DeFi (decentralized finance) has recently seen robust development and interesting use cases. The focus is on developing financial applications, such as for payments, savings, investments, and lending, that are decentralized.
This means there is not much connection to the traditional banking infrastructure, which involves managing and maintaining physical infrastructure and personnel, sometimes worldwide, to provide financial services to customers. The reason for this is that DeFi is built on blockchain and crypto technology.
While this certainly has the potential for being disruptive to the traditional financial services industry, the market opportunity is also massive. For example, PayPal CEO Dan Schulman estimates that the size of the digital payments market could reach $100 trillion.
Let’s take a deeper look at DeFi and what it means for the financial services industry.
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What is DeFi?
The financial services industry is one of the biggest spenders on IT systems. This has allowed for more efficiency and scale.
But there are still problems. After all, there remain myriad intermediaries like brokers, investment bankers, market makers, and so on, which add to the friction and costs for transactions.
Then, there is the issue of access to financial services. Often you need a strong credit rating or a long history to get capital. The result is that many small businesses are undercapitalized. There are also millions of consumers who cannot get access to affordable credit.
True, FinTech (financial technology) companies have been trying to democratize financial services, but the apps still use the existing banking infrastructure. Consider peer-to-peer payment app Venmo, which connects to the existing gateways for any payment. In fact, for a user to create an account, they need to provide information for a debit card, credit card, or bank account.
But with DeFi, there is a completely different approach. Based on blockchain, anyone can participate in the network as long as they have a connection to the internet. This peer-to-peer structure means that there is no intermediary, like a bank, to determine whether a loan should be issued and payment made.
DeFi software is based on dApps or decentralized apps. They usually operate on the Ethereum blockchain and use smart contracts, which securely store the transaction information.
“These contracts are blockchain-based programs that execute actions automatically once the agreed-upon conditions are met,” said Ramanathan Srikumar, chief solutions officer at Mphasis. “Users can become participants and shareholders on the blockchain system by earning tokens, and the user has control and ownership over their data.”
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What Can You Do With DeFi?
With DeFi, you can carry out any transaction that the traditional financial system can. The technology is also highly composable—you can interact with the protocols in seemingly endless combinations—and permissionless.
“If someone has an idea for a new type of financial instrument that doesn’t exist in DeFi, they’re able to use and combine the existing suite of DeFi primitives to bring their new idea to life,” said Nick Emmons, co-founder and CEO of Upshot. “This sort of permissionless composability, in the form of ‘money legos,’ has led to breathtaking rates of innovation in the DeFi space.
“Innovations that might take years to bring to life in traditional financial industries are able to take weeks or months in DeFi.”
The technology also allows for much quicker transactions on a global basis and lower fees. As a result, there are more opportunities to earn higher yields compared to traditional banks.
The Risks
While the benefits of DeFi are clear, there are still considerable risks. When it comes to people’s money, they want strong safeguards. This is why the U.S. government has tight regulations on the financial sector and protections like deposit insurance.
“DeFi essentially replaces the role of the intermediary and regulator in protecting consumers with smart contracts,” said Emmons. “This substitution does place more onus on the people interacting with these financial products to do their due diligence, ensuring there is no potential for technical exploits in the smart contracts.
“Most cases where consumers have lost money in DeFi to date have come from technical vulnerabilities that were later exploited.”
According to a report from Elliptic, there was more than $10 billion in stolen funds from DeFi accounts in 2021. This is up 7x compared to the following year. By comparison, there is $247 billion deposited in DeFi accounts.
The Future of DeFi
DeFi is still in its early stages, with adopters who are willing to take risks and pioneer new approaches. But if DeFi wants to become more mainstream, there will need to be improvements in making the systems easier to use as well as protections to ensure users’ financial safety.
Although, in the next few years, much of the growth in DeFi may come in emerging and frontier markets. They have the most challenges with traditional finance and need better systems to help improve economic growth.
“We’re seeing a new gig economy emerge in Kenya,” said Jackie Bona, CEO of Valora. “Workers earn their paychecks in crypto in real time and use their crypto earnings to pay for everyday expenses and use DeFi tools to save and earn more crypto.”
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