DeFi is the acronym for Decentralized Finance and is currently the fastest-growing sector in the blockchain ecosystem followed by NFT (Non-fungible token).
We have witnessed rapid growth in the DeFi space the past several years but still, not many people understand the importance of it and the associated risk that comes with all the juicy benefits.
I took an entire week off to delve deeper into DeFi so I can write this post as simple as I can for you to understand.
I condensed all my exciting findings – in simple layman terms – so you can understand DeFi a tad better without spending too much time researching yourself.
Without further ado, let’s get started…
What is DeFi?
DeFi is built around Decentralized Applications (dApps) that provide financial services on a public blockchain with no governing authority. It is a movement that allows users to access financial services such as borrowing, lending, trading without the need for centralized entities.
DeFi is NOT a single product or company but instead a set of products and services that acts as a replacement for institutions ranging from banking, insurance, bonds, and money markets.
Interesting fact #1: DeFi dApps are often called money LEGOs due to their composability.
With DeFi, you can do most of what a bank does, such as:
- Earning interest
- Buying insurance
- Trading derivatives
- Trading assets
Interesting fact #2: Some people refer to dApps as ‘Distributed Applications’ rather than ‘Decentralized Applications.’ You can call it either way.
The Importance of Banks
Banks have played a vital role in our financial industry for many centuries. Without banks, we will not have come this far.
Want to understand the importance of banks a little better?
Just imagine you just got married and you want to buy your first house with your spouse for $400,000.
All is good… except you cannot access a loan. Now that sucks, doesn’t it?
How long would it take to buy a house with your current paycheck?
Now that is the importance of banks…
Why Do We Need DeFi When We Already Have Banks?
“Don’t believe in kings believe in the kingdom.”
Chance the rapper
Banks are managed by humans… and humans, as we know, are not perfect.
Mismanagement, greed, and corruption are the three most devastating human-related risks based on our recent history.
The global financial crisis of 2008 exposed the shortcomings of the traditional financial system and warranted a need for a better system.
DeFi is the system… because we cannot afford another 2008.
Let’s explore the juicy parts now. Things are about to get very interesting so make sure you buckle up and have your stiff coffee ready…
What Are The Advantages of DeFi?
Because of blockchain technology and the advent of the internet, DeFi has 6 key advantages as compared to our banking system:
- Faster transaction
- Lower fees
- Immutability (Evergreen – the state of not changing)
- No human-related errors
To understand the benefits of DeFi a little deeper, let’s touch on 3 key segments that DeFi has an edge over traditional banking systems…
1. Remittance: The Payment and Clearance System
If you have ever tried to send money to your friends or family (or to a business) in another country, you will be familiar with the pain and struggle.
Remittances involving banks worldwide typically take several working days to complete and have all sorts of fees. Many times, we are not even aware of the fees until we are charged.
To make things worst, there may also be issues with documentation, compliance with anti-money laundering law, privacy concerns, and more.
Let’s say you are living in the United States and you would like to send US$2,000 to your friend’s account in Germany. There are three fees involved:
- The exchange rate from your bank in the United States
- The international wire outbound fee
- The international wire inbound fee
In addition to these fees, the money will take at least a few working days to arrive to the recipient’s bank depending on the location.
How DeFi Performs Better in Remittance Handling?
Firstly, DeFi allows you to bypass all the 3rd parties who are making huge profits from these transfers.
Secondly, with no intermediaries, there is absolutely no need for documentation or compliance whatsoever, therefore speeding up the entire process.
To put it simply, this is a ‘no-questions-asked’ transfer that has lower fees and faster transactions.
The transfer of cryptocurrencies, regardless of where you are in the world, takes mere seconds to a few minutes at most depending on a number of factors along with a small fee (less than US$0.50 per transaction on Cardano).
Let’s just say you receive your crypto in 20 minutes… this is still a far cry compared to traditional banks ‘few’ working days.
Transferring cryptocurrencies from Australia to Zimbabwe, Scotland to Brazil, Japan to Canada, all have the same fast transaction time and low fees.
2. Accessibility, Mass Inclusion, and Banking the Unbanked
If you are reading this, chances are, you are able to open a savings account with your bank at any time.
Nevertheless, there are many people in this world who do not have the same access to the most basic of savings account.
