DeFi holds the promise of creating financial products and services for anyone with a smartphone. The tool allows its users to transfer their funds from low-interest bank accounts, where inflation is already eroding the value of deposits, to funds linked to smart contracts. The funds held in these funds can be lent, borrowed or increased in value through a series of blockchain-based monetary mechanisms, including liquidity incentives from decentralised exchanges and synthetic derivatives. The annual percentage return can be 20% higher than traditional savings.
DeFi’s extraordinary profitability can be explained. The instrument is digital and bypasses the long chain of brokers, lawyers, dealers, lenders, authorities, and supervisors whose fees impose a staggeringly high burden on transactions. In a radical innovation – essentially by merely rejecting the role of regulators – few technological processes have the same potential as DeFi.
It is estimated that around five million people currently use DeFi applications. In November 2021, the total value of deposits tied to DeFi contracts exceeded USD 97 billion, up from USD 1 billion in June 2020. DeFi is growing at a frenetic pace due to the innovation in blockchain technology and the inability of traditional financial systems to respond or match this innovation.
De-Fi in Action
For those who wish to understand and properly appreciate DeFi, in addition to the already mentioned attractive profits that this instrument brings, a short but simple explanation is necessary. Let’s say Alice wants to buy a house from Bob. Will Bob take the money first or will Alice take the house first?
If Alice transfers the money to Bob, it may take several hours before the money is credited to Bob’s account. In the meantime, Bob may not trust Alice to sign for the house until he sees the money in his account.
To solve these problems of trust and speed of transaction, the financial system has developed a number of intermediaries. Lawyers keep the money escrowed, thus removing counterparty risk. Buyers and sellers want to eliminate lawyers and their excessive fees. DeFi empowers them to do so.
The example of Alice and Bob may seem trivial, but when the transaction involves the sale of a company, the fees can run into the millions. In such cases, the case for removing lawyers can become even more compelling.
The DeFi instrument eliminates intermediaries by creating products that are inherently unprotectable. It takes the work of buyers, sellers, banks, lawyers, insurers and regulators and puts it into a smart contract over which no one has any control. DeFi transactions do not need people to carry them out. Instead of people, software does the job. So the innovation of DeFi will have major implications for the future of banking and regulators.
An example somewhat different from that of Alice and Bob shows the staggering impact that DeFi will have on traditional financial processes and their participants. Take the CEO of a large business. His job is to grow the business. This is done by selling more and raising more capital.
DeFi helps with both. In the normal course of business, when the CEO orders a bond issue to raise capital, the company should issue a prospectus carefully drafted by lawyers, find backing for the bond by paying intermediaries, submit the bond issue to regulators for review, inform the CSD of the transactions, find a custodian to protect the bond, work with brokers and private wealth managers to find buyers.
This process usually takes months. And it is costly. Ultimately, the burden of these payments to intermediaries falls on the shoulders of the buyers. Instead, the CEO could use DeFi to tap into smart contract-based funds and remove the traditional financial chain. Another advantage is that the required funds would not only be available at a lower cost, but also within minutes.
With DeFi, a business may never have to go to a bank or venture capital fund again. When a business wants to raise money, it can get it from millions of people ready to lend. Lenders will base their decisions on the business history and credit history publicly available on DeFi. Both businesses and lenders will bypass the banking system, governments and regulators by using DeFi.
A potential hurdle
There are some challenges with this emerging innovation. DeFi is difficult to use – interoperability or cross-blockchain transfers are a challenge and the complexity of DeFi applications and protocols still requires significant improvements in the user experience. Monthly reports on the risks and shortcomings of DeFi systems present these challenges. These hurdles, however, can be overcome through innovation and collaboration.
The US Securities and Exchange Commission (SEC, for example, is trying to understand and define how DeFi’s participants, assets and activities could come under its jurisdiction. It cautiously refers to DeFi as a “shared opportunity and challenge”, inviting the DeFi community to “help promote responsible innovation”.A transparent financial future
DeFi alsointroduces a new paradigm of corporate openness and transparency. An organisation’s transactional history is made accessible, empowering individual users to decide how much trust to place in an organisation and assess its sustainability. Investors no longer need to rely on potentially biased analysts.
If DeFi grows and becomes as popular as analyst services are now, there may be no need for regulators in financial services. This seems an extreme statement, but it is a valid one. Today, governments and regulators set the rules for financial products and transactions and monitor compliance.
Those rules are written in English (or any other language). We need lawyers to interpret that language. There is nothing in the DeFi instrument written in English. Instead, ituses a programming language. The behaviours, rules and conditions are carefully and precisely translated into code, whicht does not need to be interpreted.
This transparency, combined with improved levels of transactional trust and speed in the smart-contract model, ensures that De-Fi will revolutionise and re-write traditional financial systems and services, sooner rather than later.