Decentralised Finance is booming lately - but what is DeFi, how does it differ to traditional finance and what are some pros and cons?
DeFi are financial services with no central authority. It takes cryptocurrency's promise to make money and payments universally accessible– to anyone, no matter where they are in the world - a step further by offering a global, open alternative to every financial service you are using today, with only a smartphone and internet connection.
In layman's terms, it involves taking traditional elements of the financial system and replacing the middleman with a smart contract. We can also describe it as the merger between traditional banking services with blockchain technology.
Automated loans negotiated directly between two strangers in different parts of the world, without a bank in the middle, sounds futuristic. However, there are now DeFi dapps (decentralised apps) that allow you to create stable coins (cryptocurrency whose value is pegged to the US dollar), lend out money and earn interest on your crypto, take out a loan, exchange one asset for another, go long or short assets, and implement automated, advanced investment strategies.
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This article will be discussing an in-depth review of: the new digital DeFi services available; how these DeFi services are offered to the public and their potential advantages; and how these services are disrupting and changing the current centralised financial model with a focus on the use of Blockchain-based Smart Contracts.
Money lending, money borrowing, earning interest on money and insurance are all examples of what is offered by a centralized financial service to its customers. Centralized means that the sector is controlled by a central authority overseeing the operation of the business. Although these services have been available to the public for many decades (within western countries), they possess many inefficiencies and disadvantages. One of the most memorable events which brought the whole centralized financial service into question was the global financial crisis (GFC) between the periods of 2007 and 2009. From research gathered, there appears to be no one primary cause of the GFC.
Although it is widely accepted that the deregulation of the financial industry (which allowed banks mostly based in America to lend out funds to be used to buy real estate) was then used as a hedge fund to continue their profit growth. It was this lack of transparency within the centralized financial services whereby the financial governing bodies were then not made aware that property was being used as a hedge fund leading further to a real estate crash.
Other disadvantages of a centralised financial service can be described as:
Always the requirement for a third party to oversee any transaction of assets between two parties resulting in service fees being paid by the two parties.
Plagued with regulations that exclude many people from the financial system due to its stringent requirements e.g., you have to be an Australian citizen to hold an Australian bank account.
Is at risk of fraud or mismanagement of funds from lack of transparency. A third party holds sensitive information about their customers which can be exposed.
A custodian third party (a bank) is trusted with safeguarding their customer's financial assets.
Extended time to process customers transaction due to a third party having to examine all of the necessary terms and conditions within a contract.
Conventional Financial Contracts:
Conventional financial contracts are used to ensure that both Party A and Party B meet their terms and conditions within the contract before the final execution of that contract. The disadvantage of this however is that there is always the need to incorporate a trusted third party entity which then oversees and ensures that the terms and conditions are met by both parties.
Trusted Third Party Entities:
A conventional financial contract is always used when a large expensive asset such as real estate is to be brought or sold. The two parties are going to have to utilise the services of a third party such as an estate agent and a lawyer. It is the job of these third parties to oversee that the process complies with the local law and that the transaction takes place from Party A to Party B.
Currently, without the use of these third-party services a peer-to-peer transaction would immediately run into problems. One of those problems would be an issue of trust between Party A and Party B. Once the transaction has been executed, the third parties take their commission fee. This can be as high as 6% of the sale price of the asset which would then be passed on to Party A and Party B.
The acronym “DeFi” stands for “Decentralised Finance”. It came into existence in 2018 and its explanation is within the name itself. It is simply any form of financial service or a financial sector that provides a service to its customers in a decentralised way. This means that there is no one central entity or central authority controlling the financial service that is being offered and there is no need for any third-party service within the process.
DeFi is only made possible by utilising Blockchain technology. Because a Blockchain is a decentralised network allowing for the storage of digital data that cannot be deleted or modified, it allows this data to be viewed on an open-source platform. The advantage is that this transaction can be openly viewed between two parties, thus allowing a peer-to-peer method of transfer to take place. There is now no need for any third parties to be involved to oversee the transaction.
This is only possible because a DeFi service is used by customers in the form of a computer protocol or program using a blockchain as its underlying platform. Much the same way as Microsoft Windows is the operating system for a desktop personal computer (PC). Other software programs can be built and run on top of the existing operating system such as Microsoft Word or Microsoft Excel. The Android operating system for a smartphone (owned by Google) would be another example whereby third-party developers can build and run their applications on top of the Android operating system.