In 2017, The World Bank estimates that there are roughly 1.7 billion people who do have access to financial institutions or services.
Out of the 1.7 billion people who are unbanked, more than half are from developing nations.
These are 4 main reasons for unbanked:
- Geographical issues
- Corruption/trust issues
- Lengthy verification process
To access banking is difficult (or even impossible) in many countries but, fortunately, with DeFi DApps, we can make it much easier for everyone to have the same access to financial services.
All a person needs is a mobile phone and internet connection, as opposed to waiting through a verification process that takes forever.
DeFi protocols do not discriminate. DeFi seeks to push borderless, censorship-free, and easy-to-access financial services for all.
First, Let’s Connect the Unconnected…
The World Bank estimates that roughly two-thirds of the 1.7 billion unbanked have access to mobile phones… though I am not sure how many of them have internet access.
Having a mobile phone does NOT mean you have access to the internet. Make sense?
We can only bank the unbanked when we first connect the unconnected. Without reliable internet access, banking the unbanked is impossible.
This is where RealFi project such as World Mobile comes into play – to connect the unconnected (World Mobile’s mission) – and also the reason why Cardano’s IOHK has partnered with World Mobile – so they can focus on banking the unbanked (IOHK’s mission).
A topic for another day.
3. Transparency & The Danger of Centralization
Traditional financial institutions and banks are subjected to strict government laws and regulations… they have to play by the rules set by the authority.
Banks are, no doubt, one of the safest and most secure places to store our money even in today’s context.
Nevertheless, they have their flaws. Large ‘successful’ banks can still fail.
In 2008, we saw Lehman Brothers ($639 billion in assets) and Washington Mutual (over $188 billion in deposits) failed.
In the United States alone, at least 500 bank failures have been recorded.
Banks are one of the centralized points of failure in our financial system. The fall of Lehman Brothers led to the start of the 2008 global financial crisis.
If we look back at history, the centralization of power and funds in the hands of the wrong people, in this case, the banks can be incredibly dangerous and may result in another global financial catastrophe.
The Importance of Transparency
Ask yourself, as a citizen of your country, do you fully know what the financial institutions and big banks are doing?
Fret not! You are not alone. Regular investors of the institutions have no idea too.
Some of the events leading up to the 2008 global financial crisis included credit rating agencies giving AAA ratings (best and safest investments) to high-risk mortgage-backed securities.
That is why we need Transparency… And this is where DeFi comes into play…
DeFi protocols built on public blockchains are mostly open-sourced for audit and transparency purposes.
A true DeFi project such as Cardano has decentralized governing organisations to ensure that everyone knows what is happening and that no bad actors can single-handedly make bad decisions.
The Biggest Strength of DeFi
DeFi protocols are written in lines of codes, therefore, you cannot cheat the codes… it is meant to treat every user exactly the same without discrimination of any sort.
The codes run as per programmed and any flaws can be mitigated quickly as they are open for public scrutiny.
There are many advantages to DeFi but ultimately the biggest strength lies in cutting out intermediaries (3rd parties) and operate with zero censorship (full transparency).
The Purpose of DeFi
It is unfortunate that not everyone is privileged to be banked due to inaccessibility or regulatory uncertainties.
The DeFi movement is about bridging these gaps and making finance accessible to everyone without any form of censorship.
To put it simply…
The purpose of DeFi is to banked the unbanked by allowing users to access various financial instruments without any restriction on race, religion, age, nationality, or geography.
The heart of DeFi is about equality.
Conclusion: How Decentralized is DeFi Today?
With the rapid growth of DeFi, it would be impossible for me to cover everything in this post.
If you have read this far, perhaps there is a question lurking at the back of your mind: “All is good. But how Decentralized is DeFi?”
It is a fair question, but honestly, it is not an easy one to answer.
If we separate the degrees of decentralization into three categories:
- 100% decentralized
I would say that most DeFi dApps in the Ethereum network are currently sitting in the semi-decentralized category.
At the time of writing this, Cardano does not have any dApps yet.
If you wish to learn more about the further breakdown of decentralization, please read Kyle Kistner’s article. It was written in 2019… nevertheless, it still contains a lot of priceless information.
I truly believe the future of DeFi is going to be completely decentralized in Cardano’s ecosystem.
I put my money where my mouth is. I am an investor and holder of $ADA.
Thanks for reading.