Decentralized Finance (DeFi) in 2021 and its future trajectory
Decentralized finance (DeFi) is a blockchain-based form of finance that does not lean on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead promotes smart contracts on blockchains, the most common being Ethereum. A surge of interest in decentralised finance is leading the market to question whether this is a bubble ready to burst, or whether it can overcome its growing pains to become a sustainable alternative to services offered by traditional centralised finance.
Decentralized Finance will change your understanding of Financial Systems
This DeFi-CeFi hybrid is already happening amongst real organisations within the regulated financial system, many of them utilising enterprise-grade blockchain technology as their starting point. It provides the level of access and decentralisation people want, and the new services and innovation they desire, but in step with the regulated world and institutions within it.
DeFi platforms let people lend or borrow funds from others, invest on price movements on a range of assets using derivatives, trade cryptocurrencies, guarantee against risks, and earn interest in savings-like accounts. Some DeFi applications promote high interest rates but are subject to high risk. DeFi is part of the larger decentralization movement fostering transparency, open-access and non-custodial global financial products. Decentralized finance is spread out across blockchains like Ethereum and Binance Smart Chain, and within each blockchain is an ecosystem of binned financial protocols. While these individual protocols offer great returns on lending your crypto, part of the appeal of DeFi is swapping, selling and trading crypto at the best rates, which can be challenging when financial information is spread across multiple protocols.
The Sudden Rise of DeFi: Opportunities and Risks for Financial Services
The detractors will claim that the financial services sector has already invested $1.7bn in blockchain (according to Greenwich Associates). And yet beyond the volatile world of bitcoin, it has had very little impact. Furthermore, regulation is desperately required and there are low levels of liquidity resulting in low utilisation amongst established enterprises. But challenges in traditional finance must also be considered in the context of socio-economic development. As it stands, centralised finance (CeFi) encourages financial institutions with larger balance sheets to pursue conglomeration and increase shareholder value through rent-seeking behaviour. But the next wave of demand for capital and financial services will stem from emerging economies and an SME industry underserved by traditional finance.
IS CENTRALISED FINANCE STIFLING GROWTH?
The importance of SMEs to the European economy cannot be underestimated. The most recent research from the European Parliament, highlighted how 24 million SMEs generated more than €7 trillion to the EU economy. A centralised system exacerbates the issue with “Know Your Customer” (KYC) and “Anti-Money Laundering” (AML) protocols necessary to open up an account, because individuals in developing economies don’t hold a birth certificate or passport. The World Bank believes this represents a $380bn opportunity.
DEFI AS AN ALTERNATIVE?
Decentralised finance, or DeFi, aims to give users an alternative by removing the need to trust centralised parties and opening its doors to the world. This is achieved by building digital services in an open, permissionless, and decentralised manner.
By removing the intermediary and automating many functions, DeFi can provide lower costs, higher degrees of security and privacy, resist censorship, increase accessibility and promote a decision-making democracy. The ability to borrow funds, take out loans, deposit funds into a savings account, or trade complex financial products, all without asking anyone for permission, is gaining traction.
However, the overcollateralization required for borrowers to access DeFi loans makes it impractical for these groups, unless they are already crypto owners. Additionally, many DeFi protocols require a certain level of knowledge to use safely, without which users can be inadvertently exposed to risks.
THE STRUCTURE OF DEFI
DeFi refers to financial services that are built on public blockchains and based on open protocols and decentralised applications (dApps), allowing all aspects of the platform to be automated and performed without a central authority or intermediary. Conversely, traditional finance relies on intermediaries and centralised institutions. Although many cryptocurrencies such as Bitcoin and Ethereum are decentralised and have no intermediaries, the tokens themselves are not inherently a financial service or platform. DeFi only refers to financial services built on programmable blockchains.
CHARACTERISTICS OF DEFI
Decentralisation in DeFi is built upon multiple layers.
- Permissionless and Borderless.
- Autonomous and Self-sustaining.
- Open Source and Transparent.
- Low Overhead.
- Composable and Modular.
THE GROWING PAINS
There is no denying that flaws exist in the world of DeFi, and if it’s to be accepted beyond the fringes of financial society, there are 6 critical improvements crucial for its future growth and adoption.
