the world’s economics and are considerably limited in their opportunities. The barrier between them and the world of money started to get smaller about five years ago when the idea of DeFi (decentralized finance) was born in the minds behind Compound, Dharma, dYdX, and MakerDAO.
As of today, DeFi is called the new financial system for the globe and the know-how in getting everyone together on the same level.
What is DeFi and why do we need it?
The DeFi is the concept/system of traditional financing with the decentralization of all operations. This means that the system is open for each and every individual with the internet, and it offers (or at least it aims to offer) the same line of traditional finance services.
The top characteristics of the concept are permissionless, openness, and interlocking of financial products. They allow users to receive, provide, and manage any financial operations, be they lending/borrowing or trading, at a much faster rate and with significantly smaller fees.
DeFi is based on public blockchains and smart contracts (automated enforceable agreements) which actually guarantee that openness to the users. The blockchain structure of Ethereum helps the system to remove the excessive intermediaries in every financial operation leaving only the two peers making a deal.
So why talk about DeFi solutions now?
DeFi is a buzzword today, and like any other buzzword, the concept catches attention. Just like cryptocurrency swamped the market with bitcoin back in 2009-2010, DeFi is gaining its audience today. It became yet one more use case for Etherum back in August 2017 at a cost of $4, and today, over three years later, the total value locked in DeFi reached its peak on September 2, 2020, and the number is $9,605 billion. A great raise, right?
DeFi promises a wide range of benefits which you will find below. But even the simple numbers getting from $4 to $9,605 billion in 3 years should give you an idea that this is the next gold mine. And if you don’t dive in it today, tomorrow might be too late.
Defi vs. FinTech
FinTech stands for financial technology meaning that there are companies that try to implement contemporary technological advancements in their financial operations in order to improve and automate all the processes. And while the basic definition of FinTech seems to have a massive conceptual overlap with the DeFi’s definition, the two notions have major differences in their cores.
FinTech is built on the existing financial system of traditional banking where there is a customer, a bank, and their relations. What FinTech does is facilitate those operations by means of modern technologies for both parties.
For instance, let’s say you need a loan and you decide to go with the traditional way – the bank. To apply for a loan in person you need:
- a bank itself
- a bank employee who will check whether you qualify for a loan (and usually banks take about 3 days to do so for large amounts lent)
- an ID
- some credit history (for most Western or Western-owned banks)
- most banks would also require you to have a bank account
- time to go to the bank, to wait in the line, to talk to the bank representative, to wait for approval, and to money transfer to your account
Sounds ordinary yet tiresome, right?
FinTech simplifies this process. The flattest example is a bank app to which you can log in with your fingerprint or passcode from a device. In this case, to request a loan you still need to be a bank client, have an account there, and provide some credit history, yet all this information will already be stored under your account name. This means that you can avoid going to the bank in person and waiting for several days for approval because you can request a loan directly from the app. And usually, for small loans, the approval will be issued to you right away.
This example shows that the traditional structure of a bank and a borrower remains intact, what gets improved is their cooperation and overall relationship. FinTech serves the purpose of an assistant for all bank users to borrow the money or use their funds at any time of day and night without the need to contact or visit the bank.
Now the next step of this financial operations facilitation is DeFi. The idea of decentralized finance lies in the fact that you, as a lender, do not require a FinTech solution or an actual bank to approve your request for the transaction.
The prominent DeFi technology allows cutting the number of those bullet points to the minimum: all you need is to be a part of the system and directly lend the money from someone. Once you put out a request for a loan, the Etherum miners (algorithms) validate if your transaction is possible, and if yes, it simply gets added to the blockchain hence giving you the money right away.
It is also essential to remember that with banks much of the information remains hidden from the lender (fees, conditions, repayment rules, etc.). DeFi allows everyone involved to verify the blockchain behind the offer or a deal and ensure that there is nothing hidden on the sidelines. The system makes all financial operations transparent and open to anyone in need, will, or interest to do so.
Furthermore, remember about the fees you pay to banks for a loan. 3%, 12%, 35%, 300% for bad credit loans… The numbers are crazy and unaffordable for most borrowers. DeFi minimizes the fee paid by the borrower (less than 1%) making the loan as affordable as a can of Coca Cola. And this can become available to anyone and everywhere even if they don’t have access to the traditional banking infrastructure or the latter is blocked in their region/country.
