DeFi, crypto, and the future of money
Somewhere down the road, there could be a time when people will be telling their children stories of how they used to make payments in ‘cash’. It may not resonate with the kids, as all they will know about are digital currencies and associated practices. It might sound like an exaggeration today, but the fact remains that the use of cash has been on the decline for quite a while now, with the pandemic further edging it out of the transaction ecosystem. While it is digital wallets that are taking the place of cash and credit cards, in the coming years, it could be digital currencies.
The growing interest in cryptocurrency
In a short period of time, cryptocurrencies have grown from a digital novelty to a trillion-dollar industry and are all set to disrupt the global financial system. As per a market research and data analytics report by YouGov, 67% of UAE residents are now interested in trading with cryptocurrencies. That’s a large number of people, signalling the impending explosion in the use of digital, blockchain-powered currencies.
Cryptocurrencies are transacted on decentralized computer networks between users of virtual wallets. Transactions using cryptocurrency are recorded on blockchains, which are tamper-proof ledgers. Blockchains do not record the real names or physical addresses of the users; instead, they focus on transfers between digital wallets. Thus, they provide total anonymity to users. The open-source framework prevents the currency from being duplicated while eliminating the need for a bank to validate transactions. It enables users to send and receive money to anyone and anywhere in the world without a centralised intermediary.
The most popular cryptocurrency, Bitcoin, created in 2009, has a total value of almost $1 trillion, with Ethereum, the second-most popular one, launched in 2015, being close behind. Numerous others have come to the fore in recent years.
Crypto to DeFi and smart contracts
Cryptocurrencies and blockchain technology have given rise to a new financial term: Decentralized finance, or DeFi. It is a relatively new idea in the fintech world, but has been gaining traction rapidly over the past year or so. Since DeFi uses blockchain, several entities can hold a copy of transactions, ensuring that nothing is controlled by a single source. As the name suggests, transactions are decentralized.
Rising to prominence in 2020, DeFi is a bottom-up instrument that replaces human involvement with math-based processes, paperwork with smart contracts, and legal enforcement with cryptographic enforcement. Open-source code and public ledger take the place of a third-party audit. DeFi eliminates intermediaries by enabling people and businesses to conduct financial transactions through blockchain technology.
Thanks to DeFi, people can securely lend, borrow, and trade using software that records and verifies financial actions in distributed databases, which are accessible irrespective of geography. Data is collected and aggregated from all users, and a consensual mechanism is used to verify it. As a result, DeFi eliminates centralized finance models, enabling anyone in the world to access financial services anywhere in the world. It gives users more control over their money through personal wallets and trading services. It has been estimated that DeFi is ten times better, faster, and cheaper compared to conventional financial services.
The use of smart contracts has grown side by side with DeFi, with the two being associated applications of blockchain. Several cryptocurrencies and decentralized applications (DApps) use the smart contract code in order to function. Just as the users of centralized financial institutions, like banks, rely on intermediaries to make transactions, DApps use smart contracts to ensure that each transaction is legitimate, transparent, and safe. Smart contracts ensure that all parties concerned are fulfilling their end of the agreement.
For users of DeFi, a smart contract is an automatic and self-executing agreement, which operates without the need of a central authority, or a third party that demands a commission. Smart contracts maintain transparency and visibility on the blockchain. They eliminate tedious paperwork and do away with intermediaries that are required to facilitate contracts, transactions, and exchanges. A smart contract works by creating a digital agreement, wherein each party inputs a number of predetermined conditions or provisions that must be completed in order for the contract to be executed — all without a middleman.
The real value of smart contracts is in their wide-ranging use cases, from payments (in cryptocurrency or fiat) and supply chains to more complex DeFi applications, including the lending protocol, derivatives, decentralized exchanges, insurance, and transfer of digital assets, and so forth.
Traditional vs modern financial transaction methods
The rationale behind the decentralized financial system is to give financial control to individuals, by circumventing the traditional centralized systems. The legacy systems limit the speed, flexibility, and transparency of transactions, giving users less direct control over their money. DeFi, on the other hand, offers speedy and secure transactions. Besides, in the traditional system, large transaction throughput always requires several visits to the bank and a load of paperwork.
Ever since DeFi took off, blockchain networks have been streamlining the process of borrowing and lending. In the traditional system, obtaining loans often take a lot of time. The banks have to do a lot of investigation and finalizing of the collateral before disbursing the loan. But in the world of DeFi, such processes are pretty simple. The only thing needed is collateral, which could simply be another crypto asset. DeFi completely does away with intermediaries in the lending and borrowing process. One does not need to approach intermediaries like banks to get loans; one can get them directly from a lender.
Cross communication and the ability to exchange assets are other distinct advantages that DeFi offers over the traditional method. The traditional financial models provided only limited interoperability. For instance, tools like Swift connect one banking institution to another. But DeFi offers unlimited interoperability across blockchain networks, and even between two different financial worlds: Crypto and traditional.
Moreover, DeFi scores big time over the traditional system in terms of honesty and trust. Fraudulent activities have been a major problem in the traditional financial system. One of the reasons behind the 2008 financial crisis was the corruption in banking institutions. DeFi offers far greater honesty, transparency, and trust as its applications are based on blockchains. All transactions are public and permanent for immediate and future review, as just about anyone can view and audit blockchain and DeFi data.
DeFi is far more accessible than the institutions operating in the traditional financial system. In the DeFi space, there is no need for third-party approvals. The network works 24/7, enabling users to make transactions whenever they want. And unlike traditional financial institutions, DeFi allows users to remain in the custody of their financial assets.
DeFi: The future of financial transactions?
While it is of recent vintage, DeFi’s growth has been powered by several structural factors. It is evolving and expanding swiftly with the rise in decentralised exchanges and the lending and borrowing of different asset types and insurance products. In fact, DeFi is mirroring the growth of the traditional financial services ecosystem fairly quickly and very efficiently.
Such a growth rate is likely to have an impact on the future of centralised finance. Already, it is being hailed as an alternative that is cheaper, quicker, and safer. For its proponents, it is the ultimate, unbiased, trust-based option compared to legacy financial instruments. Based on data and sheer volumes, one can safely conclude that DeFi is not only here to stay but also set to find mainstream adoption.