The Convergence Of CeFi And DeFi: The Banks’ Big Opportunity
How payments are made between individuals and institutions has evolved over time, especially since the advent of digital devices. Consequently, several mechanisms were created to support each payment instrument, resulting in different fee structures depending on the number of intermediaries, a transaction’s value and the network requirements. Today, payment cards still dominate the facilitation of transactions. In 2019, the global payment volumes attributed to payment cards and mobile wallets amounted to 52.55%, which is expected to rise in the coming year to reach 65%+, driven by the adoption of mobile wallets10. Despite positive forecasting, card infrastructure is not very well established in emerging economies across APAC, LATAM, and Africa, where there is also a high percentage of unbanked consumers. In addition, a growing concern around card fraud has negatively impacted the growth of payment cards used for e-commerce. More globally, the process to clear a transaction can be anything up to 3 days, which impacts on a merchant’s working capital. And the average credit card processing cost for a retail business is 1.90%-2.15% and 2.30%-2.50% online. The merchant also bears the risk of chargebacks for up to 90-120 days and the cost. Conversely, cryptocurrency transfers can be done trustlessly with payment networks that are able to reduce the delay in transactions by conducting off-chain transactions with a probabilistic finality.
Finally, decentralised payment tools are designed to facilitate invoicing and payments between merchants and customers, which can mitigate against chargebacks. Consequently, it is likely that the switch from centralised and traditional payments to a crypto system will come from merchants, who can release capital that would have been otherwise tied up in a centralised processing system.
Comparison of fees between centralised credit cards and DeFi
Litecoin merchants save on credit card fees that can range from 0.5% to 5% (plus a flat fee on each transaction made), but the usage of blockchain payment solutions is subject to network fees which can greatly fluctuate depending on the protocol (e.g. LTC vs BTC vs ETH vs BCH) and the congestion of the network. As opposed to a percentage-based fee, blockchain network fees are fixed at any given moment and do not increase with transaction size (ranging typically from $0.02-2). Hence, blockchain payments solutions greatly favour large-value payments.
The current status-quo in a centralised environment is to set fixed rates and earn the difference. For example, if the interest rate for investors is set at 4%, and 10% for borrowers, a bank absorbs 6%. Except banks set their own rates and earn the difference. Conversely, crypto lending proposes a dynamic rate model, where the borrowing rates fluctuate according to a network’s utilisation of lender capital. For example, a market with $10,000 pooled by lenders and $100 requested by borrowers should have a lending interest rate lower than a market with $10,000 pooled by lenders and $1,000 requested by borrowers. The model allows borrowers to pay less when there is less borrowing demand, and for lenders to receive higher rates when demand is high. Furthermore, since crypto lending currently occurs on a collateralized basis, there is no need for credit checks or KYC processes – smart contracts 20-30% in CeFi. In the case of Compound’s DAI market, only around 0.2% of the outstanding borrow amount is kept by the protocol to incentivise governance token holders to perform governance functions, versus overwhelmingly higher fractions in CeFi. The value extracted by banks in traditional lending significantly outpaces the level seen in DeFi lending protocols because banks incur significant labour costs for their operations, and they are able to extract higher economic rents due to their central position. Conversely, the lending protocols in decentralised finance have minimal ongoing costs that are there to compensate governance token holders for carrying out their functions. In the case of Compound’s DAI market, only around 0.2% of the outstanding borrow amount is kept by the protocol to incentivize governance token holders to perform governance functions, versus overwhelmingly higher fractions in CeFi. The value extracted by banks in traditional lending significantly outpaces the level seen in DeFi lending protocols. The main reason for this is that banks incur significant labour costs for its operations and they are able to extract higher economic rents due to their central position, while decentralized lending protocols have minimal ongoing costs, with the only cost being to compensate governance token holders for carrying out their functions.