Dapps definition and role in DeFi system
Before defining Dapps, one needs to understand the value of smart contracts in DeFi. The smart contracts concept is executed automatically when a particular set of conditions is met. And by improving and intertwining these basic conditioning rules, developers build apps to make use of these functionalities.
These are Dapps (decentralized apps). The word “decentralized” here means that there is no single server responsible for the development and running of an app. Moreover, while operating within the open DeFi system, the Dapps have open code that can be used and improved by any other developer. All needed to earn something here is the right idea.
To clarify how it is possible, let’s look at InstaDapp. Its developers took the basic DeFi functionality (access to protocols) and put it to a new level with better UX and UI. As a result, this Dapp promoted other Dapps and DeFi products while raising $2.4 million for expanding and improving the service. And while the app does not get into the best Dapps in 2020, it continues to hold its locked value high enough – at more than $100 million.
Dapps meaning and task for today is simple – redesign the technological world and simplify financial operations for anyone in need.
Key features of DeFi
Key features, in fact, are the main reasons why decentralized finance gains popularity around the world. Here are the top ones.
- Open-source of the DeFi makes its apps and source code available for any user. Anyone can check the code, validate a transaction, confirm security, and learn the capabilities. This makes them more trustworthy and reliable.
- Transparency of Dapps is obvious – they operate on the open-source code and public blockchains making every transaction open for verification and history confirmation. You need any info on the loan – you can get it at any time, no hidden rocks.
- The constant availability of DeFi is what unites all its users together. Whether you don’t have a bank account, it is 3 AM or you are in the middle of the hiking trip – with a smartphone and internet connection you can access the money and perform any financial action within seconds.
- Permissionless is what scares and yet attracts developers. Scares because a Dapp code can be reviewed and accessed by any blockchain developer but the possibility to build over an existing code for improvement is the idea that changes the world.
- Flexibility comes from permissionless, open-source, and constant availability features. Whatever one wants to do in DeFi, one can! Take someone’s code and redefine it, improve someone’s app, build an idea from scratch, improve the UI, integrate with others, and many more solutions. DeFi offers them all.
- Universal improvement by the community from every country makes DeFi an ever-changing and ever-developing structure. While banks stay within their boxes, regulations, and legislation, DeFi redefines the rules and brings them to a new level of comfort and peace of mind.
- Low fees for transactions if compared to traditional and even FinTech regulations. Forget about overpaying for a house 40% of the initial price, pay less than 1% in DeFi, and get your own place of dreams.
- Borderless finance gives access to financial operations even if they are prohibited in a particular part of the world or for a particular person. For example, a citizen of Syria cannot officially pay for anything in US dollars. Yet with DeFi, they can pay for a house in the US via some Dapp by simply having an internet-supplied phone. Or think of a political or economic refugee whose accounts are sealed by the government; DeFi allows them to live outside of the legislation borders (at least for now).
- Lack of currency implanting gives freedom to DeFi users. The traditional finance system makes its users operate within the currencies available in a particular country or jurisdiction. DeFi offers a number of cryptocurrency alternatives and does not make any user select any particular one.
- Peace of mind in terms of money storing and interest rates. ETH is a relatively stable cryptocurrency and it is much more reliable than many fiat currencies used by countries. For instance, while the Venezuelan crisis continues to improve, the inflation in the country was estimated at almost 40,000% in December 2019 while dropping to 2358.5% on July 2, 2020.
This means that should Venezuelans have stored their money within DeFi in cryptocurrency, they wouldn’t have lost pretty much everything in 2019, when the inflation hit its peak.
- The speed of operation with DeFi is much faster for any type of operation one performs. Whether it is a purchase, a loan, or lending – the protocols get verified almost instantly by the miners saving the peers a lot of time on the long-lasting verification and decision-making procedures of traditional banks.
