11 March 2022

Real-world Implications of Decentralized Finance

by Sam Ghosh

Though it has been more than a decade since Bitcoin came into existence, Web3 technologies like DeFi or Decentralized Finance may seem esoteric. Many may think that DeFi will not impact them as it is “just another crypto stuff”.

This article will try to make a case that DeFi will impact all of us in some way or other, and it is time we learn about it.

What is Decentralized Finance?

The fundamental idea of DeFi is ‘disintermediation’ – removing the need for financial intermediaries such as banks, exchanges, and asset management companies with the help of algorithms and liquidity pools.

So, let us understand how DeFi platforms can replace intermediaries. For that let us first understand what these intermediaries really do.

In a broad sense, intermediaries like banks do two things

  1. Matching buyers and sellers
  2. Providing liquidity i.e. adding depth to markets

For example, banks match people who have excess funds to people who want to borrow funds. Lenders deposit their funds in savings accounts, current accounts, and time deposits. Banks pool the funds and lend them to retail and corporate borrowers.

Now, coming to the liquidity part. This involves market making.

What is market-making?

Consider you have some security you want to sell. For that, you need a buyer who wants to buy. Depending on the market condition, it may be possible that nobody wants to buy now. The opposite is also possible: you want to buy some security but cannot find anyone who wants to sell. Market makers hold these assets in their books and provide buy and sell quotes continuously. So, due to market makers, all trades can be fulfilled all the time.

How does DeFi deal with these two requirements?

Similar to intermediaries, DeFi platforms pool liquidity (crypto assets) through a process called Automated Market Making. The providers of crypto assets get rewarded in many ways – interest, share in trading fees, governance tokens, etc. Markets are created around these liquidity pools with the help of smart contracts – self-executing programs running on blockchain networks.

What changes does DeFi bring?

The primary changes that DeFi is bringing are

  1. Broader access to financial services
  2. Increased transparency
  3. Ownership for the market participants.

Traditional financial systems require various identity verification and documents. Many may not have the documents required. Apart from that, these requirements make accessing financial services a slow process. DeFi replaces those processes with collateral requirements.

DeFi systems are permissionless automated systems. No need to take anyone’s permission to access financial services, just connect your crypto wallet. This will allow many “thin file customers” access financial services.

Another important point is that DeFi will make it possible to tokenize many illiquid assets and use them as collateral to access financial services. We will discuss this later in this article.

Now, coming to transparency. 

Do you know how your bank or the security exchange decides the processes which you have to follow?

Do you know the people who are creating the processes?

How much do you know about the financial health of the institution you are depositing your money in?

Do you know how much your bank is charging for lending and how much of that they are passing on to the suppliers of those funds i.e. depositors?

In most cases, we do not know. Yes, regulators receive a summary of information periodically, but the customers often do not have any idea about the financial health of the organization they are availing services from.

As DeFi platforms are built on public blockchains, every information such as processes (which are automated and written on auditable smart contracts), transaction history, account balances, etc. are transparent and auditable.

Now, let us talk about ownership.

In the traditional financial system, market participants who have the largest stake in the health of the system, have no say on how the process works. There is a huge disconnect between liability and control. A depositor does not have a voice on the workings of a bank even if her life savings are at stake, and a trader does not have any voice on the workings of an exchange even if her livelihood and future depends on the working of the exchange.

DeFi brings a completely different view on it. The governance of DeFi platforms is decentralized. What does it mean?

The rules governing the DeFi platforms are driven by Decentralized Autonomous Organizations or DAOs. The rules can be modified through a voting mechanism. A special type of token called governance tokens drives the voting process. Holding of the governance tokens gives voting power.

Now, the important point – market participants receive governance tokens just for using the platforms. That means market participants such as depositors, borrowers and traders receive power to influence how the DeFi platforms work. Governance token holders can raise proposals to change the processes and vote on the proposals.

This is a fundamental change in how we think about financial services.

What does the future look like?

Currently, most DeFi platforms are only dealing with crypto assets. So, how can they impact the fiat economy?

There is a growing trend of tokenization of real-world assets into crypto assets. One such example is AAVE’s Real World Asset (RWA) markets which offer loans against collateral of tokenized accounts receivables, real estate, cargo invoices, etc. This initiative enables the use of potentially illiquid assets to avail of financial services.

This paves the way for the migration of fiat assets on blockchain networks and being used on DeFi platforms.

In the long run, various assets such as stocks, bonds, derivative contracts, etc. can be directly issued as tokens and used on DeFi platforms. Obviously for that to be a reality the regulatory structure needs to adapt and blockchain networks need to be far more efficient.

If you are interested to learn more about DeFi, have a look at Sam Gosh’s book on Amazon Kindle and his accompanying course on Udemy.

Sam Ghosh
Sam Ghosh is an engineer, holds an MBA from the University of Calgary, Canada, and Passed all three levels of the CFA Program. He has been an entrepreneur in the FinTech domain and writes about emerging industries and emerging technologies.

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