Even amid a crashing financial market, DeFi remains one of the hottest topics in the crypto space. What’s it all about? Why is it so important in today’s global economy? And does it differ from financial technologies (FinTech)? These are the things we look at in this episode of CoinFalcon Learn.
Image source: Shutterstock
What is Decentralized Finance?
DeFi (also called open finance), is simply a blanket term for financial services and instruments that are built using decentralized infrastructure, such as blockchains and smart contracts, and would be completely out of the hands of governments’ and companies’ control.
To better understand DeFi, it’s important to first take a look at our traditional financial system. Central authorities of each country issue the regular currency to drive their respective economies. This means the power to regulate the printing and circulation of such currencies in the market rests in their hands. That constitutes a lot of trust on our part.
We must trust our government to not print more money overnight for the sake of doing so. We must trust commercial banks to safely store our money, and we must even trust a financial management company to handle our monetary investments. And yet, we have very little say in how corporations handle these monies, let alone being able to influence how our governments manage the economy. The problem here is that since this level of control is centralized, the biggest risk is also at the center.
Drawbacks of our Centralized Financial Systems
What if central banks decide to print more money to tackle some form of crisis and it backfires? This has been known to happen with the Venezuelan and Zimbabwean governments who through their poor monetary policies, which included printing massive amounts of money – resulted in the world’s top two leading cases of hyperinflation.
What about the money in your bank account? Commercial banks and other financial institutions use that money to invest in various markets and gain massive profits. And yet they give us such miserly interest rate returns, many even below 1%. What’s worse, these same banks turn around and give us exorbitant interest rates when we’re applying for loans, some over 15%. There’s also the fact that since we basically have no say in how these organizations invest our money, there’s always the potential for a lack of transparency.
For several years now, inflation rates have been way higher than banks savings account rates across the world. So if the interest rate on your bank account is not growing at least at the same pace with the inflation rate in your country, then you’re actually losing money. There’s even the case of negative interest rates, which refers to a system where banking institutions charge a fee for storing your money with them instead of giving you interest income on your cash deposits. Several countries, including Germany, Denmark and Switzerland have implemented negative rate policies.
These are just some of the issues the world is facing today because of the centralization of the financial system that runs the global economy.
In response to these issues, decentralized finance ushers in a different era. DeFi is about creating a financial system that is open to everyone and slashes our need to trust and rely on central authorities for the regulation and circulation of our monetary assets. Cryptography and blockchain technology have provided us with the tools to collectively build and maintain a financial system without involving central banks and other legacy financial organizations. More importantly, with decentralization, we can eliminate the burden of having to establish trust because we can simply verify for ourselves every transaction occurring on the blockchain.
Bitcoin and Ethereum are the original applications in the DeFi space. Instead of central authorities, they are both controlled by large networks of computers spread across the globe. Bitcoin’s fixed supply means it will only gain more value over time which is a stark opposite of today’s inflationary economic model. Ethereum, on the other hand, has been instrumental in the rise of smart contracts, which have served as the foundation for many of today’s DeFi services.
The value of crypto assets locked in DeFi smart contracts rose from $4 to $634.5 million between 2017 to 2019 | Chart Source: DeFi Pulse
Smart, self-executing contracts essentially allow for the elimination of middlemen. Without middlemen in the financial system, you can apply for a loan and receive it almost instantly without having to wait for bank approval, earn real interest on your assets, and make payments to anyone in the world with low, sometimes even zero fees.
Newer applications are arising and gaining popularity in the DeFi conversation. For instance, there’s the DAI stablecoin, a digital token whose value is pegged to the U.S. dollar and is designed to be a global currency without any influence by central banks. This makes it a lot less volatile compared to Bitcoin and makes it a more practical mode of payment for everyday purchases. Another example is Compound, a crypto version of a money market fund that also lets users earn interest income.
Benefits of DeFi
In addition to eliminating middlemen, there’s many other reasons why a decentralized financial system would be a welcome addition to our global economy. These include:
No entry barrier
Perhaps you’ve heard of the term Permissionless Finance, which essentially means that anyone can participate in and enjoy access to financial services. The World Bank states that around 1.7 billion people don’t have access to a bank or mobile money account. This represents about a little more than 1 out of 5 people in the world. There’s a number of different reasons for this, but one key consideration is that most of these individuals are unbanked because they are not able to acquire certain items that others often take for granted like IDs, proof of billing documents, credit scores, etc, all of which are necessary to open a bank account, take out a loan or apply for credit products.
