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In its most simple form, DeFi (abbreviated for Decentralised Finance) is a broad term for various financial services built on a blockchain (usually public, involving cryptocurrencies) to solve the problems that exist within the traditional financial system. The beauty of this radical system is that it's not controlled by any centralized financial intermediaries.
30 January 2022
The ongoing Covid taught us about the role of technology in our life. The combination of Finance and Technology, known as Fintech, is one of the significant revolutions which made financial services like Payments, Insurance, and Claim Settlement, Availing Loans, Cross-Border Payments, and the like, accessible at just one click from the comfort of our homes. This Technology transformation exposure has made us realize the importance of change and continuously improve the traditional financial structures. One such parallel technological advancement of finance is to broaden the reach of such financial services through Blockchain Technology without the involvement of intermediaries, popularly known as Defi (Decentralized Finance). The world of blockchain and its application is way more than just price speculations, and that is something we would like to bring to your attention. A simple view of how the field of finance is transforming can be observed from image-1 below.
Decentralized Finance emerged as a result of uncanny and slow traditional finance. TradeFi is an abbreviation for Traditional Finance. For our financial transactions, we heavily depend upon financial intermediaries like Banks, NBFCs, Exchanges, Brokerages, etc. These intermediaries are governed by Central Institutions (like RBI, SEBI, IRDAI) or International Institutions (IMF, World Bank, WTO). The Central Institutions provide a mandatory framework for regulating the respective sectors for the users like KYC, Eligibility Norms (For availing loans, PAN for opening Demat), dependency on officials for grievances. All the Central Authorities and Financial Institutions manage the data provided by the customers centrally. Even with all these regulations and frameworks, there are still limitations to TradeFi like which are:
1. High Transaction Cost
At around $83 Billion, India is the largest global inbound remitter. As per a report published by PwC it costs anywhere between 0.3% to 20% of the transaction amount to transmit this money. The service provider charges could include transaction amount, payment method, transfer destination, and exchange rates, which may vary across markets and service providers.
2. Slow Process
Currently, we depend on the banking officials for availing the services which have their infrastructures. Navigating through various such infrastructures makes the transaction slow and the process, time-consuming. One of the examples is availing loans from Bank. In respect to the Credit TAT of the banks, CIBIL and SIDBI joint report published in 2018, stated that an MSME gets a loan in 26 days.
3. Lack of Transparency
Even with so many regulators involved and a constant overview being maintained, many things that happen within TradeFi that are not ethical and often we see such reports highlighting these facts. The FinCEN leaks cover over 200,000 suspicious financial transactions between 1999 and 2017 valued at over US$2 trillion by multiple global financial institutions. This shows manipulations and a lack of transparency in the domain. 4. Low Return on savings
The operational cost of handling cash is costlier currently in the bank savings account, and such costs are passed on to the depositors thereby the return is reduced. Considering the various types of deposits existing in the current time, a depositor earns interest of around 2% to 6% p.a. Couple it with taxes and the CPI/WPI inflation rates, an individual loses money when kept in these conventional places. Let us take an example, Suppose Mr. A had INR 1L to deposit in a saving account in India. He was getting a return of 6% p.a. and his income was taxable in the 20% slab. The net interest earned by Mr. A is presented in table-1 below:
| Interest @6% p.a. | 6000 | |
| Less | Tax @20% | 1200 |
| Net Interest | 4800 | |
| Net Return in Percentage | 4.80% | |
| Less | Inflation Forecast FY22 by RBI | 5.30% |
| Net Return on Saving Interest | -0.50% |
FinTech
Owning to the limitations faced in the current traditional system, FinTech eased these issues by leveraging the technology to provide financial services and accessibility to the wider population. Fintech is enabling the use of financial services at ease by continuing with the existing traditional process. A recent report by IMF sees digital finance as an enabler to wider financial inclusion and may increase the GDP growth of an economy by ~2%.
To vouch for the ease and growth of FinTech, NPCI statistics could reflect this through the growth in the number of UPI transactions by almost 100% in Sep-21 (~3.6Bn transactions) as compared to Sep-20 (~1.8Bn Transactions). Although, digital finance is gaining momentum, here also the FinTech acts as an intermediary between the banks and the users. We need a financial system that is free from intermediaries and human bias. Hence, we need an even better system.
