TradeFi Vs DeFi.

Introduction 

In the rapidly changing world, we are witnessing yet another revolution, and this time it is happening in the sector of finance. Finance as we know it is centrally governed but what if we tell you there is a much more efficient, transparent & cheaper solution just around the corner, ready to make colossal changes in finance as we know it? This article aims to draw expectations from DeFi in the coming future and how far we have come already. As we all know, finance in any country is governed by the central authority. For instance, Federal Reserve System (commonly known as FED) is for the United States and the Reserve Bank of India (RBI) for India. The main role of the central authority is to control the supply and use of money. It utilizes monetary tools and printing of money to control inflation and drive overall economic activities in the country. The DeFi system aims to be decentralized i.e., no central authority will be able to control or regulate the transactions. The transactions will be done following a certain set of rules (codes) which will be equal for everyone. Since there won’t be a central authority, the whole economy will be governed by the pure market forces of demand and supply. DeFi stands for Decentralized Finance. According to Peter Walls, CEO of Agro Blockchain, a global crypto mining company, DeFi is an umbrella term that is meant to define a financial system that functions without third-party intermediaries like banks. Decentralized finance started gaining prominence as a replacement for the traditional finance system in 2018 when 15 Ethereum-based projects came together with the aim of building an independent, secure, and open financial system.

DeFi exploded during the COVID-19 crisis. Loans on such platforms have risen more than seven-fold since March to $3.7 billion, according to industry site DeFi Pulse. Investors are hunting returns at a time when central banks across the world have slashed interest rates to prop up economies battered by the pandemic. Some jurisdictions, such as the Eurozone, are now in negative interest rates territory. Others, such as the US and UK, could potentially follow. The gross value locked in DeFi was almost $110B as of 31st October 2021.

De-Fi v/s Trade-Fi – A comparative study 1. Nature of Traditional Banking and risks associated with it 

Traditional banking is based on trust, relationships, and exchanging favors with each other. It is still largely a paper-based business. Banks operating in India reported fraud of Rs 4.92 trillion as of March 31, 2021, representing nearly 4.5% of the total bank credit, showed Reserve Bank of India (RBI) data. High-profile cases like PNB – Nirav Modi brought to light the limitations in the traditional finance system where a handful of bank staffers at a branch issued fake bank guarantees over Rs. 13,800 crores over the years. In a study done by (Ashu Khanna, 2009), this dependence on human interventions & lack of trail of end-use of money is a major cause behind frauds in the banking sector in India. The table below summarizes the major financial irregularities happening in India and the nature of the scandal.

Similarly, the banking industry is not ironclad in the US as well. A total of 511 banks have failed in the US itself since 2009, with more than 75 billion USD Bank failure cost to Deposit Insurance Fund (DIF)

The subprime lending crisis of 2007-2008 reached its climax with the bankruptcy of Lehman Brothers on September 15, 2008, and a subsequent international banking crisis.

DeFi will reduce this favoritism in the banking industry and prevent fraud as the transactions will be based on smart contracts. Despite being designed by humans, if adequate caution at the design level is taken while including various input parameters, proper end-use of money can be ensured. It can be said that DeFi has the power to bring the equality which was aimed.

1. Immutability property of De-Fi and security challenges:

The biggest upside for DeFi is, however, that since every transaction will be recorded on a blockchain and distributed ledgers which are practically impossible to edit, it will create a complete audit trail for all the transactions, and it can be viewed by anyone who further promotes transparency and helps create traces to find any wrongdoings. In contrast, traditional financial systems are still susceptible to manual overrides and evidence tampering. The downside with DeFi is that since the codes are open source, i.e., anyone can inspect the code and build upon them, it makes the work of hackers easier since they get a complete understanding of the code and can find ways to counter the audit and control systems. A global blockchain analytics firm, CipherTrace, estimated that the fraudsters have globally earned somewhere around $432 million between January- April this year. Looking at the broader picture, almost 55% of all major cryptocurrency scams were DeFi hacks. That means out of a total theft amount of $432 million, $240 million can solely be attributed to DeFi. The table below gives an idea of the incidents of hacking and the quantum involved therein.