In a traditional exchange value chain, commissions for trades charged by brokers typically fall in the 0.2-0.3% range, before slippage is taken into consideration. This 0.2-0.3% commission encapsulates depository and custodian fees. Slippage varies per stock, and ranges from 0.03% to 3% of the price, depending on the liquidity available and the level of competition between market makers for the stock. Unlike centralised exchanges, decentralised exchanges (DEX) perform transactions in a peer-to-peer manner via smart contracts. This allows users to trade without relying on a third party for clearing, settlement, or order matching, eliminating another layer of fees. DEXs can also do this without any account opening processes. DEXs typically pool liquidity from users in a decentralised manner. This allows traders to deal against pools of liquidity supplied by market makers, eliminating the need for an order book. Token swappers further enable anybody to provide liquidity, which differentiates it from centralised exchanges, where the act of market making is limited to a select group of sophisticated players. Decentralised order book exchanges also exist, and their fee structures are similar to that of token swapper DEXs. With decentralised exchanges, there are typically three types of cost borne by users; trading fees (like commission), slippage, and network fees. Trading fees for DEXs range from 0.04% to 0.3% (in addition to network fees that run the smart contracts). Since network fees are a fixed amount and do not depend on the size of the transaction, larger trades will see reduced fees as a percentage of trade volume. And although network fees for decentralised exchanges can be significant during times of network congestion, as blockchain scalability improves over time these costs will become negligible.
PROS AND CONS OF DECENTRALISED GOVERNANCE
- Reduces the risk of fraud, mismanagement, and security breaches
- Allows stakeholders to control every single element of the protocol, from high-level design to the smallest details
- Fosters an active and vibrant community of stakeholders
- Slow at making big design changes
- Requires protocol to first reach a mature stage of development
If you do not understand I would suggest watching the video.
Flexa - a payment network that enables merchants to accept digital currencies without the risk of fraud or volatility through off-chain collateralization.
LotPayments - a payment network that enables merchants to accept digital currencies without the risk of fraud or volatility through off-chain collateralization.
A comparison with DeFi and SeFi
You hold your money.
Your money is held by companies.
You control where your money goes and how it's spent.
You have to trust companies not to mismanage your money, like lend to risky borrowers.
Transfers of funds happen in minutes.
Payments can take days due to manual processes.
Transaction activity is pseudonymous.
Financial activity is tightly coupled with your identity.
DeFi is open to anyone.
You must apply to use financial services.
The markets are always open.
Markets close because employees need breaks.
It's built on transparency – anyone can look at a product's data and inspect how the system works.
Financial institutions are closed books: you can't ask to see their loan history, a record of their managed assets, and so on.
How does DeFi work?
DeFi uses cryptocurrencies and smart contracts to provide services that don't need intermediaries. In today's financial world, financial institutions act as guarantors of transactions. This gives these institutions immense power because your money flows through them. Plus billions of people around the world can't even access a bank account.
Ethereum and DeFi
Ethereum is the perfect foundation for DeFi for a number of reasons:
- No one owns Ethereum or the smart contracts that live on it – this gives everyone an opportunity to use DeFi. This also means no one can change the rules on you.
- DeFi products all speak the same language behind the scenes: Ethereum. This means many of the products work together seamlessly. You can lend tokens on one platform and exchange the interest-bearing token in a different market on an entirely different application. This is like being able to cash loyalty points in at your bank.
- Tokens and cryptocurrency are built into Ethereum, a shared ledger – keeping track of transactions and ownership is kinda Ethereum's thing.
- Ethereum allows complete financial freedom – most products will never take custody of your funds, leaving you in control.
You can think of DeFi in layers:
- The blockchain – Ethereum contains the transaction history and state of accounts.
- The assets – ETH and the other tokens (currencies).
- The protocols – smart contracts that provide the functionality, for example a service that allows for decentralized lending of assets.
- The applications – the products we use to manage and access the protocols.
Decentralized Finance is generally broken up into the following categories:
- Asset Exchange
- Credit Scoring
- Stable Coins
- Smart Securities
- Prediction Markets
- Open Source Banking Applications
Blockchain based financial services are superior to their centralized counterparts across the following primary features:
- Permissionless: An internet connection is all you need to access these services
- Censorship Resistance: No central party is able to reverse the order of transactions and turn off the service
- Trustless: Users don't have to trust a central party to ensure that transactions are valid
- Transparent: Public blockchains like Ethereum are completely transparent and auditable
- Programmable: Developers can create and intertwine financial services at a very low cost
- Efficiency: Open financial services are powered by code, not humans, and as such entail much lower middleman costs, if at all
Ethereum is an ideal platform for crowdfunding:
- Potential funders can come from anywhere – Ethereum and its tokens are open to anybody, anywhere in the world.
- It's transparent so fundraisers can prove how much money has been raised. You can even trace how funds are being spent later down the line.
- Fundraisers can set up automatic refunds if, for example, there is a specific deadline and minimum amount that isn't met.