Defi – Introduction
In its most simple form, DeFi (abbreviated for Decentralised Finance) is a broad term for various financial services built on a blockchain (usually public, involving cryptocurrencies) to solve the problems that exist within the traditional financial system. The beauty of this radical system is that it's not controlled by any centralized financial intermediaries. Now before we move ahead and discuss the DeFi world, let us explain to you the role of cryptocurrencies and why they form a necessary element of this ecosystem. When we talk about geographical ecosystems like India, to transact and do business we require the Indian Rupee. Similarly, if you are in the US, you need US Dollars to transact. However, if you go to the US and try to transact with INR, no one would be ready to accept INR. When we talk about Decentralized Finance, the ecosystems it caters to are not limited to one single geography and hence acceptance of one single currency across the globe could have been a big hurdle. Also, connecting the banks to carry out the transactions would have meant including intermediaries and slowing the system down. Hence the need for cryptocurrencies. Today’s financial system consists of centralized database systems involving a plethora of cost-sucking middlemen, high fees, and hold-ups. With DeFi, closed financial systems can be transformed into an open financial economy based on open-source protocols that are more accessible, with fewer intermediaries, and more transparent. Since these new financial protocols utilize smart contracts deployed on various public blockchains, they are both programmable and easy to build, with no entry barriers. Let’s try to know about the history of the Defi in brief and the timelines of development in the year 2020 through the image 2 & 3 below: -
Apart from blockchain, DeFi uses Smart Contracts and Oracles to provide their services 24*7, without any human involvement. Smart contracts are automated agreements between the service provider and the recipient, where the terms are written in codes. Smart Contracts are Immutable and Irreversible. They are closed systems and do not interact with the external world to keep a check on the occurrence of external events triggering the execution of the agreement. Hence, the smart contracts use specialized software known as Oracles, which helps the smart contracts gain external information. In simpler terms, Smart Contracts are digital “if-then” rule codes, defining the terms between two (or more) parties, where if one party's needs and conditions are met, then the pre-agreed terms are triggered and the contract gets executed. For instance, · A is required to pay rent to B worth INR 1,000 every month for 12 months · One of the ways can be, A arrange for paying B INR 1000 every month at regular intervals via bank transfer · Alternatively, A can arrange for an escrow account and deposit the amount of INR 12,000 in it and get regular transfers done from there to B's account through NACH · However, all these methods in the existing financial system would require human intervention and are subject to error and delays, or imagine a bank server under maintenance when your payment had to be processed! · Alternative and better approach could be to use Smart Contracts through the Blockchain technology, which can execute the entire transaction in an automated, error-free, and unbiased manner · A regular smart contract is capable of executing this entire chain of events as required in this case · The entire amount of transaction (INR 12,000) could be locked in a smart contract by A via appropriate tokens of the same worth, and conditions could be set for their timely release to B. · As and when the conditions keep fulfilling, i.e., the due date of payment occurs, the smart contract keeps getting triggered and transmits the amounts to B · This is primarily how smart contracts can change the functioning in the world of finance. Now that we're aware of the functioning of smart contracts, it would be easy to understand how with the help of smart contracts one can create virtually any type of financial product which are completely new. Accessing a DeFi platform can be done through decentralized applications. Dapps are applications that focus on building financial services using cryptocurrencies. DApps allow users to directly interact with the blockchain platforms like Ethereum blockchain through digital wallets. Some of the most popular DApps include MetaMask, Uniswap, Trust Wallet, Brave, MakerDAO. As the services provided on the Defi platforms are under development at a high speed, few services offered currently are highlighted in image-4 and characteristics of the Defi in the Image-5)
In addition to the above use-cases, the following are some examples of financial transactions that can be performed on the Defi Platform: · Lending or Borrowing money around the Globe · Trading or investing in Cryptocurrencies · Earning Returns by lending crypto to the liquidity pools · Payments · Crowdfunding · Transacting in Insurance Products One might be thinking that with all the above-listed benefits and use cases of DeFi, there shall be an extensive resource requirement for accessing the DeFi ecosystem. Contrary to this, one will need only three things: · An Internet Connection · A system (PC or Smartphone) · DApps or Defi wallet With the advancement of the financial services at a rapid pace in the world of DeFi, let us try to evaluate the ecosystem on its Strengths and Weaknesses, along with the Opportunities it comes with, and the Threats it faces in the current scenario.
