Before we dive into how DeFi is changing banking, let’s quickly recap what it DeFi is. According to the Ethereum network, DeFi is defined as a collective term for financial products and services designed for anyone who has access to the blockchain, that is, anyone who can access the internet
After the financial crisis of 2008, many governments, financial institutions, and major players in the finance sector were called into question. Many individuals were unsure whether these conventional institutions had their best interests at heart or were out to make profits.
However, with the advent of bitcoin in 2009, the world now had the tools needed to establish another financial system — one that is distributed and based on decentralized consensus as opposed to centralized fiat. Fast forward to 2015, the launch of Ethereum took this a step further by introducing decentralized finance or, in short, DeFi. Today decentralized finance is transforming the financial sector so that users can operate and transact without intermediaries.
Recap: What is decentralized finance?
In short, DeFi is a financial ecosystem built on the blockchain network using smart contracts. Smart contracts are automated agreements that are enforced through code written on the blockchain and executed when certain conditions are met.
Smart contracts consist of autonomous peer-to-peer protocols that allow users and developers to transact on the network without any intermediaries. Currently, most developers launch DeFi applications on the Ethereum blockchain, but there are a plethora of blockchain protocols that support DeFi. Some of the most popular DeFi blockchains include Solana, Avalanche, and Terra network, to mention a few.
A closer look at the various types of conventional banks and the services they offer
As you are aware, the banking industry handles cash, credit and other financial transactions for individual customers and businesses. Moreover, banking institutions provide liquidity to families and businesses to invest in the future, and they are one of the key players in a country’s economy.
Depending on their services, the financial sector places banks into various categories. Let’s have a look at some of these types.
1. Central banks
Perhaps the most popular category is a central bank. In the United States, the Federal Reserve acts as the central bank, but most countries have their own version. Generally, central banks are responsible for four main functions:
- Increase money supply by buying more securities and assets on the open market
- Set lending interest rates by changing the interest rates they offer to other retail or commercial banks
- Lend out money to other banks
- Change monetary policies to support liquidity and maintain stability
Over the years, the banking sector has become intensely complicated, and they currently offer a variety of services and products to the economy and financial industry.
2. Internet banking
Further, one of the popular banking categories, internet banking, also known as e-banking or online banking, provides financial services through the World Wide Web. Your bank’s mobile app is an excellent example of internet banking.
3. Savings and loans banking
Although less popular to investors, savings and loans are specialized entities in the banking sector that offer relatively higher interest rates to incentivize users to save more. They are primarily used as a great financial vehicle to raise money and fund mortgages for middle-class Americans.
4. Investment banks
Investment banks are more popular with investors since they find funding for corporations through initial public stock offerings or bonds. They help you list your company in a security exchange to get funding. The largest investment banks include Bank of America, Goldman Sachs and J.P Morgan, to mention a few.
5. Regional and community banks
Regional banks are smaller than the categories we mentioned above. They focus more on the local market by providing specialized services to the customers, primarily individuals. They rarely get into business with large corporations.
Why do we need a decentralized financial system?
One key feature of all the above categories is that they are controlled by central authorities and third parties that process financial transactions and services. For instance, the Federal Reserve controls the supply of banknotes in the American economy.
According to TechStartups, 80% of all the U.S. dollars in existence were printed in 22 months, from $4 trillion in January 2020 to $20 trillion in October 2021. As a result, the annual inflation rate surged to around 7.5% in January 2022, the highest since 1982.
This is just one of the examples of the devastating effects a centralized financial entity has, not only on the economy but also on people’s purchasing power or choices. For that matter, decentralized finance presents the tools to facilitate a trustless alternative to the banking structure.
How DeFi is changing banking With Technology
1. Blockchain technology
The backbone of DeFi is a decentralized and distributed ledger of transactions. Unlike conventional banking institutions, blockchain distributes transaction data across all the network’s participants. As such, transaction data is transparent and immutable.
Cryptocurrencies are scarce programmable currencies that facilitate transactions across the blockchain network. Since they reside on the blockchain, they offer peer-to-peer services. With cryptos, you do not need conventional institutions to facilitate transactions but rather smart contracts.
One of the significant drawbacks of cryptocurrencies as a medium of exchange is that they are very volatile. To counter this, the crypto community developed stablecoins — specialized cryptocurrencies that are pegged on a 1:1 ratio with fiat currencies. A good example is USDC, the stablecoin of the Circle network.
