Globally, commercial banks and other financial institutions play key roles in financial intermediations. Essentially, they engage in mobilizing funds from the surplus sector of the economy and lend such funds to the deficit sector. In other words, banks put people who want to lend in contact with people who want to borrow. A simple example is that of building societies. They collect savings from individuals and lend to home buyers who want a mortgage. In order to fund their loan assets, banks rely on deposits from their customers. They pay moderate interest on such deposits. They re-lend the same deposits at higher rates of interest to those willing to borrow. Most of them make substantial profit margins, that is, the difference between the rates paid to depositors and the rates gained from lending to borrowers.
With the increasing rate of penetration of financial technology (FinTech) in the financial services industry, this major source of income for commercial banks may be threatened by peer-to-peer lending, particularly with the growing popularity and adoption of the concept of Decentralized Finance. Will technology eliminate or eradicate traditional finance?
Decentralized finance or ‘DeFi’, is more than the latest buzzword to enter the FinTech lexicon. Presently, most banking, lending, and trading is managed by centralized systems, operated by the traditional banks, exchanges, and financial regulators. DeFi aims to ‘democratize’ finance by replacing legacy, centralized institutions with peer-to-peer relationships that can provide a full spectrum of financial services, ranging from banking, loans, and mortgages, to complicated contractual relationships and asset trading. DeFi’s growth trajectory has been phenomenal. It has grown the market of locked-up assets from less than USD1 billion in 2019 to more than USD100 billion just two years later, attracting at least one million global investors in the process. With more institutional investors entering the Defi industry, it’s a market that is expected to grow to a staggering USD800 billion in 2022.
DeFi is essentially the unbundling of traditional finance; with huge implications to disrupt the financial services industry. It takes the key elements of the work done by traditional banks, exchanges, and insurers today – like lending, borrowing, insurance, and trading – and puts them in the hands of consumers. It does this using cryptocurrency, on the public blockchain, based on open protocols that allow individuals or firms to perform financial transactions over the internet on a non-custodial basis without requiring an intermediary.
But why does DeFi work so well and how does it play out in practical terms for savvy financial services consumers?
Consumers of financial products are paying middlemen a steep price for the privilege of accessing capital. These banks, exchanges, and lenders earn an outsize percentage on every financial and banking transaction they process as profit. Today, you might put your savings in a traditional savings account and the bank pays you a 0.5% interest rate on your money. The bank then turns around and lends that money to another customer at 3% interest and keeps the 2.5% profit margin. DeFi disempowers financial intermediaries and gatekeepers and empowers consumers with peer-to-peer exchanges. With DeFi, people lend their savings directly to others, eliminating that 2.5% profit loss and earning the full 3% return on their money without sharing it with the banks.
If this sounds familiar, it is – sort of. Think of mobile applications (apps) like PayPal that allow us to send money directly to friends and to pay for services. The difference is that with these kinds of apps, you still need a linked debit card or bank account to send funds. So, that class of peer-to-peer payments actually piggybacks on centralized financial intermediaries – unlike DeFi. Blockchain uses a decentralized, distributed public ledger where financial transactions are recorded in computer code. A blockchain, being a distributed public ledger, means that all parties using a DeFi application have an identical copy of the public ledger, which records each and every transaction in encrypted code. That secures the system by providing users with anonymity (the transactions are traceable by entities that have access), plus verification of payments and a record of asset ownership that is nearly impossible to alter by fraudulent activity. No middlemen, and multiple possibilities. To illustrate, it may be instructive to consider the anatomy of a DeFi transaction.
Take the example of crowdfunding. You want to raise funds for charity or some other cause. In the conventional financial system, you have to trust a third-party platform to collect the funds from the donors and give them to the charity when the funding goal is achieved. In a decentralized system, however, you can replace the intermediary and save on platform fees. You could simply define the parameters of this exchange and encode it in a smart contract on the blockchain. If the criteria in the smart contract are met, the money is automatically sent to the charity. If it is not met, the funds are returned automatically to all of the donors
According to finance experts, DeFi has quite a few attractions for financial consumers, over traditional centralized alternatives. Some of these have already been alluded to:
● It eliminates the fees that banks and other financial institutions charge for using their financial services.
● Consumers can hold their money in secured digital wallets that are quite nimble, instead of keeping them in banks.
● Anyone with an internet connection can use it without requiring an ‘approval’.
● Transactions are in real-time – The underlying blockchain is updated the moment a transaction is completed.
● DeFi data is ‘tamper-proof’; secure, and auditable, thanks to the use of blockchain architecture.
● Many DeFi protocols are open source.
As DeFi appears to offer everything that traditional finance does and even more, is it going to spell the end of the traditional finance? There are still significant risks that need to be better understood and mitigated. The first is a lack of consumer protection. DeFi has thrived in the absence of rules and regulations. But this means users often have little or no protection when things go wrong. Secondly, hackers are a real threat. While hacking is also a risk in traditional finance, DeFi’s extended technological architecture, with multiple points of potential failure, increases the so-called ‘surface’ available to sophisticated hackers. Lastly, there are private key requirements. With DeFi and cryptocurrency, users must secure the wallets used to store crypto assets. This is an important requirement for private investors. Private keys, which are long, unique codes known only to the wallet’s owners are used to do this. If a private investor loses their key, for example, they lose access to their funds forever.
So, many experts remain guarded in their assessments of whether DeFi will completely disrupt financial services. The answer is much more nuanced and layered. To what extent, and how soon, will the rest of the world embrace this model of decentralized finance – where you are essentially your own bank? Being independent in this way, comes with its rewards. But then stripping away the guardrails of the more expensive, but arguably (at least for the foreseeable future) safer, conventional banking will likely come slowly for much of the world’s population. Experts believe that intermediaries will not automatically disappear, not for some time, but that their role will have to evolve. They will find themselves facing demands to prove their added value to the public as they will no longer enjoy a monopoly over financial services. To say the least, banks will always remain relevant as they are more regulated and have more pooled resources (than DeFi operators) to offer matching finance to borrowers (with huge borrowing appetite), however, it is not in doubt that with the pace of technological revolution that banks would definitely transform in the near future into virtual financial institutions aided by financial technology. Also, there are strong arguments that cryptocurrency does not satisfy or perform the essential requirements of a physical money, considering that it has no recognized institution that can measure and sustain its underlying existence.
DeFi is still in its infancy. Globally, it is unregulated which means that the ecosystem is still riddled with infrastructural mishaps, hacks, and scams. Current financial laws were drafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents key questions for this type of regulation. For example, which country will be responsible for investigating a financial crime that occurs across borders, protocols, and DeFi apps? Who would enforce the regulations, and how would they enforce them? These questions and others must be answered, and advancements made before DeFi goes mainstream. Always speak to your legal and financial advisors before making significant financial investments or decisions in this virtual financial space.