31.05.2023

How Decentralized Finance Will Change Your Understanding Of Financial Systems

How Decentralized Finance Will Change Your Understanding Of Financial Syst

Decentralized Finance (DeFi) is likely to have a significant impact on how banks operate in the future – and even has the potential to shift the structure of the whole financial system at a macroeconomic level. Before we discuss and substantiate this hypothesis, we would first like to introduce the core concept of DeFi.

Decentralized Finance or “DeFi” in short, is an umbrella term encompassing the vision of a financial system that functions without any intermediaries, such as banks, insurances or clearinghouses, and is operated just by the power of smart contracts. DeFi applications strive to fulfill the services of traditional finance (also coined as Centralized Finance, or just CeFi) – but in a completely permissionless, global and transparent manner. 

DeFi applications could be at the verge of challenging traditional finance actors on various fronts 

The vision of a new financial system accompanies the blockchain space since its inception. However, while it has been an aspirational dream for the blockchain community in the past, the vision of a new financial system has come some steps closer. 

Since 2020, DeFi is growing at an astonishing pace and billions of USD have been put in the ecosystem. The growth is mainly led by applications (also denominated as protocols) that are built on the Ethereum blockchain. In the following, we give an overview of the actors in the DeFi ecosystem from an economic point of view, introduce the maturity stages of DeFi and explain the potential of DeFi to outperform the traditional finance system in the years to come. 

Commercial banks

The primary business model of commercial banks is to accept deposits and to give loans to its clients. Borrowing and lending are an elementary cornerstone of an efficient financial system as holders of funds get an incentive to provide liquidity to the markets and in exchange earn a return on their otherwise unproductive assets.

DeFi protocols enable for the first time to borrow or lend money on a large scale between unknown participants and without any intermediaries. Those applications bring lenders and borrowers together and set interest rates automatically in accordance with supply and demand. Moreover, those protocols are truly inclusive, as anybody can interact with them at any time, from any location, and with any amount. 

In fact, the recent hype around DeFi applications is largely driven by the advancement of borrowing and lending protocols, such as Compound. In contrast to traditional finance, loans in DeFi are commonly secured by over-collateralization. However, companies such as Aave are currently working on enabling uncollateralized loans similarly to traditional finance.

Investment banks and issuers of financial instruments

The business model of investment banks usually involves the advisory on financial transactions. Also, the creation or trading of complex financial products and the management of assets fall in the realm of investment banks. DeFi protocols are already offering similar products. 

For instance, Synthetix is a derivatives issuance protocol, which enables the decentral creation and trading of derivatives on assets such as stocks, currencies, and commodities. Also, decentral asset management for cryptocurrencies is evolving. Yearn Finance, for example, is an autonomous protocol, which searches for the best yields in the DeFi space and invests automatically for its users.

Exchanges

The function of an exchange is to organize the trading of different assets, such as stocks or foreign currencies, between two or more market participants. Even the exchange of cryptocurrencies against fiat money (e.g. US Dollar) can be attributed to CeFi, as the regular holder of cryptocurrencies needs to use exchanges like Coinbase or Binance (which are centralized organizations) to swap a unit of a cryptocurrency against another. 

Now, with the emergence of decentralized exchanges (DEX), holders of cryptocurrencies no longer need to leave the crypto space for swapping their tokens. A prominent example of a DEX is Uniswap. DEX are composed of smart contracts that hold liquidity reserves and function according to defined pricing mechanisms. Such automated liquidity protocols play a key role in the development of an independent decentralized ecosystem without any CeFi intermediaries.

Insurances

An important function of insurance is to smooth out risks and bring security for market participants. An example of decentralized insurance is Nexus Mutual, which offers insurances that cover bugs in smart contracts. Since everything is based on smart contracts in DeFi, vulnerabilities in the code of smart contracts is a fundamental risk for DeFi users. Decentralized insurances are still in their infancy, but it can be expected that a larger amount and more sophisticated insurance models have the potential to emerge in the DeFi space in the future.

Central banks

So-called stablecoins are based on blockchain protocols that have the principle of price stability inherently encoded and, thus, fulfill the function of a reserve currency. The introduction of stablecoins set the foundation of the functioning decentralized financial system, as they enable participants to engage with each other without the underlying risk of price volatility. There are three options how a cryptocurrency can reach price stability. 

First, stablecoins can reach high degrees of price stability by pegging a currency to other assets. For example, for each issued unit of USD Coin a real US Dollar is held in reserve. 

From a decentralized finance perspective, another interesting approach is the issuance of stablecoins by using other cryptocurrencies as collateral. A central protocol for the Defi ecosystem is Maker DAO, which issues the cryptocurrency DAI that is backed by other cryptocurrencies and ensures with its algorithm that the value of 1 DAI is hovering around the value of 1 US Dollar. 

Thirdly, there are more experimental approaches that aim to reach price stability without the use of collaterals. For instance, the protocol Ampleforth automatically adjusts the supply of token in accordance with demand.