How Decentralized Finance (DeFi) will change the Financial Ecosystem

How Decentralized Finance (DeFi) will change the Financial Ecosystem

The Decentralized financial system will change how we think about money and finance. The future of DeFi seems bright and promising as it could in high probability replace the current, traditional financial system and provide a more efficient, less expensive, and more transparent alternative.

The issues with the current financial setup 

The traditional banking system has been in place for centuries and has its own set of challenges in executing a myriad of financial transactions. The current setup is a centralized entity that is prey to the non-transparent and non-interoperable nature of the system, the distorted financial operations fuelled by corruption, defaulting payments, and frauds. In addition, intermediaries and clearinghouses are the downsides of the present system that act as a deterrent.

An introduction to DeFi and the history behind its conceptualization

DeFi is a new type of blockchain technology built on distributed ledger technology similar to cryptocurrencies. It provides an alternative to existing blockchain networks with regard to scalability, privacy, and security. In addition, it uses a unique consensus algorithm called Proof-of-Cooperation that can be used to solve many of the issues that other blockchains are currently facing. 

Decentralized Finance as a concept was brainstormed in 2018 by a group of entrepreneurs who wanted to disrupt and provide solutions to the problems in the current financial system. Also, the idea behind the conceptualization of DeFi was to confront the legacy of conventional and centralized economic systems. Furthermore, it can create an alternative financial ecosystem where all users can buy, sell, trade, lend, borrow, stake, and invest in other cryptocurrencies. DeFi will also allow them to view, store data, and share information with each other without any meddling or need of a third party.

DeFi is primarily based on the powerhouse Ethereum blockchain and uses other vital components of the crypto world, such as smart contracts and cryptocurrency. The roots of DeFi can be traced to the year 2015, when MakerDao, the first DeFi project, was built on the Ethereum blockchain. It allowed users to generate Dai, a stable coin via smart contracts using Tether currency. Dai was pegged to US dollars, which paved the way for the inception of a decentralized bank called Oasis, which in turn allowed users to lend and borrow stablecoins directly. However, some would argue that Bitcoin was indeed the first-ever DeFi application.

The key features of DeFi

What works for DeFi are the countervailing properties of its core structure as opposed to the current financial system. Decentralized Finance’s purpose is to serve as an infrastructure to DApps, the decentralized, digital applications that run on Ethereum blockchain and use smart contracts to execute various services, in this case, financial. DeFi is structured so that every module (stablecoins, software, and hardware) in the system works in synchronization to raise tangible world assets powered by the following features.

* Accessible – Decentralised Finance is permissionless, which is one of the core features of DeFi applications. Incorporating this feature allows users to view the DeFi solutions on the Blockchain freely. They can do so with as little as access to an internet connection and crypto-wallets. The two prerequisites open up the doors of accessibility to users disregarding their demographic placement or limitations of funds. 

Decentralized Finance

* Decentralised and immutable– Blockchain is a decentralized platform, which means it is open-source and doesn’t allow one entity to control the narrative. This salient feature of digital ledgers makes them a reliable, democratic, and secure system. With no single entity owning the financial system, DeFi works in sharp contrast to the closed doors policies of traditional setups. Blockchain data is public information, and it cannot be changed or deleted by any institution or individual, making it immutable. Any changes made will be viewed publicly, and the authenticity of the change is verifiable. A malicious attempt could be marked and vilified as well. 

* Interoperable – The cross-chaining of DeFi protocols and applications will allow different protocols to work together and make them more malleable. Their flexibility will allow developers and product teams to integrate third-party applications, provide clear solutions, and add new services to existing protocols.

* Non-custodial or unsupervised- The most crucial feature of DeFi is that it allows the users to have absolute control over the private keys and control their personal data and cryptocurrencies. For example, a DeFi wallet like Coinbase and Metamask securely stores users’ assets while giving them complete power over their usage without third-party involvement.

Concept of Centralised Finance and how it differs from DeFi

The exponential growth of cryptocurrencies can be justified by their diversified use in various industrial sectors. As a result, the virtual currency market is estimated to be worth an astronomical $4.94 billion by 2030. 