In the DeFi ecosystem, users use stablecoins the same way they use fiat currencies in the real world. You can use them to purchase goods and services from specific merchants, take loans or earn interest on your stablecoin savings.
4. Smart contracts
Smart contracts are a crucial aspect of the DeFi ecosystem. They allow any type of transaction, clauses for traditional agreements and ownership of assets to be transferred through DeFi.
5. Data oracles
A data oracle is a web application or software that sends data from the outside world to the DeFi ecosystem so that the smart contract can execute agreements when they meet certain conditions.
However, unlike traditional oracles that acquire data from centralized data sources, blockchain oracles gather data from a distributed and decentralized data source. Moreover, they verify and validate data sources before adding them to the blockchain.
6. Decentralized applications (DApps)
DApps are applications or software developed on the blockchain. Unlike conventional applications that store data on centralized servers, DApps leverage the same reliable decentralized infrastructural concepts that make blockchain work.
How DeFi is taking over the banking world
1. Autonomous financial organizations
Decentralized Autonomous Organizations, commonly known as DAOs, govern most DeFi applications, from Uniswap to Aave. DAOs are governing bodies that keep an eye on the allocation of resources tied to an associated crypto project and ensure a project’s long-term success.
Like many crypto applications, developers also leverage smart contracts to create DAOs. In these smart contracts, rights and responsibilities that banking institutions would otherwise undertake are inscribed in the code as self-executing contracts.
Moreover, members of the network handle decisions within DAOs. Members of the DAOs use tokens associated with the project to vote on the rules that govern the larger decentralized ecosystem. After users pass a suggestion, the token holders have the option to vote for or against it. Different DAOs have different quorums and working mechanisms, but generally, the majority rules, just like democracies around the globe.
Since DAO development is open source, it’s now easier for developers because they can use existing DAO structures such as Aragon, MolochDAO or DXdao. DXDao is one of the popular structures, and it’s used to manage Rails, a micropayment platform on the Ethereum blockchain.
2. Financial inclusion
The DeFi ecosystem offers various cutting edge financial products that remove third parties, put consumers in control of their finances and divert stakeholder reward models to users. DeFi is moving away from fiat currencies and the centralized nature of fiscal and monetary policies by harnessing cryptocurrencies and digital assets.
Moreover, DeFi eliminates most of the rules and conditions put in place by traditional banks and institutions when opening an account or making investments. The DeFi ecosystem is open to anyone regardless of their credit history, net worth, or geographical location. To maintain the convenience of daily banking services, DeFi offers a digital wallet. While earlier versions required tech-savvy individuals, digital wallets have evolved into simple interfaces that make it easier for users to buy, trade and use their crypto for payments instead of fiat. Users do not need a bank account to facilitate or make transactions.
3. Peer-to-peer (P2P) transactions and a transparent financial system
Peer-to-peer payment solutions are the foundational use case of the DeFi space and blockchain ecosystem. Blockchain technology is designed so that consumers can transact cryptocurrencies securely and directly with one another, without any intermediaries. DeFi payment solutions offer an open economic system for the underbanked and the unbanked population.
Moreover, according to a video by 99Bitcoins, blockchain projects like Ripple (XRP) are also shifting how conventional banks work. Ripple is helping financial institutions and banks streamline cross border transfers. It offers market infrastructure and a reliable liquidity option that allows banks to make direct P2P transactions from one bank to another using the XRP token.
DeFi is also a P2P network and a distributed ledger technology that allows participants to view the ground truth system of record, also known as the ledger. Each network participant has an exact up to date ledger that reflects changes. Also, using platforms like Etherscan, an Ethereum blockchain explorer, users can look through a transaction ledger.
4. Low-interest loans
As you might already know, the government and third parties control virtually every aspect of the banking system and interest on loans. As we discussed above, in the U.S., the FED has control over loan interest rates and the supply of money in the economy. Moreover, U.S. regulatory bodies like the Security Exchange Commission also lay down rules for centralized banking institutions, destabilizing interest rates.
However, DeFi provides users with direct on-chain financial services like loans away from banks, lenders or brokerage firms. This means that you can get loans directly from the blockchain without going through credit checks from banks. Moreover, since DeFi eliminates intermediaries, on-chain loans are issued at relatively lower prices.
For instance, the Tezos Ecosystem implements on-chain lending protocols that enable users to borrow stablecoins without intermediaries or invasive checks. All the terms of the loans are collateralized for the automated lending and borrowing triggered by a mechanism written on Tezos smart contract ecosystem.
