By Jason Wu, CEO of DeFiner.org
DeFi, or decentralized finance, aims to disrupt the current financial system by providing new solutions on a public blockchain. DeFi is reshaping existing traditional financial systems, which are defined by centralization, and allowing people to interact directly on decentralized, secure, and transparent protocols. The movement’s very nature takes the issue of trust out of the hands of humans and uses the code it runs upon to create total security. By using blockchain technology, single points of failure are eliminated as the data is recorded instantly and spread across thousands of nodes, making malicious attacks or corruption nearly impossible.
Exciting new developments offer a glimpse at a new era of finance - one that is faster, safer, more cost-efficient, and more secure. With 1.7 billion unbanked adults in the world having limited access to financial services or support, a huge erosion of trust in the banking sector, and a looming economic crisis anticipated as a result of the COVID 19 pandemic, 2020 may well be the year for DeFi to come into the mainstream.
DeFi offers solutions amid economic crisis
In the context of the current pandemic, DeFi could facilitate the disbursement of government payments such as Universal Basic Income (UBI) far more effectively than the current outdated processes being used, such as the American Automated Clearing House (AACH). DeFi can enable the distribution of payments from the government to millions of people instantly. It offers a cost-effective method and a solution for traceable payments. Adopting DeFi in areas like this is essential not only for the health of the global economy, but also for increased transparency in financial systems. As many of us remember from the previous financial crash in 2008, corruption can be rampant in traditional financial institutions. Preventing this from recurring in the future should be a top priority.
Amid an economic crisis, DeFi could also play a vital role in helping serve borrowers’ and lenders’ needs better, with centralized financial networks coming under pressure from a slow economic growth outlook and outdated technology. DeFi applications do not require credit records and banking history for participation, things which are considered a prerequisite for traditional financial institutions. Instead, DeFi’s smart contracts enable security and credibility checks, allowing for borrowers in distress to have fast, fair access to funds.
DeFi lending innovation is widespread, for example with the introduction of flash loans. Flash loans allow traders to take out uncollateralized loans to increase the payout on a singular trade. In theory, it’s a win-win situation, as a user can borrow funds quickly to make a profit elsewhere and the lender receives their money back quickly, too. All transactions occur at once on the network, using smart contracts. Although flash loans have negative press following hacks in the past, with some adjustments they will foster opportunity in the space. In essence, the hack occurring is not a fundamental flaw in DeFi, but rather a temporary glitch which emphasizes the experimental and early stage of this industry. Once perfected, the idea will stand the test of time.
While the borrower undoubtedly benefits from DeFi lending, so too does the lender. In traditional, centralized banking, if a borrower cannot pay back a loan, it is the lender (the bank or the financial institution) that will take the hit and may be forced to write off a debt. However, in decentralized banking, the lender does not lose out. By using smart contracts, decentralized financial platforms can automatically cancel transactions if the borrower cannot pay the money back. This results in the borrower receiving no funds, and the lender not losing any money as funds are “returned”. This low-risk lending offers huge protection to a lender and similarly provides borrowers with instant liquidity that fits their needs.
The concept of “money lego” also highlights opportunities for DeFi. This is based on Lego, the childhood toy. In some cases, people build from preassembled combinations of Lego blocks, which is the intention for DeFi, where projects can be stand-alone concepts, but also can be easily integrated into other networks to create something better. This ties into the core concept behind DeFi: interoperability. DeFi offers the opportunity not only to build new financial systems, but to integrate new technology into existing systems to improve them enormously.
DeFi works to increase speed and liquidity
Speed and scalability are DeFi’s biggest challenges. The public blockchains underlying DeFi are currently unequipped to process such large volumes of data at a scalable speed. While Visa can process 24,000 transactions per second (TPS), the Bitcoin network can only process up to seven TPS and Ethereum can process just 15 TPS. However, DeFi is actively solving these issues with developments such as the Lightning Network, which is based on the idea that not every single transaction needs to be recorded on the blockchain and instead the final one of multiple may be sufficient.
A lack of liquidity is also a danger to DeFi. Concerns around a lack of liquidity contribute to crypto price volatility, as investors constantly feel the need to sell and the market grapples with an ongoing long squeeze. In turn, when such large sums are traded on a public blockchain, it’s next near impossible to avoid slippage, lending even more to price volatility and investor fears. Centralized financial systems benefit from Central Bank support, helping to shore up liquidity, which is arguably the biggest incentive for users to remain loyal to these traditional systems. But solutions for DeFi’s liquidity issue are coming to light — the use of decentralized liquidity pools, for example, is a promising innovation. The concept of sharing liquidity in ‘pools’ is one that embodies the core values of the decentralized community.
Having explored some of the challenges associated with DeFi, and how they are being overcome with solutions and exciting opportunities in the market, one can see how DeFi will flourish in the future, especially during testing times. Amid times of economic crisis, people yearn for trust. After years of instilling faith in third parties such as banks, financial institutions, law firms, and regulatory bodies, maybe it’s time to shed light on a black-and-white, wrong-or-right system secured on code and mathematics.
There is no denying that flaws exist in the world of DeFi, and that improvements will be crucial for future growth and adoption. However, we must remind ourselves of the early stage of this industry, recognise the abundance of opportunities already presented to us, and realise that it is only a matter of time before any issues are fixed. There is huge potential for DeFi to thrive and prosper, whether that means succeeding in solidarity or in combination with traditional systems. Whatever solutions are available to ease the impending economic crisis, should be welcomed.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.