October 17, 2022

DeFi, a Paradigm Shift in the Financial Industry

Only a few years ago, in 2018, developers and entrepreneurs were planning a revolutionary set of decentralised financial services using blockchain technology. Fast forward to today, DeFi (the name they settled on) is making huge changes across the planet.

DeFi, a Paradigm Shift in the Financial Industry

DeFi is banking the unbanked and taking a real shot at the traditional banking systems that have let us down and taken large chunks of our cash over the years.
Welcome to the new age, welcome to DeFi!

Key Takeaways

  • DeFi is an acronym for decentralised finance. DeFi products intend to provide financial services to those with no access to banking as well as making the financial industry fairer and more open to everyone.
  • DeFi products include; lending, borrowing, trading and saving.
  • There are many advantages to DeFi, but as with any new technology, that are things to be aware of as we discuss below.

What is DeFi?

Decentralised finance (DeFi) is a catch-all term used to describe blockchain-based financial services.

In the same way that you make use of your bank to manage your money, buy insurance or trade assets, DeFi platforms allow you to do the same.

However, because it all takes place on public blockchains, it is faster, there’s less red tape and perhaps most importantly, as it is a peer-to-peer system, no banker or broker is taking a large chunk of your cash!

DeFi is designed to be global and open to everyone, whether you are in Zurich or Zambia everyone can use DeFi services, especially useful for the millions of people around the world who do not have access to traditional finance institutions.

There are many other benefits and a few more cautionary things to consider.

In this article, we will be taking a deep dive into everything you need to know about DeFi, but first, let's explain a few of the key terms that we’ll come across.

  • Blockchain
  • In simple terms, a blockchain is a digital ledger of transactions performed on it which is recorded on all of the computers on that blockchain.
  • Peer-to-peer
  • Transactions that take place between two people, without the need for a centralised system (such as a bank or a broker).
  • Pseudonymous
  • There is no requirement to share personal details, such as your name, contact information or credit history.
  • Smart Contracts
  • Smart contracts are software programs that are stored on a blockchain that execute when certain conditions are met. Transactions performed using smart contracts are transparent, traceable and irreversible.
  • Governance
  • The very essence of DeFi, governance refers to the idea that no one entity controls a DeFi platform. Once a platform gains momentum, the initial organisation behind its inception removes itself from the equation, handing over decision making to the users of the platform.

How does DeFi work?

Users interact with DeFi platforms by using decentralised apps (dApps) which run on smart contract blockchains (Like Ethereum or Cardano). These dApps give users access to an ever-growing suite of products.

As they are decentralised, there is no middleman, meaning that for the most part anyone, anywhere can make use of these financial services.

Here are some examples of DeFi financial services:

  • Lending.
  • Lend out your crypto to other users to earn interest and rewards. This is possible because smart contracts handle the transactions.
  • Borrowing.
  • You can borrow money easily and quickly, often much cheaper than from a bank. You use you’re own crypto holdings as collateral.
  • Trading.
  • Unlike centralised exchanges, decentralised exchanges (DEXs) like Cardax, do not require you to hand over custody of your crypto holdings, often allowing you to trade directly with other users.
  • Saving.
  • There are huge benefits from saving crypto over cash in the bank, the interest you receive is often much higher than in a regular savings account.
  • Derivatives.
  • These platforms allow you to make long or short bets on certain assets (cryptos version stock options or futures contracts).

“DeFi is banking the unbanked and taking a real shot at the traditional banking systems that have let us down and taken large chunks of our cash over the years.”

Will DeFi Change the World?

Well, that’s the plan!

Back in 2018, when DeFi was just an idea, there were 1.7 billion adults globally who were without access to banking services, however, two-thirds of them had a mobile device.

This is a huge opportunity for change and several blockchains have made banking the unbanked a top priority, especially Cardano (they already have agreements for several African nation-states).

Will DeFi Replace Traditional Banks?

It isn’t just the unbanked that will benefit from DeFi though. Trust in the traditional banking system is, let’s say shaky, at best. Whether it’s huge bonuses, corruption or excessive fees (not to mention the global financial crisis of 2007-2008), people in all areas of society are looking for a better option.With the transparent, traceable and trusted nature of DeFi, it’s obvious that it is a huge improvement over traditional finance.

