What is DeFi?
DeFi (Decentralized Finance) refers to a collection of financial products and services that are built on top of blockchain networks. It is a brand-new monetary system that is being developed into an open and global financial system, as an alternative to the current traditional banking system. Its purpose is to create an open-source, permissionless, decentralized financial system that is accessible to everyone and eliminates the role of a central authority.
DeFi does not rely on central financial intermediaries like brokerages, exchanges, or banks. Instead, it uses smart contracts, which are self-executing contracts that come to fruition when specific conditions are met. In addition to this, DeFi allows for a peer-to-peer (P2P) system where users would maintain full control over their assets through DApps (Decentralized Apps).
An interesting aspect of DeFi is the ability to stack DApps together to maximize returns. DeFi protocols are modular, which means it opens up the possibility for protocols or DApps to be mixed and matched to unlock unique combos. Anyone can create, adapt, mix, link or build on an existing DeFi product without permission. This modular approach has given DeFi another name, Lego Money.
The potential use cases for DeFi include borrowing and lending money, trading cryptocurrencies in Decentralized Exchanges (DEX), earning returns through yield farming and liquidity mining, issuance of stablecoins, mortgages, and insurance.
Disruption to Banks
Decentralized finance is still in its infancy and has a long way to go. But the sector is evolving fast and gaining popularity and has already started to cause disruptions to the traditional banking and finance sector. DeFi, a sector that had a market cap of a few millions in 2017 is now rumoured to have a total market capitalization of at least $100 billion.
Today, the majority of the DeFi applications are built on Ethereum. But recently, more smart contract platforms like Cardano and Polkadot are gaining traction. And the number of DApps being built on different platforms is expected to explode. This has the potential to cause major changes in the banking and finance sector.
One of the main benefits of DeFi over banks is the easy access to financial services. Platforms like Cardano are being built with a focus on delivering robust financial services to the unbanked and underbanked. This could change the way we bank and interact with other assets. And an entirely new class of financial instruments may be introduced as the sector evolves.
DeFi Vs Banks: The Difference
One of the headline differences between DeFi and centralized banks is the potential returns on capital or savings that users can expect. While some of the banks provide interest rates as low as 0.1%, the average rate of return remains around 1-3% in the US. This is in stark contrast to returns that a DeFi investor can earn. While a lot of the DeFi protocols offer a return of around 6-8%, some offer even more. And the modular nature of DApps provides opportunities to earn even higher returns. From the perspective of financial returns, DeFi is far ahead of the banking and financial sector.
Another major factor that is propelling DeFi ahead of the banking sector is its culture of innovation. While the banking sector is notoriously slow to adapt, DeFi is far ahead by introducing new protocols, DApps and other innovative features. This is not to say that banks haven’t delivered any major innovations. In the past few decades, banks have managed to add several value-added features like card payment technology, internet banking facilities, telephone banking and mobile apps.
Decentralized lending works without either party having to provide information about themselves. Instead, the borrower will be providing a collateral that the lender will receive if the loan is not repaid on time. This is not how banks work. Banks need to know whether the borrower is likely to repay a loan before lending. This involves completing a credit check, calculating income and requiring a collateral. Banks also require their customers to complete a KYC (Know Your Customer) even before an account is opened.
4. Ease of Access
Another significant advantage for DeFi is the ease of access it provides to individuals that otherwise wouldn’t have access to any financial services. Since the traditional financial systems rely heavily on the intermediaries making a profit, the services that they provide are usually absent from rural and low-income communities. However, since the cost associated with DeFi are significantly lower, low-income individuals and other marginalized communities can also benefit from a broader range of financial services.
5. Level of Experience/ Sophistication
The level of experience required to get started with DeFi services is far higher compared to that of the banks. But in the case of banks, there are customer-facing departments that are meant to help the customers. The presence of physical branches and call centers means that inexperienced customers still can have all their financial needs met without much hassles and inconveniences. When it comes to DeFi, inexperienced investors are at particular risk of losing money due to the sophistication required to interact with such platforms and the lack of a customer-facing department. And many investors choose to avoid DeFi because many of them find it hard to find the right information and get enough customer support.
6. Human Error
DeFi uses smart contracts, which means all the contracts are automatically fulfilled when certain conditions are met. This approach has helped DeFi in drastically reducing the number of human-related errors. This is in contrast to the functioning of banks, where human error on a day-to-day basis can lead to transactions being delayed, cancelled or even sent to wrong accounts. There is also potential for fraud. The flipside of using smart contracts is, if the contracts are poorly written, it could cause major problems to the users.
7. Fixing Errors
But the banks have an advantage when it comes to fixing errors; both human and technical errors. Banks have the means and ability to reverse transactions that were processed due to human or technical error. The same is not true when it comes to DeFi as it uses blockchain technology. Blockchain transactions are irreversible, which means that any incorrect transaction made with a DeFi platform cannot always be easily corrected.
While banks have managed to earn the trust of the majority of the population, safety remains a major concern for DeFi. Coding errors and hacks are common. The potential for fraud is high as the person or entity behind the protocol or DApp may be unknown and could disappear with investors’ money. The banks also have the advantage of having insurance to protect the investors in the event of a hack or other fraudulent activity. But when it comes to DeFi, the investors are left to fend for themselves if something goes wrong.
When it comes to interoperability, the banking sector is ahead of DeFi platforms. While Ethereum is the most popular DeFi platform, there are more smart contract platforms that are in development and several that are already making headway. Ethereum, Binance Smart Chain, Cardano, each have their own DeFi ecosystem and community. Interoperability between these blockchains and platforms remains a major hurdle for DeFi. Even though there are hundreds and hundreds of banks, the interoperability between them is not a major concern.
Scalability or performance has always been an issue for blockchain technology. And this translates to the DApps that are built on top of them. While Ethereum can process 15 transactions per second, Bitcoin can only process 3.3 to 7 transactions per second. This is in comparison to Visa’s capability to process 65,000 transactions per minute. While scalability is an issue to a lot of the blockchains, there are several smaller blockchains that promise a higher number of transactions per second than Visa.
Over the decades and centuries, banks have built up the perfect ecosystem to help it grow and meet its needs. But as for DeFi, it has a daunting task of figuring out its long-term needs and goals and fine tuning the ecosystem to meet the demands of both users and developers. Right now, the DeFi ecosystem is cluttered and finding a DApp for a specific use could prove difficult. And for developers, building DApps that would fit into the broader DeFi ecosystem is a challenge.
Today, all banks are subject to various regulations. Current laws were crafted based on the idea of a separate set of laws and rules for institutions that fall under different financial jurisdictions. DeFi’s borderless nature presents lots of questions regarding the type of regulations it has to face. The open and relatively distributed nature of the ecosystem also makes it hard for countries to enforce these rules and regulations. Also, holding the wrongdoing parties accountable could prove challenging.
DeFi protocols don’t worry about trusting the borrowers because they often over-collateralize. Often the value of the staked asset (the collateral) is prohibitively high when compared to the loan amount itself. DeFi projects over-collateralize to counter the removal of obstacles like credit ratings. Banks are comparatively more lenient when it comes to the requirement of collateral when securing loans.
14. Trading hours & Delays
Another major difference between banks and DeFi is the trading hours. The Trading hours in banks are often limited to business hours of specific time zones. This can cause limitations to the services the customers can access during the non-trading hours. But for DeFi, the platform is available 24/7 and is always open for trade. Apart from the limited trading hours of banks, holidays and other events can also cause delays in transactions.