Security experts recommend a smart contract to undergo an audit, usually through independent auditors. An audit could help detect and possibly rectify smart vulnerabilities in code and check the reliability of the smart contract's interactions. Kava Labs CEO Brian Kerr told Cointelegraph in May 2020 that it is critical for anyone who wants to use a DeFi protocol first to check audits and peer reviews. But even then, he warns of associated technical and market risks since the sector, again, is still new. 

  1. Smart Contracts and their enforceability: The fascinating use case for DeFi is how it can help contracts get honored using a system called “Smart Contracts”. In smart contracts, the expectations of both parties are programmed, and then once those expectations/events are met, the payment is released. For example, you are renting a car, in this case, you will have to link your DeFi account with the service provider's app and deposit some of the crypto assets as collateral for taking this service. Suppose you rent the car at 3$ per 10 Kms, then after riding for 300 Kms, 90$ worth of your collateral will be deducted from your deposit, and the rest will be sent back to you in your DeFi wallet. This way, there will not be any dispute from both parties & the contract can be said to be honored fairly. This new technology of smart contracts, in addition to the DeFi, has the potential to alter the very nature of business and commerce as we know it. However, there are two critical challenges in the widespread adoption of smart contracts: A) Converting the agreement into code and, B) Enforceability of the smart contracts 

  a. Converting the agreement into code: While some analogize this to hiring a lawyer to explain “the legalese” of a traditional text-based contract, the analogy is misplaced. Non-lawyers typically can understand simple short-form agreements and many provisions of longer agreements, especially those set forth business terms. But a non-programmer would be at a total loss to understand even the most basic smart contract and is therefore significantly more beholden to an expert to explain what the contract “says.” 

  b. Enforceability of the smart contracts: For enforceability, there is no federal contract law in the United States; instead, the enforceability and interpretation of contracts are determined at the state level. Thus, while certain core principles apply consistently across state lines, and there has been a drive to harmonize state laws by the National Conference of Commissioners on Uniform State Laws, any conclusions regarding smart contracts must be tempered by the reality that states may adopt different views. In the Indian scenario, the transactions of Smart Contracts will be governed by clauses of the Indian Contract Act 1872 in the absence of a specific governing text. In addition to the contract act, it will also attract various provisions of the Information Technology Act. 

  2. De-Fi as an investment opportunity: 

 DeFi is known to offer a higher yield on crypto-assets as compared to other conventional means. Today, DeFi platforms and apps can provide you with a full spectrum of financial services. These range from trading, lending, decentralized exchanges, borrowing, asset management, and much more. But many DeFi platforms run on open-source smart contracts, which gives hackers the chance to probe these networks for weaknesses. This also makes it highly vulnerable to sudden vanishing and absconding post-raising funds for a project.   

3. De-Fi and customer redressals 

 As there is no central authority in the DeFi, it is unregulated, and there is little to no recourse available to the users in De-Fi. It will be interesting to see how the disputes in DeFi transactions will be resolved and mediated. Trade-Fi and banking industry, in general, has matured long enough and has seen its share of ups and downs to create a system due to which systems, people, and processes are in place in case of disputes and if mediation is required. The grievance redressal machinery of the Reserve Bank of India (RBI) - Despite an increase of 64.97% in the receipt of complaints under the three Ombudsman Schemes, the receipt of complaints increased by a whopping 64.97% after the launch of a web-based system in 2019 from 2,00,362 complaints in 2018-19 to 3,30,543 complaints in 2019-20, the disposal rate of more than 92% was achieved. 

  4. De-Fi and services therein: DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts. Some of the Non-Fund Facilities generally offered by traditional banks, such as Letter of Credits, Bank Guarantees which are instrumental in international trade and commerce, are yet to be made available in the De-Fi ecosystem. 