5. Yield farming and high return on investments
According to a video by Whiteboard Crypto, yield farming is putting your cryptocurrency coins in the most optimized spot so that they will generate higher interest and earn you free crypto. Yield farming is an excellent alternative to saving your funds in a normal bank account since it offers higher interest rates.
There are several ways to generate yield.
You can stake your coins, which is generally locking up your cryptocurrencies with a crypto project and taking part in its governance. Blockchains such as Solana and Cordano use a proof-of-stake mechanism to govern their network and also reward stakeholders for verifying transactions.
Becoming a Liquidity Provider
The second way is becoming a liquidity provider on a decentralized exchange or DEX like Uniswap — an Ethereum based DEX. A decentralized exchange is a P2P marketplace that allows users to transact or swap cryptocurrencies directly.
The transactions are facilitated by a pool of crypto pairs provided by users who deposit funds to provide liquidity, also known as liquidity providers. As liquidity providers, the network rewards users with a portion of the transaction fees collected by the exchange.
Lending your cryptocurrency coins
Lastly is through lending your crypto assets, as we mentioned above. Borrowers also use lending protocols like Compound or Aave to take out loans against their crypto assets. Some protocols like Aave offer up to 11.82% APY.
6. Stablecoins and digital currencies
Introduced to represent their physical counterpart, fiat currencies like the dollar and stablecoins have played a crucial part in reducing volatility in the overall crypto market. They also strengthen the bridge between traditional financial services offered by banks and the crypto markets. Stablecoins facilitate this by providing a base value for issuing loans and derivatives and measuring financial assets and products.
You do not need to convert your crypto assets to fiat during high volatility in today’s crypto ecosystem. You can simply swap them to stablecoins to maintain the value of your coins. Additionally, various merchants worldwide like CheapAir accept stablecoins as a checkout method when making purchases.
7. Decentralized crowdfunding
As one of the essential tools for DeFi, smart contracts in crowdfunding aim to provide three main solutions:
- Provide a trustless ecosystem for investors and startups,
- Eliminate the dependency on third parties like banks, and
- Speed out payout funds in the crowdfunding process.
In crowdfunding, a smart contract is crucial because it automatically executes agreements between an investor and the fundraiser or startup. Depending on which milestone processes need to be automated and placed on the blockchain, it can also be between other parties.
Unlike traditional crowdfunding processes, where fundraisers have to wait for a bank or financial institution to authorize the payments, smart contracts automatically release the funds immediately after a milestone is marked as complete. This provides better liquidity, inherent security from the blockchain, and faster fund disbursement.
Security risks attached to Decentralized finance
According to Ecency, cryptocurrencies and DeFi applications are set to replace traditional banking systems and current capital market dynamics. However, DeFi has drawn attention to some of the security risks involved with its growing popularity.
i. Rug pulls and Ponzi schemes
Due to their lack of regulation and centralized oversight, DeFi protocols are highly susceptible to Ponzi schemes and rug pulls. Rug pulls involve instances where a DeFi project raises money by selling tokens to investors. After the project has raised a substantial amount of capital, the project and the team behind it disappear.
Since the project owners do not register these projects with the government or any financial institutions, the investors lose their investments eventually.
ii. A 51% Attack
51% attacks are more common in proof of stake projects that allow token holders to govern and control a project. If an attacker owns more than 51% of the tokens, they would gain access to the computational power, future changes, or even exploit the protocol. Most importantly, attackers can perform double-spend attacks through a 51% attack and drain most of the coins from the network wallets.
iii. False liquidity pool estimates and front running attacks
Since no central authority governs DeFi applications, attackers can easily create a project to lure investors. They can also publish false liquidity pools and offer high interests to lenders to seem more profitable.
In more advanced attacks, attackers can implement flash loan attacks where they introduce imbalances to the liquidity pool during a certain transaction. This would result in some investors purchasing tokens at a higher price than the market value, and the attackers end up compromising the pool’s value.
The only way is up for decentralized finance
Despite the security risks mentioned above, DeFi is certainly a vital disruptor of the banking and financial sectors. After the 2008 financial crisis, a portion of the global population sought a way to shift from centralized services to decentralized services, and DeFi enabled this. Moreover, with an institution such as the FED looking into developing a digital currency, it’s quite clear that DeFi cannot be ignored.
The concept that finance is increasingly becoming more software-based and decentralized is clear. In the near future, we will see more innovation in DeFi-type architecture types built within or on top of conventional banking systems.