DeFi vs CeFi – Decentralized Finance vs Centralized Finance

Before diving into how DeFi is set to revolutionize financial services further, it’s essential to understand its peer, the concept of centralized finance. With the introduction of Blockchain and cryptocurrencies, the idea of centralized finance soon gained traction in the crypto world. Therefore, blockchain use in the banking system was a natural and expected step to challenge the usual banking services pertaining to lending, borrowing, and other transactional processes. 

Centralized Finance is DeFi’s predecessor and is the conventional way of trading cryptocurrencies. In centralized finance, all transactions are channeled through a centralized exchange platform. These exchange platforms are the custodians of the finances and not the user. One could say that if DeFi protocols are transparent, the CeFi’s are, at best, translucent.

Let’s comprehend how CeFi differs from DeFi:

  • Regulation: Centralised finance is a regulated system, contrasting DeFi. It means that the finances run through the exchange platforms, and therefore users neither own nor have access to private keys. Whereas In DeFi, the users have complete control of their assets, and they hold their private keys, making them the decision-makers in the process.
  • Risk management: In DeFi, unlike CeFi, the financial risks lie with the owner and not the exchange platforms. The exchange platforms have a set of rules and practices that narrow down options and restrict the users’ influence. Although these lending platforms are less stringent than traditional banks, they don’t offer the privileges that DeFi does. Let’s take an example of Binance, which offers stablecoins such as ETH, BTC, Ripple, and many other coins for loans. However, the loan conditions are set up by Binance, such as their LTV ratio and APR rates. In sharp contrast, DeFi allows crypto borrowing or lending via smart contracts without the precedence of intermediaries, and the rate of interest is set with the understanding of the borrower and the lender via smart contracts. 
  • Permissionless: In CeFi, exchange platforms that regulate the trading also have security measures in place to keep a check on frauds, money laundering, and other such malicious activities. Putting checks in place such as fund management, submission of KYC by the customers, dictating loan terms, the inclusion of trusted digital currencies for trade, etc., enthuses trust in users’ minds regarding the safety of their money. On the other hand, DeFi users are responsible for the security aspect as they are the custodians of the funds. However, it can be perceived as a drawback as the security of funds depends on the technology used by the user.

DeFi is permissionless as an exchange between lender and borrower depends solely on the trust between the two parties. The KYC is not required under DeFi protocols which allows faster loan processing. DeFi has encouraged the concept of flash loans and over-collateralized loans. More and more users are getting enticed to trade in under-collateralized loans as they are an emerging trend in crypto trading and are perceived to be the future of decentralized finance.

  • Technological Innovation: If we introspect on DeFi vs CeFi phenomena, it’s easy to conclude that DeFi has the potential to grow and expand into the tenets of the financial services. In addition, it can disrupt the whole banking ecosystem from its core and replace it. DeFi allows seamless and free interoperability of cryptocurrencies which the present system constricts with its various regulations. DeFi’s strengths lie in its unorthodox nature, which will promote scalability, privacy, and free trading without the involvement of a third party in the banking sector.
  • Implementation of smart contracts: Smart contracts are the backbone of DeFi as Blockchain is the framework within which these preset contracts work. The use of smart contracts surged in 2020 as they present a trusted, faster, less complicated, and more transparent exchange of goods and services. In comparison, traditional and centralized banking institutions depend on intermediaries.

Use case of DeFi solutions

Let’s ascertain DeFi use cases that have benefited users since inception and speculated to scale and expand in forthcoming years.

  • Decentralized Automation Organisations (DAOs)

DAOs are decentralized organizations that run on Ethereum blockchain abiding by the set rules of smart contracts. These organizations have a built-in system for managing the funds without relying on intermediaries as opposed to TradeFi (traditional finance) or CeFi. DAOs are presently used in crowdfunding, capital venturing, governance, etc.

  • Analysing data and risk management

DeFi protocols are transparent in nature and allow micro scrutiny of data and transactions on its network. The consolidated data is available through analytics sites and dashboards such as DeFi pulse and Daily Metrics, allowing users to access risk management, make business decisions, and explore and exploit financial opportunities.

