Blockchain is evolving, and we have seen how its use cases have grown and expanded within a decade’s time frame. At present, all the discussions and innovations in blockchain are focused on decentralised finance or DeFi, which is one of the fastest-growing sub-sectors in the crypto ecosystem. As per estimates, the total value locked (TVL) in DeFi has surpassed $250 billion, which is quite an astonishing number.
Total Value Locked indicates the total value of crypto assets currently staked in a blockchain network or crypto ecosystem.
So, why are people banking heavily on DeFi and why it is called the future of the global financial system.
This article will try to figure out what DeFi is, how it is revolutionising the traditional financial system, and how it benefits users. Let’s learn about this in detail.
Inefficiencies in Traditional Financial Systems
To understand why DeFi became so huge in such a short period, we have to understand the inefficiencies in the current traditional financial system.
At present, we deal through a financial system that is highly centralised and intermediary-driven, which leads to a series of problems, like:
- High transaction cost
- High entry-barrier
- Time-consuming transactional processes
- Higher chances of errors, manipulation, and frauds in the system
- Frequent system crashes
- No reliable point of contact and lack of transparency
These problems make the system highly unreliable and out of reach for many. For example, SWIFT payment, currently used by banks for processing international payments, takes 1 to 4 working days to settle payments. Plus, the charges for transferring money range between 5-10% of the transfer amount, including exchange rate fees, transfer charges, and local government taxes.
Take lending as the next example, the segment where most DeFi players focus. At present, banks play the role of an intermediary, taking money from depositors and lending to borrowers. The bank charges hefty service fees and interest rates from the borrowers for these services. Also, the borrowers have to fulfil specific eligibility requirements, making it difficult for everyone to access the system.
Above all these, biases and preconceived notions of office bearers slows down the process significantly.
This is where DeFi solves all these problems in one go.
How DeFi Solves the Inefficiencies in the Financial System
DeFi does it by democratising the financial system through smart contracts. It allows anyone to access the financial system with a smartphone and internet connection. DeFi is borderless.
Before moving forward, we should understand the concept of smart contracts.
Smart contracts are programmable self-executing contracts stored in the blockchain that get executed automatically when all the pre-determined conditions are met. The contracts can be as simple as a transaction between two parties to a complex one, where multiple parties are involved.
Learn more about smart contracts here.
In DeFi, smart contracts do the hard work by doing the activities that banks generally do, thus eliminating all the intermediaries. DeFi is setting the stage for the creation of the modern financial system. Let’s go through some of the DeFi use cases and how it is revolutionising the system.
DeFi Use Cases
DeFi Lending and Borrowing
DeFi allows lending and borrowing in a completely decentralised and P2P fashion, such that the individuals have complete control over their assets at all times. Let’s find out how it works.
The heart of DeFi lending and borrowing is the DeFi protocol. The protocol collects money from the lenders to a money market, where it pools liquidity and uses them to issue loans via smart contracts.
The borrowers who intend to borrow from the protocol need to pledge assets for collateral, usually larger than the amount to be borrowed. Once the pledge amount is provided and locked in a smart contract, the borrower receives the funds denominated in cryptocurrency or fiat currency. During the loan tenure, if the value of collateral drops, the borrower needs to increase the pledged amount, or else it will be auctioned to cover the lender’s risks.
Once the borrower repays the loan amount and interest at the end of the loan tenure, the smart contract releases the cryptocurrencies pledged as collateral.
DeFi lending makes sense because one can avail of the loan instantly, and there are no eligibility criteria to fulfil.
Decentralised Exchanges (DEX)
Currently, the major part of crypto trading and investing services are executed by centralised exchanges. Although centralised exchanges provide scalability and better market matching ability, they lag in security and are prone to crashes, making them highly unreliable.
On the other hand, decentralised exchanges use smart contract functionality for all trade-related functions. For example, Uniswap, a decentralised exchange pools liquidity in smart contracts and transfers to users only when the contract terms are met.
Here’s a simple breakdown of the process to exchange tokens in a DEX:
The user or the token owner raises a sell order to exchange the token with any of the available tokens in the DEX with details like the number of tokens and price.
Once the sell order is created on a smart contract, buyers can make a bid, and once the terms of the contracts are met, the order is executed on the smart contract. The tokens are debited from the seller’s wallet and credited to the buyer’s wallet.
In the whole process, the seller doesn’t have to transfer tokens to the exchange account, which makes the process very secure.
Crypto Synthetic Asset
The synthetic crypto asset is an emerging DeFi niche in the crypto market. It is a tokenised form of crypto asset that derives its value from another asset or mimics another asset and can be traded in a P2P fashion. In other words, crypto synthetic assets are a form of financial instrument on smart contracts that track and provide returns of another asset without the need to hold that asset.
For example, a tokenised version of equity stock or gold, which can be bought, sold, and traded using cryptocurrencies. Crypto synthetic assets help bridge the gap between the crypto market and traditional financial markets, which helps you to take advantage of both the world.