Defi - Common Misconceptions
A lot of talks about crypto and DeFi lately, right? Many people have different aspects and perspectives about this emerging world. Some people associate the technology more with its negative aspects than its positives. In the below section we have tried to cover a few common arguments/beliefs against it: -
Defi is in a developing stage having a disruptive nature and trying to bridge gaps in the existing traditional finance model. It is a fast-developing space with people associated learning continuously and trying to eradicate the lacunas in the projects such that the protocols are easy to use and grievance-free. Most attacks on DEFI applications are due to defective coding. All these are temporary issues as big organizations entering this space means more and more skilled people coming up to resolve issues, in the long term no one remembers all these attacks.
Post busting the myths about Defi, let’s try to explore the advantages of DeFi over the Traditional Finance
TradeFi Vs DeFi
Post discussion on Traditional Finance and the Decentralised Finance, let’s take this conversion of TradeFi Vs Defi ahead and try to find out how Defi tries to solve limitations of TradeFi as an emerging technology: -
1. Centralization
In TradeFi, financial services are provided, controlled, and managed by Central Systems. These systems often have centralized servers and data management systems.
On the other hand, DeFi applications aim to decentralize servers, databases, ownership, and management by making their community-owned by issuing governance tokens. All the governance token owners have the right to participate in the day-to-day decision-making of the project and all the necessary data is available in public which makes it a more transparent system.
2. Permission
Traditional systems require permission from centralized authorities like IRDAI, RBI, SEBI, to use or provide certain financial services. Even as an individual, it requires various KYC norms to be fulfilled which require permissions from Identity Management Authorities like Passport Office, Aadhar Approval, PAN Card approval.
Whereas In DeFi, neither the service provider protocol nor the user requires any permission from the centralized authorities or submit KYC or any other document. The Defi is built upon rule-based Smart Contracts and all we require is to honor those transactional rules.
3. Borrowing
TradeFi requires KYC and Credit Score as a mandatory criterian for availing loan, while the same is not required in Defi.
4. Custody of Collateralized assets
In TradeFi, the custody of assets is mainly held by the Centralized Authorities on behalf of the asset owners whereas, Defi requires all the collateralized assets to be pooled in the protocol itself and is not under the custody of any authority.
5. Conversion of Fiat Currency
Traditional fiat exchange enables the conversion of fiat currency through intermediaries by charging a commission, but in the Defi, the fiat can be interchanged with any currency or Cryptocurrencies in a matter of a click without requiring permissions or intermediaries through decentralized platforms.
6. Governance
It is managed by the rules of the service provider, marketplace, regulator, or self-regulatory organizations, whereas, it is managed by the governance token owners having participation rights and there is no restriction to become a governance token owner, it just requires the purchase of the tokens.
7. Investor Protection
In TradeFi, Government mandates disclosure and consumer protections, anti-fraud enforcement, exposure limits, and insurance schemes whereas the user assumes all the risk in the case of DeFi. However, there are insurance products in Defi, which offer compensation against losses.
The difference in the Traditional Finance Structure and Defi is reflected in image-6 below.
Defi combines new-age banking solutions with conventional practices to deliver an innovative and modern approach to accessing financial services. It defines a new perspective about how can Traditional Finance practices could perform more transparently and efficiently through the use of emerging technologies like Blockchain. In other words, Defi is a way to offer traditional finance services in a decentralized setup, with Defi coming up people have more ease accessing financial transactions. Forbes recently recognized the disruptive nature of this emerging technology in one of its articles. Considering all the Risks and Misconceptions, the benefits offered by Defi are far more than the TradeFi, and are making people attracted towards Defi from Traditional Finance. This is evident by the increase in the asset locked in Defi Protocols to $ 200B recently from $60B (Oct’20). This shows that it has the potential to disrupt traditional practices and will undoubtedly play a significant role in the future of finance and global banking. In just one line we can elude that "Banking will stay, Banks however might not”. Below Image-7 shows the growth in the total amount locked in the Defi Protocols in USD