- Passive income options with Dapps are enormous. There are Dapps like Compound and Dharma that offer high-interest “savings accounts” (around 4% monthly interest if compared to the bank’s 0.15% at most). Other apps allow you to invest some money for interest at the end of the month. When the time comes, there is a lottery and one of the investors takes everyone else’s interests altogether. The cool fact here is that the rest still gets their investment at the end of the month, so this is a 0% risk lottery.
Technical risks and threats of DeFi
As John Phillips put it: “Technology makes things faster and more cost-effective, but it's not perfect.” While multiple benefits of DeFi solutions seem to be thrilling, there is always more to it.
Unfortunately, even though these are the best minds of the development world who work with Dapps, a user needs to be even more attentive to the downsides and potential risks of this futuristic financial system.
- Multiple security weak spots in Dapps and DeFi in general occur from their definition – decentralization. Hackers can attack a single transaction in many places and it is hard to protect it from all scenarios. (One of the largest hacks in the history was from DAO when the company lost about $70 million).
- The data feed is centralized in DeFi. Blockchains use oracles to get access to data feeds and update their contracts based on this information. Whenever the information is true, it goes smoothly. But if the info is wrong (the flight was not canceled but just delayed), blockchain might update its data and issue all passengers a refund for the tickets causing the air-company huge losses.
- Risk should become your best friend and enemy with decentralized finance and apps. The risks with all DeFi crypto currencies are always high simply because a collapse situation is possible at any moment. Of course, fiat currencies have their falls as well but they have big governmental resources to stabilize, in the crypto world the decentralization took that single point of support away.
- Knowledge is yet another characteristic that might turn some people away. DeFi does require specialized knowledge from the users on obtaining and using cryptocurrency in a safe manner.
- Constant monitoring is a must for any financial matter. In DeFi one needs to always be on alert. This is related to the ever-changing governance rules for Dapps. For instance, procedural fees for MakerDAO jumped from zero to hero (less than 1% to more than 20%) which makes all the difference for the users. So constant monitoring of the market is a must for those willing to earn some money with DeFi.
- Admin keys also pose some concern in the community since de-facto they would guarantee that admins have access to the users’ tokens. The admin keys are essential to perform Dapp updates and for the out-of-ordinary cases, yet they do give access to your own access tokens.
- Centralization within decentralized finance is omnipresent and has no solution as of today. About 10% of all USDC is being stored within DeFi, and USDC is controlled by (a centralized) Coinbase. This means that if some government decides that the Maker crosses some laws, DAI gets undercollateralized and might lead to collapse like on March 14, 2020.
- Smaller loan amounts are a thing with DeFi. While anyone who has some collateral in DeFi can get a loan, its size would be smaller if compared to the FinTech offers on the table.
Is it worth risking?
Tim Swanson, director of research at Post Oak Labs, said: “In 2020, it will still be ill-defined and overhyped.” And this is true. There is still too small of a percentage of people who understand what is happening, who know what to do, and yet a big one gaining interest in using DeFi. Decentralized finance is now a buzzword and attracts thousands of people in the search for easy money.
Worth or not, DeFi is the future. And despite the threats listed above, even the critics (Vitalik Buterin) say that “Plenty of responsible DeFi projects have survived a long time without getting attacked. It’s definitely not an inherent property in DeFi itself, and there is a way to do it responsibly”.
Yes, there are risks, yes there are gains, and yes it develops fast. So if you doubt whether crypto world and DeFi solutions are your cup of tea, start small and buy very little of ETH to make a test drive.
The bottom line
DeFi is definitely a buzzword these days. Savvy participants of the world’s financial system found a way to improve the existing order of centralized control. They spread the responsibility for every financial operation among all users of the new system, giving them rights to verify any operation, and gain great profits on the financial market.
DeFi is new. DeFi is innovative. DeFi is promising.
The new system allows developers to build their own Dapps on top of the existing processes and earn on the minor yet essential process improvements. DeFi makes money accessible to anyone, anywhere, and at any time. This is a universal globally-available financial market that will revolutionize the way people borrow and lend money, earn on stocks, and conduct their finances in general.
It is true that the system has some drawbacks and holes in its security, however, considering that it is less than a decade old, the results genuinely impress. So there is much more to DeFi than just a buzzword; and it definitely is a major competitor to the old-fashioned FinTech solutions.