  5. De-Fi and International Trade: A cross-border payment refers to a transaction involving individuals, companies, banks, or settlement institutions operating in at least two different countries that don’t necessarily share a border. The funds are paid to or taken in from different countries, so the location where the merchant is registered is different from the country where the customer's card was issued. When the two countries involved in the transaction use different currencies, the parties making the transaction need to complete a foreign currency exchange to complete the payment. Multinational companies do business in several countries where they deal with assets, sales, procurement, and taxes to run their day-to-day business. Today’s e-commerce world has a global reach. Payments, remittances, and purchases all often require money exchanged across borders. Currently, there are 0.7 international transactions per capita every year, up from 0.5 in 2014. In the traditional banking system, when someone makes a purchase, there’s a system that carries the money from the buyer’s account to the merchant’s account. With cross-border payments, it becomes more complex. International transactions require a change of currency, foreign transaction fees, and dealing with an exchange rate. In every cross-border payment, banks and a group of varying domestic entities work together to transfer funds. When a purchase is made, a “correspondent bank,” or the entity requesting the money, speaks with the “respondent bank,” which represents the entity buying something. Throughout the major cities of the world, each bank has a counterpart in another city. So funds will first leave the buyer’s bank and go to that bank’s counterpart in the merchant’s country to prepare for remittance. The merchant’s bank will then receive the remitted funds, and they will be settled into the merchant’s account. These banks often work with others to transfer the money, which often involves more than four banking locations dealing with one another, navigating currencies, varying taxes, and transaction fees. Because there are so many entities working on a single purchase, the process can be very slow (may take a few days) and expensive. How expensive? There are numerous costs when it comes to cross-border transactions. Most of them are absorbed by bank fees, which are more costly. Other processing fees include a cross-border fee if a foreign credit card is used. The biggest unknown taxes, as each country has its own tax system. Finally, each country has its own currency, which means exchange rates must be calculated. In the case of Traditional Financial operations, there are chains of intermediaries which increase the cost of any transaction substantially. Every step of the way, fees are taken by middlemen leaving you to earn at best 1-2% short-term in current market conditions. But if you remove all those middlemen and safely connect the lender and borrower directly, suddenly you can earn rates closer to 8% in the US markets, and for Indian markets, this rate can go as high as 13-14% per annum. However, the major drawback with this system is the current acceptability of DeFi & cryptocurrencies as a medium of exchange. These new methods of transactions and settlements are not as widely accepted as their counterparts in traditional finances. These costs from intermediaries increase if it is a cross-border transaction (CBT). In the case of CBT, the exchange rate which is chosen to convert the currency is the highest rate from the two weeks period. It typically takes 7-10 days to remit funds, and if instant funds are required, then an additional premium is charged on the same. However, in the case of DeFi, such costs do not exist, and the difference in transaction cost for a local transaction or an international transaction is more or less comparable.

Now let's look into how your bank does while navigating through these channels to usher the money along across the border. J.P. Morgan releases Unlocking $120 billion in Cross-Border Payments report. The report estimates that of the nearly $24 trillion in wholesale payments that moved across borders each year, global corporates incur more than $120 billion in total transaction costs; this excludes potential hidden costs in trapped liquidity and delayed settlements. Central banks around the world who are at various stages of CBDC development are considering how to build an infrastructure where systems operate and work together with the necessary controls in place. In the meanwhile, decentralized exchanges can help businesses move their money to another country in a much cheaper and quicker way. Uniswap, one of the most popular DEXes on Ethereum with a TVL of $5.2 billion, has a transaction fee of 0.3% for exchanging assets. PancakeSwap, running on Binance Smart Chain (BSC) with a TVL of $3.76 billion, has a transaction fee of 0.2%. A full-scale central bank digital currency network can save global corporations several billion a year in bank fees and can make this transfer work way quicker. 

  1. De-Fi and Regulation around the Globe: As cryptocurrencies spread across the globe, so are the regulations put in place to try, and govern them. The landscape is constantly evolving and keeping up to date with the rules in different territories isn’t easy. At BlockchainByte, we are providing you with a good overview of the crypto regulations happening around the globe, which will make you understand that cryptocurrencies are neither illegal nor invalid but are the future of the 21st century. The following world map tries to address the following questions: 1. Do the countries have to have a license to operate as a VASP (Virtual Asset Service Provider) in a given region? 

2. Does the region have its own central bank digital currency (CBDC) project underway?