As with all mass change, it’s generational. Younger people are more likely to adopt new ideas than older generations. Also, the big players in the current financial sector are generally older (white) men.While they will do anything they can to hold on to their power, time is on our side.

With around US $100 billion total value locked in DeFi (at the time of writing) and with many more products being launched almost daily, across many blockchains, it’s hard not to presume it’s going away!

What are the Advantages and Disadvantages of DeFi?

Whilst the opportunities are huge and the benefits much more rewarding than traditional banking, it would be remiss of us not to mention any potential downsides, it is new tech after all!

Let’s start with the advantages.

Advantages of DeFi

  • DeFi is non-custodial.You don’t have to give up control of your assets, or as the common phrase goes “Your keys, your coins
  • Smart contracts eliminate human error and mismanagement. Provided the smart contracts are written diligently (as they are on Cardano), any transaction will take place without error.
  • DeFi is open 24hrs a day, 365 days a year. If you need financial services, you will always have quick and permanent access to them. Gone are the days of waiting in line at the bank or in a call centre queue.
  • There are no forms to fill in or ID to show. Just pick up your phone or open your laptop and you’re done, DeFi removes people slowing things down!
  • You don’t need to share personal information.Identity fraud…bye bye!!
  • Much higher interest rates than the bank for “savers”.Cardano for instance, give you around 5% APY when you stake your ADA (Cardano’s native token). Good luck getting that from your bank. Some DeFi products even pay much higher!
  • DeFi is transparent.While you don’t have to give personal information anyone can view transactions made on the blockchain. Banks and corporations definitely won’t show you what they’ve been up to with your money!

Disadvantages of DeFi

  • Security and stability of the underlying blockchain.If the Blockchain a DeFi product is built on, has bugs or security issues then the DeFi product itself may inherit them. In November 2021, risk management firm Elliptic estimated that DeFi users lost $12 billion to hacks and scams over the preceding two years. Most of these losses were on Ethereum but newer third-generation blockchains, especially Cardano, are much more securely built.
  • You are responsible for everything.Removing the middlemen puts the onus on you to keep your assets secure, do your own taxes (if applicable) and to recognise potential scams.
  • Insurance is rare.While traditional financial organisations are insured against something happening to your assets, insurance in DeFi is much less common (at present).

Disadvantages that DeFi has overcome already.

DeFi is still in its infancy but as adoption has increased, many downsides have already been overcome or are in the process of doing so.

  • Scalability.Third generation blockchains like Cardano are much easier to scale than older blockchains like Ethereum. Ethereum can handle around 15-45 transactions per second, leading to huge congestion and ballooning transaction fees (so much so that the blockchain is being completely rebuilt (from proof of work to proof of stake). Cardano was designed with scalability in mind and with upgrades being launched soon, could be able to handle millions of transactions per second (Hydra).
  • Interoperability between blockchains.Up until recently, different blockchains only had very limited ability to interact with each other. Recent solutions include “bridges” between blockchains and “converters”, allowing you to convert your native tokens from one blockchain to those of another.

Will DeFi be Regulated?

Currently, there are no regulatory frameworks that pertain to DeFi. The only regulations apply only to traditional finance and given that DeFi is, well, DeFi, applying those regulations would be like trying to put a round peg in a square hole!

What this does mean though that the very same custodians of traditional finance that we mentioned earlier, are taking a very close look at DeFi.

One of the main concerns that regulators have is projects that market themselves as decentralised, when in fact they are not (or not as decentralised as they should be). In its purest form, no DeFi platform should be controlled by a very small minority of individuals.

In September 2020, the founder of a Uniswap offshoot; Sushiswap, almost collapsed the entire fledgling DeFi space.

When Sushiswap was first launched, its native token price rose quickly to nearly US$16. At this point, the founder (known as chef Nomi), cashed out and removed his liquidity (majority holding in the project), plunging the token price by more than 50%.

There will always be bad apples in any industry so, to prevent things like this from happening in Defi, there does need to be some protection and auditing of initial product developers.

Final Thoughts

There is no doubt that DeFi could bring much needed financial products to those who don’t have access to them and offer everyone a much-needed shake-up of how the financial industry works.

However, it is still in its very early days; there will be bumps in the road and challenges to overcome (as in any new industry) but as long as you do your own research, DeFi will grow and be a huge benefit to anyone who uses it.

The future of finances is now! We are glad to have you along for the ride.

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