“Bank the unbanked! Banking for the people! Upend the dominant paradigm!” Decentralized finance, or DeFi, is touted as the next big revolution in the world of banking and markets, just like Bitcoin was supposed to be the next big revolution in the world of currency. Oh, wait, one Bitcoin is currently worth over USD 10k, so maybe it isn’t going to replace the dollar, but it’s certainly been a revolution. In its turn, DeFi could be a solution for the unbanked, but maybe it is actually the solution for many of the problems and headaches faced by those of us who already use banks.
Maybe, DeFi can help bank the banked. New services, old services done better, headaches removed. Let’s take a look.
But what is DeFi in the first place?
A couple of notes, first, on what DeFi is. The 21st Century has seen the appearance of a lot of head-turning technologies and ways to use them, and this is not going to stop soon. DeFi is a way to bring together some of those technologies and our changed expectations for what we can do.
Decentralized finance does away with many aspects of 20th Century banking that are now seen as out-of-date or wishful thinking, or just in the way. These aspects range from centralized ledgers to fraud prevention to currency exchange delays and fees that are increasingly difficult to defend.
Distributed ledger technology (DLT), in which multiple nodes carry data instead of a single source, is vital to DeFi. This is not necessarily blockchain technology, which Bitcoin has made famous, because centralized blockchains also exist. DLT can be faster than a centralized chain, because of the way the information that needs to be passed on in a DLT is smaller and takes less time to process. The Lightning Network, which operates as an overlay on blockchains, is an example — some work is done “off chain”. Other platforms, such as Tagion, which released its AlphaOne net in Summer 2020, avoid blockchain altogether, and rely on a consensus model between nodes via DLT with short transaction messages to reach high volumes and quick processing.
Other technologies to handle Know Your Customer issues, currency exchange and security round out the technologies needed by various DeFi services. Like blockchain and DLT, these are evolving all the time. But the essential elements are in place for banking straight between people or between companies without a central authority, so let’s see what DeFi can do.
Transferring money is probably the most obvious banking function, but the possibilities are much greater than just sending a ten of something to your friend. It’s more like sending (just about) any amount of any currency to anyone anywhere. Whether current systems support it or not, DeFi makes it easy to pay in, say, US Dollars, and receive in Thai Bhat or any other supported currency. Moreover, it can happen without worrying about large forex and transfer fees.
So what’s new? At the simplest level, meaning within one currency in one country, probably not much; DeFi can make it a little faster or cheaper. And some current money transfer systems can take you between currencies — input dollars, receive koruna, but it slows down quickly, sometimes to a matter of days, and the fees add up even faster. DeFi can definitely make a difference there.
‘Plain vanilla’ banking with a cherry on top
Savings and lending are two financial services that are the bread and butter of banking. Does DeFi present at threat? Saving money in a bank is essentially a loan to the bank at a lower interest rate than what the bank expects when it does the lending. In 2019, Americans saved an estimated USD 9 trillion.
For people with a low risk appetite, putting money into savings at a fixed rate is a simple solution, and while DeFi savings platforms are likely to appear, it’s the world of lending that is drawing the attention of even smaller investors with relatively low tech skills.
Lending that avoids traditional banking systems is becoming popular to the point that there are even Top-10 lists of the best lending platforms. Both person-to-person lending and pooled — in which a person parks their money with a fund — can be found. The typical platform uses smart contracts and collateral in the form of a cryptocurrency. But smart contracts could in theory be used to collateralize anything from homes to intellectual property rights, so if you go off the beaten path, securing a loan can become inventive.
Investing in DeFi
Lending and investing are separated, though they can both be seen as making your money work for you. Investing, though, has a broader scope, and in DeFi, this could also mean investing in DeFi projects themselves. No matter what you’re investing into, though, remember this: especially in a trustless, DeFi environment, DO YOUR HOMEWORK! Listening to hype is no substitute for learning about your intended investment target or vehicle. DeFi is born largely out of the blockchain, open source, and Fintech communities, and much of the investment made in a DeFi manner is connected to the industry. This makes sense, as the industry is unfolding, and there are plenty of projects designed to build its infrastructure that need funding. Fortunately, this means that the ways of looking at a project and determining if it is legitimate or not, depending on its stage of development, are not secrets.
Traditional, advanced investment vehicles
If you’re comfortable with derivatives and options trading, you can do this on any of several platforms that already exist. Some of them are focused on fintech, because understanding such a business in order to insure a company (or underwrite those insurers) is required.
What isn’t available?
No matter what your risk appetite, financial savvy, and level of IT knowledge, Decentralized Finance is or will soon be available. For example, at this time there is no direct way to access traditional equity and debt markets through DeFi. Even though by definition, DeFi would be an alternative to traditional, centralized markets, the connections will inevitably come about.