Automated Investing Platforms
Automated investing platforms are like mutual funds of the crypto market, where the protocol will manage your holdings as per the pre-determined strategy to maximise yield. The only difference is, everything happens on the blockchain and the entire process is automated.
Stablecoins are a huge part of the DeFi ecosystem and can be ascertained by the fact that the total market cap of stablecoins has surpassed the $150 billion mark.
Stablecoins address the issue of volatility in cryptocurrencies that hinders their ability to be used as a payment mode for everyday transactions.
What makes stablecoins unique is that a reserve asset backs them. For example, for every USDT coin circulating in the market, a dollar is pegged to it, thus incorporating the feature of price stability. It offers benefits of both worlds, stability of a fiat currency and security and privacy of cryptocurrencies.
DeFi Payment Protocols
One of the emerging sub-sectors of the DeFi ecosystem is the payment protocols. For organisations, it automates the payment request process to receive payments on blockchain, thus removing intermediaries from the processes. Such systems are similar to Paypal where you can create invoices, request payments, and receive payments in preferred currencies.
Popular DeFi Tokens You Should Not Miss
AAVE is an open-source DeFi protocol that allows users to earn interest on crypto holdings and borrow assets. It was launched in November 2017 and was initially known as ETHLend. In the recent bull rally, the coin has made an all-time high level of $666.86 (₹56,401).
Maker (MKR) is an ERC-20 token and is the governance token of MakerDAO and Maker Protocol. The MakerDAO is a DeFi lending platform that allows users to lend and borrow cryptocurrencies without a centralised authority.
The MakerDAO protocol is also responsible for creating its own USD-pegged DAI stablecoin. MKR showed up 2021 at $531(₹39,449) and has made an all-time high level of $6,339 (₹5,08,350) in the recent bull run.
Uniswap is a decentralised exchange (DEX) built on the Ethereum blockchain. It pools liquidity in smart contracts that help users swap tokens in seconds without needing a third-party intermediary.
UNI, the native token of Uniswap, which was launched in September 2020 is one of the top-performing tokens in the market and has grown by almost 20 times in value in such a short period. Its all-time high level is $44.97 (₹3,611).
Synthetix Network Token (SNX)
Synthetix is a DeFi protocol that enables the creation of synthetic assets of popular assets such as cryptocurrencies, stocks, fiat currencies, commodities and other assets that can be traded on-chain. They capture the asset’s price movement without slippages and let you trade the assets without requiring you to hold them directly.
SNX is one of the popular crypto synthetic asset platforms with a total value locked in the platform that has crossed over $350 million.
yearn.finance is an aggregator service for DeFi investors that uses automation to maximise yields on your crypto holdings. For this purpose, one needs to transfer their crypto holdings to Yearn Vault, select an investment strategy that best suits your risk profile, and deploy the funds. By shifting capital, rebalancing, auto compounding, Yearn’s tech helps to maximise yields passively for you, and everything happens on the blockchain.
YFI token was once the priciest token in the crypto market. It made an all-time high level of $93,453 (₹77,71,032) in May 2021.
COTI leverages the features of stablecoins and enables organisations to build their own decentralised payment solutions by digitising any currency to save time and cost in the payment process while providing the security and features of blockchain.
COTI is currently trading around the $0.30 (₹ 22.65) level and has grown over 10 times in value in the past 12 months. Its all-time high level is $0.68 (₹51.34).
Request is a decentralised protocol for payment requests that lets you raise requests for payments and receive payments in your preferred digital currencies, including Ether, ERC-20 tokens, Polygon, CELO, Fantom, and Near without involving intermediaries.
Request removes the artificial barrier and provides a seamless payment experience to individuals and organisations. REQ is currently trading at $0.39 (₹29.44) has grown by over 20 times in the past one year. It has recorded an all-time high of $1.08 (₹81.54).
Why is DeFi Better than a Traditional Financial System?
DeFi is based on smart contracts, which are a single source of truth. Once the rules and regulations of the smart contracts are set, they cannot be changed or manipulated. And, the execution of smart contracts is totally based on the actions of the parties involved. It doesn’t require any human interference in the whole process until the expiration of the smart contract.
These features make DeFi a highly transparent, accessible, and safer form of finance compared to traditional financial systems.
The utility of DeFi can be ascertained from the fact that in a year, the DeFi ecosystem has grown from near $8 billion to over $100 billion crypto ecosystem.
Here is another example of why DeFi is gaining popularity and is preferred by high-net-worth investors. In April 2020, a user transferred BTC worth $1.1 billion or roughly 161,500 BTC for a fee of only 0.00010019 BTC — approximately $0.68. If the same amount was transferred through banking channels, the transaction fee would have easily run in thousands of dollars.
The more we talk about the power of DeFi, the less it seems. DeFi can help realise the dream of a financially inclusive society, which the traditional financial system has struggled to achieve for many years.
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Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.
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