  •   Synthetic assets

A fairly new concept, synthetic assets are basically tokenized derivatives. Derivatives in finance represent the financial asset that a person doesn’t own but would want to buy or sell in the foreseeable future. Tokenization of derivatives simply means a derivative data is added to the Blockchain, thereby creating a token through a smart contract. Usage of synthetic assets is becoming increasingly popular among DeFi enthusiasts as the investors are at liberty to tokenize an asset and take a risk with the fluctuations in prices of that asset. Synthetic assets are safe bets due to the transparency, flexibility, and secure nature of Blockchain, and hence more DeFi solutions are entering the fold. Synthetix is one big name in the DeFi market, followed by MakerDao and Cream Finance as the next best alternatives.

  • P2P borrowing and lending

DeFi platforms like Compound and Dharma provide peer-to-peer crypto loans and lending in a trustless environment. Unlike traditional banking, a P2P platform allows lenders and borrowers to deal directly via smart contracts sans intermediaries. Lenders can also earn interest over lent digital assets, while borrowers can pay at their behest. Numerous DeFi projects have been deployed in a short time, given the rising popularity of the P2P model.

  • Insurance

The insurance sector has been the biggest gainer as DeFi solutions counter various problematic areas of traditional insurance such as lengthy paperwork, red tapes, and unreliable auditing systems. Many companies such as Nexus Mutual, InsurAce, Insure DeFi etc., are already using smart contract-based insurance solutions.

  • Decentralized Finance exchange

The DeFi exchange platforms are applications that allow a multitude of activities such as trading cryptocurrencies, lending/borrowing digital currencies, earning interest from savings, and others. Through digital wallets like MetaMask, Binance Wallet, Coinbase, etc., the users connect to these platforms and start trading straight away without KYC. 

Future of DeFi

If we speculate on the future of DeFi, it would not be wrong to say that DeFi is a natural successor to the current financial ecosystems. How fast it is emerging as a competition to the financial systems can be gauged by the total value locked (TVL) in DeFi protocols which is a staggering figure of $240 billion in 2021. In comparison, the TVL ratio in May 2020 was $78 billion. The total value locked in entirety represents the total amount of cryptocurrencies deposits tied up in DeFi related financial activities. The numbers speak for themselves, which clearly indicate how the DeFi industry has exploded despite being in the nascent stage of development. This exponential growth could be attributed to the inherent quirk of DeFi to innovate, evolve, and introduce fresher concepts that strengthen its core infrastructure.

Future of DeFi in the traditional banking system

The rapid growth of DeFi is steered by the digital industry, investors, and crypto enthusiasts. However, conventional banking systems are yet to accept the concept of open finance with open arms. Therefore, the future of DeFi relies heavily on its acknowledgment and subsequent investments into the DeFi industry. Such acceptance will help the current financial ecosystem reach its peak and further adopt the DeFi solutions. However, how much of it is likely to happen remains on how soon DeFi will stop being perceived as a threat to the system by the financial institutions and how seamlessly DeFi solutions get integrated into the traditional setup.

DeFi solutions @Sofocle

For 4 years, Sofocle has been at the helm of the blockchain sector by providing Blockchain-based solutions to clients. Our exceptionally capable team includes Blockchain developers, Ui/Ux professionals, engineers, and highly-qualified security analysts. We are particularly proficient in blockchain protocols like Ethereum, the development of dApps, crypto-economics, and other protocols that fuel DeFi solutions. Our portfolio includes powerful names in blockchain development like Ethereum, EOS, R3, and Flurre. In addition, we invest in advanced and emerging technologies to present the best DeFi solutions to our esteemed customers. Our services include:

  • P2P lending borrowing platforms.
  • Decentralized exchanges.
  • Derivative exchange platforms.
  • DeFi wallets.
  • Insurance solutions.
  • Designing and developing DeFi smart wallets.
  • dApps and stablecoins.
  • Tokenizing assets.
  • DeFi Apps infrastructure management powered by Zevee Automation Blockchain Platform.

Sofocle provides you with a smorgasbord of DeFi services and solutions. Book a free consultation call now with our blockchain specialist and get a perfect solution that exceeds your expectations.