The financial services industry has been long due for a change. For years, Centralized Finance (CeFi) was – and in most markets still is – a reality, where the big banking conglomerates aggregated all the value since they were the central authority for all the transactions. There’s got to be a better way!
As with other blockchain applications, Decentralized Finance (DeFi) will eliminate the intermediary. The ecosystem of financial apps built on top of blockchain networks will theoretically distribute the value and spur economic growth. This will be particularly impactful among small and medium enterprises and emerging economies since it will most likely create new products, services, and financial markets. On top of this, it will promote access to financial services for those who are isolated from the current financial system.
The comparison is inevitable, but they are two different things. While open banking refers to a system where third-party financial service suppliers can access data through Application Programming Interfaces (APIs), enabling the networking of accounts and data between banks and non-bank financial institutions, and enabling the entrance of new types of products and services within the traditional financial system, DeFi proposes an entirely new and independent financial system that does not require permission to access to the economic infrastructure.
Here’s an example that illustrates the difference between them: open banking permits the management of all traditional financial instruments in a single application by gathering data from banks and institutions. DeFi, however, makes the management of entirely new tools and ways of employing them possible.
The fact that DeFi does not require an intermediary to function, since the code specifies the resolution of every possible dispute, not only substantially reduces the costs with providing and using products, but also allows a direct and frictionless financial system. On this note, it’s extremely relevant to point out the social impact of such solutions. The traditional market relies on intermediaries to make a profit, which in turn means that the services often ignore low-income communities. Without the requirement of a profitable intermediary, such individuals can also benefit from a broader range of financial services.
Another feature that’s usually a hard task for market incumbents, since their structure is usually built on top of an outdated legacy system which is often built on different networks, is the deployment of applications, whether they are new products or services. These players have a hard time and bugs and errors often occur during the deployment phase. With DeFi, this does not apply since the frameworks can be built in advance and are all stored in the same blockchain network.
Moreover, in this decentralized reality users will face a fraction of the risks when it comes to money laundering. First and foremost, instead of relying on a bank to secure your money, you will be guardian and keeper of your own funds. Crypto wallets – which are usually more secure than your average two-step authentication – like MetaMask, where you can do everything, from buying and selling, to transferring and receiving crypto, make this possible. Secondly, in traditional finance, compliance around anti-money laundering depends on know-your-customer guidelines (used to verify the identity, suitability, and risks involved). In the parallel and futuristic universe of DeFi, the decentralized infrastructure enables modern compliance analysis around the behavior of participating addresses rather than one’s identity.
Instead of focusing on the individual, DeFi focuses on the transaction itself, assessing the risk in real-time and protecting against fraud and financial crimes.
Yup! Smart contacts have a vital point in the DeFi space. Most of the applications already implemented or the potential ones involve the creation and execution of smart contracts. If you’re not familiar with the subject, you can read all about it on our “Smart Contracts 101: Farewell Outdated Middlemen”. But long story short, while a regular contract uses legal terminology to stipulate the conditions of a business or relationship between the entities involved, a smart contract uses computer code.
Marketplaces. Who thought marketplaces could be disrupted? Decentralized protocols are supporting a variety of online marketplaces that enable users to trade products and services globally and peer-to-peer. This is being applied to everything, from freelance payments and digital assets to real-world products, such as clothing. Since they require less maintenance work, decentralized exchanges typically have lower trading fees than the ones practiced on traditional platforms.
By the way, did you know you can also sell your own stuff on our marketplace and earn KAI? Learn more here.
Open lending & borrowing protocols. This is one of the most popular applications since it has the potential of reducing counterparty risk, making borrow and lend activities faster, cheaper, and available to everyone. Cool, right? The advantages of such a solution over the current system are countless and this will hopefully become the standard for such activities in the upcoming years. Dharma, a semi-centralized peer-to-peer lending and borrowing platform based on Ethereum is a good example of this. It allows users to lend or borrow coins for 90 days with a fixed interest rate for both activities.
Peer-to-peer payments. As we already discussed, the transactions are arguably on the genesis of the blockchain ecosystem. DeFi is bringing this possibility to peer-to-peer payments as well, creating a more open economic system for the underbanked and unbanked populations while also helping big financial companies enhance their customer service.
Stablecoins. If you’re not familiar with the term, the word might sound odd (hint: it has nothing to do with horses). It is a cryptocurrency that is directly linked to a basket of assets – gold, dollar, euro, or even other cryptocurrencies. These types of currencies were developed to, as the name says, make crypto more stable and a viable payments solution. They are now being implemented and are the go-to solution when it comes to lending and borrowing and payments platforms. On a very interesting note, these coins are also being studied to be used as central banks’ digital currencies (CBDC) – read Bank of England publication on it here.
As you can see, there are plenty of solutions and possible use cases that can be developed in the DeFi ecosystem. But keep in mind these wouldn’t be possible if we did not have networks to develop the solutions on.
Telos is a prime example of a user-friendly blockchain which makes DeFi apps possible. By the way, we have a challenge with the Telos Foundation, a non-profit organization charged with promoting the Telos blockchain, happening right now (the applications are open until September 30th). One of the challenges is to build a DeFi innovative application using Telos Decide. Interested? Visit the official challenge page.
Before mass adoption, there are certain challenges that must be surpassed.
Poor performance could be the first one to look at. Blockchains are usually slower than their centralized counterparts, which in turn means the apps built on top are also a little slower than they should. However, devs can take these limitations into account and optimize the products keeping them in mind.
Bad user experience and high risk are two other challenges that must be surpassed. As of today, the apps not only require a little extra work from the user side, which makes it harder to push for wide adoption, but they also transfer the responsibility from the intermediaries to the user, which can be a problem for many users.
Finally, the ecosystem is messy. Say, for instance, that you’re an organization trying to find the application most suitable for peer-to-peer lending and borrowing activities. You probably want to find the best choice, but you’ll have a hard time if your team doesn’t have a person familiar with the subject. The ecosystem must be organized in order to proceed to wider adoption.
There are a few steps the Decentralized Finance ecosystem will have to take. However, after jumping these hurdles, it will take power from large centralized organizations and transfer it to the individual and the open-source community. Looking forward to this future.
Until then, you can win KAI tokens and rewards by participating in our challenges.