With DeFi, however, you don’t need these items to access some form of financial service. For instance, MakerDAO. the most popular DeFi application allows anyone to obtain a loan using their ETH tokens as collateral.
Access to alternative capital forms
With DeFi, you’re not obligated to accept capital in only the forms approved and imposed by central authorities. Consider, for instance, the case of Argentina in which its central bank was forced to impose yet another capital controls on all residents back in October 2019 in order to protect the Argentine peso from further decline. The measure effects a new limit of $200 per month for Argentine citizens looking to buy U.S. dollars and $100 per month for non citizens and legal residents.
The value of the Argentine Peso against the U.S. Dollar experienced a steep decline over the years | Source: Forbes
A decentralized financial system offers a practical alternative. For one, people under capital controls could use DAI to store their wealth without any restrictions on how much to buy in a month. Since DAI is meant to mirror the U.S. Dollar, it’s basically the same purchase but in a different form of capital.
Stay in control of your finances
DeFi Dapps let you remain in control of your finances. Yes you’ll have to deposit your crypto but there’s no one on the other side manipulating your money. The lines of code that make up smart contracts are immutable and automatically execute the terms of the agreement without human intervention. This means you get paid interest on your deposit when due, there are no unscrupulous charges snuck in and no chances of some bureaucrat freezing your account or taking your money just because they can.
This may not seem like a big deal for many people, but consider the case of Cyprus, a previously wealthy European country that was hit with a debilitating banking crisis in 2012. By 2013, the government needed to intervene. Their method — seize around 6.75% to 10% of its citizens’ bank deposits in order to bail out the banks.
In 2013, Bank of Cyprus seized 47.5% of depositor savings exceeding 100,000 euros | Image source: sigmalive.com
With DeFi, you don’t have to worry about this kind of scenario since you fully understand the terms of the contract you’re getting into and are assured that only the terms of said contract will be enforced — no more, no less.
Open finance without borders
Cryptocurrencies like BTC, LTC and XRP are already borderless, but DeFi takes it up a notch by adding other financial services like open lending and borrowing. In today’s legacy financial system, borrowing money from a bank means long wait times for approvals, high fees, complicated arbitrations and a whole of other hurdles. Plus the chances of getting a loan from a bank outside your home country are pretty much nonexistent, especially for those without the right connections. With DeFi, however, you could borrow money from anywhere in the world and make payments to suppliers, creditors, employees, or otherwise grow your business simply with your ETH or some other crypto asset collateral. This feature alone has the potential to revolutionize business as we know it all over the world.
Create your own DeFi project easily
As previously mentioned, most DeFi apps are built on the Ethereum blockchain, which offers open-source protocols. This simply means that if you have access to the internet and know your way around coding your own smart contracts or projects, you can easily get into the DeFi space. In this way, DeFi isn’t just to users but its creators as well.
These are just some of the many benefits to be gained from a decentralized financial system. Of course, DeFi is not without its limitations and potential drawbacks (we’ll discuss those in part two of this series). But if you really think about it, DeFi really is a game changer and the more its use cases evolve, the more it will grow.
DeFi vs. Fintech
Image Source: cashwagon.id
If you think about it, DeFi does sound similar to Fintech since they both aim to use technology to improve financial services. The fundamental difference between these two is that Fintech builds upon traditional financial infrastructure for its projects and services, while DeFi utilizes new technologies like the blockchain to replace the existing financial system.
Some good examples of Fintech companies today are PayPal and Transferwise. They facilitate international payments across the globe, but still use bank accounts and other legacy financial systems to get it done. This means that even though their fees are minimal compared to doing international money transfers from one bank in your country to another bank in say Brazil, you still have to trust them to approve and clear the transaction, among other things. The recipient also needs to provide relevant documentation like IDs in order to get the payment. There’s also a number of blacklisted countries that PayPal and many other Fintech companies do not provide their services to, so people in those countries are at the mercy of whatever traditional financial infrastructure is available to them.
Now compare that with DeFi projects which allows access to everyone and removes the need to establish trust in the company handling your transaction. The transfer time is also a lot faster, some done in a matter of seconds, instead of waiting a couple of business days to access your funds, as with traditional financial infrastructure.
In the part two of this series, we’ll cover the limitations of DeFi as well as some of the most exciting DeFi projects available today. If you’re looking to get into the DeFi space, CoinFalcon offers the best way to buy the crypto assets that you need to get started. Buy ETH, BTC, and other digital assets with your credit card or through bank transfers. Open your CoinFalcon account today and get the future of money in your hands.