💸 De-centralized Finance (Defi) - A BIG SCAM or the Next Banking killer?
Banks have been around for centuries. While they have continued to evolve with changing times, de-centralized finance promises a utopian world that can de-throne the banks from this position of power.
🚨Disclaimer: This is not investment advice. I am not an investment advisor. This information is meant to be for educational purposes - DYOR(Do Your Own Research).
Are we really living in a world of Traditional Finance?
Money has been around for centuries - from seashells to gold coins to pieces of paper. We replaced the barter system with forms of money and through the process got many obvious advantages - one of them being a universally acceptable medium of exchange ( the blade-smith did not need to find a meat-smith who needed his swords to eat chicken for dinner - seemed obvious). This system worked well when people were transacting in small communities and almost everyone knew each other.
As trade grew, we needed intermediaries to facilitate the interactions as we did not really know people far away in distant lands. These intermediaries provided services for a fee. While the fee seemed small as a % of the transaction for the convenience offered, it added up across 100s of millions of transactions.
Fast forwards a few 1000 years, we now have a global financial system with money moving and being settled around the world. Technology has enabled millions of transactions per second, advanced algorithmic trading systems, real-time onboarding of people. You can send money to your friends via their phone number or email address. Buy things from merchants halfway around the world with assurances that the goods will be delivered as expected.
Can we really call this traditional finance?
Let’s understand how Traditional Finance works?
If I told you that you could walk into a stranger’s shop, pick up any item and walk out saying you will pay them later - do you think that would be possible. That’s exactly what happens - in today’s world. When you buy a cup of coffee with a “Credit Card” and tap your card to make the payment - no money exchanges hands. It is all based on a system of IOUs (I owe You). While there is a real-time transaction to validate whether your credit card is active and you have enough credit line from your bank - the coffee merchant doesn’t get paid till a few days later + there is the possibility that for 90/120 days the customer can dispute the transaction
So what does all of this have to do with anything?
A critical component of the financial services infrastructure as we know it today involves large financial intermediaries such as Retail & Commercial Banks.
These intermediaries are the glue that brings trust together and enables unrelated participants to transact with each other.
When 2 unrelated participants don’t have the same banker, the banker establishes a level of trust amongst themselves e.g. Citi, JP Morgan, HSBC - may all be involved in a transaction to remit money from Hong Kong to the US.
So what is Decentralized Finance?
DECENTRALIZED FINANCE = NO MIDDLE MAN
The development of Bitcoin and thousands of other cryptocurrencies in a little over a decade has changed the definition of money and spawned a parallel universe of alternative financial services, allowing crypto businesses to move into traditional banking territory.
DeFi turns this arrangement of middle me on its head by re-conceiving of financial services as decentralized software applications that operate without ever taking custody of user funds.
Defi uses public blockchains such as Ethereum and builds layers of software programs to perform specific activities similar to the functions done by the departments in a bank. These use Web 3.0 technology that makes it easy to lock in the funds, make transactions and interact with smart contracts (computer programs) directly from your web-browser.
Want a loan? You can get one instantly by simply putting cryptocurrency up as collateral. This creates a “smart contract” that finds you money from other people who made a pool of funds available on the blockchain. No bank loan officer is necessary. Everything runs on so-called stablecoins, which are currency like tokens typically pegged to the U.S. dollar to avoid the volatility of bitcoin and other cryptocurrencies. And transactions settle automatically on a blockchain – essentially a digital ledger of transactions that is distributed across a network of computers – rather than through a bank or other middleman taking a cut.
DeFi platforms are structured to become independent from their developers and backers over time and to ultimately be governed by a community of users whose power comes from holding the protocol’s tokens.
There is also a Hybrid model - centralized finance, or CeFi (Mix of Traditional Finance & Decentralized Finance) where consumers enter into an agreement with a company like BlockFi that collects information about them, requires them to turn over their crypto and also serves as a central point for regulators.
History of Defi
Size of the Defi Market -$70-100Bn
Measured in “Total Value Locked”. What does that mean it is a similar concept as “Assets under Management” used by financial institutions to reflect how much money are they managing for their Clients. “Total Value Locked” represents the $ value of Tokens like Bitcoin, Ethereum, USD Stable coins that have been locked into Smart Contracts (or borrowing/lending programs) . The higher this number the more people are using these platforms and transacting them.
Defi alternatives to traditional finance products?
Defi Alternative Product <> Traditional Prod
Ability to make Tokens <> Central bank to make a new currency (USD, SGD)
Buy & Sell Tokens (Decentralized Exchanges) <> Buy & Sell currencies / stocks in on an exchange
Decentralized Payment <> Alternative to payment networks (Visa/Master) or SWIFT (international remitance)
Liquidity Pools (or Deposits) <> Place for depositors to put money in the bank
Borrowing Pools (or Loans/Lending) = Place for people to take loans leveraging deposits
Insurance
Fund Management
Derivate Products
Other interesting offshoots - Lottery and many more
So how can I visualize this world?
Currently, centralized exchanges like Binance, Coinsbase, Gemini - act as gateways across these two worlds. They are a critical player in the ecosystem that allows you to move money in & out of cryptocurrencies.
As time goes on, more avenues of convergence of Traditional & Crypto capabilities have started to emerge
Ability to pay for your everyday expenses with a crypto card that end of the month you can settle with crypto holdings
Use crypto as collateral to take a fiat loan
Buy real-world assets with crypto.
Will this be the end of Banks?
Is Defi like the meteor above that will destroy the Traditional Banking planet
Simple answer - Not for the next 20+ years.
Long answer - The Defi world still has a lot to figure out still. It is a 3-4 year-old industry that still has a lot to figure out in terms of User trust, complex UI/UX, Regulatory compliance and has not been battle-tested over centuries similar to banks.
At the end of the day, we are talking about people’s money, hard-earned cash - representing their lives savings.
What are the risks with Defi?
DeFi cuts out trusted intermediaries that financial regulators rely on to ensure market integrity. Licensed operators like banks and brokers play a quasi-governmental role in traditional finance, collecting and reporting data to the authorities, including information on capital gains on investments made by their clients, to ensure taxes are paid. Their participation in the market depends on following lots of rules.
By contrast, DeFi programs are unregulated apps created by coders interested in capital markets. Users’ assets can and have been hacked, and not all of the operations are built in good faith. “Rug pulls,” when developers abandon programs after investors contribute significant assets, are notorious in DeFi.
Scams, Rug Pulls, Crazy Volatility and permanent Capital Loss all part of the Defi Landscape today
Summary
Finance has moved Traditional (Manual) to Digitized to Digital Banking
However, it is still plagued by many of the fundamental problems such as requirements of large intermediaries and legacy technology
Blockchain based Decentralized Finance provides an exponential step change in this paradigm.
While the promise is strong, these are still early days of what lies ahead
In this unregulated world many things still need to be worked on - Trust, Scalability of technology, User Experience, Consumer protection etc.
A truly integrated E2E experience leveraging the benefits of Decentralized and Centralized capabilities, will help customer benefits from the strengths of both worlds
Some of my earlier posts if you have not read them yet
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🚨Reminder of Disclaimer: This is not investment advice. I am not an investment advisor. This information is meant to be for educational purposes - DYOR(Do Your Own Research). Please do your own research before you decide to invest your hard-earned money. If you are unsure seek help from a professional financial advisor who can understand the full breadth of your financial needs & commitments to advise you on what you should do.
Nice article Saurav, thanks