These comparisons can be used to describe a DeFi program explained again, it is simply a computer protocol or program operating on top of a blockchain platform that services its customer's financial needs. More specifically, a DeFi protocol can also be termed as a “smart contract”.
Before reviewing what exactly is a smart contract it must be noted that there are currently many different types of Blockchains available and still in development. Each of these Blockchains is being designed so that they can work and integrate within a given industry as each industry functions in its own unique manner. For example, there is now Blockchains in development to serve:
• The logistics and distribution industry; • The video streaming industry; and • The gaming industry.
It must also be noted that earlier blockchains are incapable of running smart contracts. They are now too basic and were never designed to run smart contracts. Think of this in terms of trying to run a high-performance video game on a PC built in the early 90s.
A smart contract is a digital automated agreement or terms and conditions that only execute when certain agreements within the contract have been met. Their main advantages and purposes are to:
• Remove the typical third party seen within conventional contracts so that the smart contract can be executed in a peer-to-peer fashion between Party A and Party B; and • To execute the transaction by minimizing the amount of trust required between Party A and Party B.
The Vending Machine:
A popular real-world comparison used is the vending machine example. This is whereby a customer inserts their funds into the machine with the intent of purchasing a soda drink, then the corresponding buttons are pressed and the selection of drink is made. The mechanical lever within the machine is activated and the soda drink is dispensed. The take-home point is that the transaction occurred without the need for third-party intervention, no cashier, clerk or governing body was needed and the transaction was peer to peer.
When in operation, the vending machine is following a set of rules (or algorithms) which it does not deviate away from. It is told (or programmed) to only dispensed the soda drink when the correct amount of funds has been inserted and only once these terms and conditions have been met then the drink can be dispensed (contract fully executed).
A vending machine can be seen as a physical device that executes a smart contract in the real world. By digitalizing this concept and running it on top of a Blockchain, a smart contract can offer many new advantages to the customer.
Advantages of DeFi:
The world bank estimates that 1.7 billion people are currently unbanked and have no access to financial services. DeFi services give the potential to open up the rest of the world to new financial services irrespective of their income, race, wealth, culture or geographic location. A new user only requires internet access.
Because smart contracts allow for the use of peer-to-peer methods of transfer, they can save both parties funds by not having to pay for third party services. The result is that these transactions are drastically faster than traditional methods. Now the sale of real estate that usually could take months to finalise can potentially just take a few days. This would in turn potentially speed up the process it takes to unlock this financial capital which for many people is their largest asset. The trust issues between the two parties are now minimized but unfortunately not completely eliminated just yet.
It can however be seen that:
Digital peer to peer transactions is now a reality;
Transactions are cheaper because the third party is no longer taking a commission fee from the transaction;
Faster transactions occur because no third party is required to oversee and sign off on the transaction; and
Because the smart contract is digital, it opens up new business opportunities to the world.
Disadvantages of DeFi:
Because DeFi is still such a new and emerging industry, many problems have already been reported such as:
A Blockchain being unstable would have a knock-on effect on the operating smart contract.
Scalability is a Blockchains ability to process transactions. If there is too much data traffic on the Blockchain then this will cause a slow down in transaction speeds.
The coding within a Smart Contract must be written without any errors or bugs what so ever. If a Smart Contract is in operation containing errors it could lead to the complete loss of funds.
Smart Contracts are and can have poor user interfaces, therefore making them confusing to use for the customer.
When evaluating the data gathered, the new DeFi industry can be seen as what Uber has done to the Taxi industry or what AirBNB has done to the hotel industry. It is a new transition away from the traditional financial services and giving way to customers having more freedom and options. Smart Contracts should save both parties a lot of time and money by not having to utilise third party services. The DeFi industry could open up a whole world to new financial services as only an internet connection is required.
DeFi is any form of financial service that services its customers in a decentralized way. A Smart Contract is simply a piece of code running on top of a blockchain that cannot be deleted or modified. It can be viewed by both parties simultaneously which brings trust and transparency to the transaction. It will only execute once certain terms and conditions within the contract have been met. No third parties are needed to oversee the Smart Contract as the coding within the contract already complies with local laws and terms and conditions are already set out.
Conventional financial contracts will most likely still be used for many years to come until the general public gains much-needed knowledge and better user interfaces are developed that makes a smart contract much easier to use by the average person.