What is DeFi and How is it Impacting Banking?

Decentralized Finance – DeFi, on a circuit board.

DeFi, short for decentralized finance, encompasses many different actions that can take place via blockchain and decentralized currency. These actions mimic those traditionally carried out by banks and other financial institutions, but without the ‘middleman’.

While DeFi is still in its infancy, it is growing in popularity. As such, many businesses and investors see opportunities to create a new financial system. One which is carried out digitally and does not rely on traditional financial intermediaries for processing and verification of transactions. This new system could provide additional opportunities for individuals and businesses to expand their investments. It could also create new challenges for traditional banks.

What is DeFi?

To understand DeFi you must first have a basic knowledge of blockchain technology. Blockchain was first theorized in 1991 but wasn’t fully realized until 2008 when Bitcoin was created. The main function of blockchain is to provide a pseudonymous, decentralized ledger of all transactions on a peer-to-peer network. This type of ledger is the basis for cryptocurrencies, NFTs, and DeFi applications.

Cryptocurrency lies at the heart of most DeFi transactions and is based on the principle of decentralization. In general, no single person or company controls the cryptocurrency exchange and the ledger lives in the public domain. DeFi applications take this one step further and allow financial activities like investing and lending in a similarly decentralized manner.

The emergence of this technology has empowered coders to create applications on the blockchain which are transparent and immutable— meaning that once the application is deployed, no individual or company has control over it. These applications have led to a new way of doing business with ‘smart contracts.’ These smart contracts have the advantage of being stored on a blockchain so they can facilitate verified actions without human intervention.

Smart contracts also enable a rules-based ecosystem where financial transactions such as lending and investing can take place without the necessity of third-parties like banks and brokerage houses. With DeFi, lending, trading, and transferring money happen automatically when the conditions of the smart contract are met, as opposed to traditional finance where many people and systems can be involved in processing, verification, and logging of transactions. With DeFi, these transactions are recorded on the immutable ledger and independently verified by thousands of computers around the globe.

Benefits of DeFi

DeFi aims to make financial services faster, more reliable, and more accessible. When smart contracts are used to facilitate financial contracts, both human error and manual validation are eliminated from the processing and validation functions. These factors can make DeFi quicker and more reliable than traditional financial services methods, but these are not the only advantages to these types of transactions.

Because DeFi is digital, it is available 24/7 from anywhere with an internet connection, eliminating the need to trade when markets are open or to conduct business during banking hours. This can make DeFi more accessible to those who want to trade during off hours and those who live in a time zone where traditional banking hours are inconvenient.

DeFi can also open new avenues for investing that are traditionally reserved for the very wealthy. For example, prior to the invention of DeFi, only very wealthy individuals and large institutions could engage in yield farming. This process allows investors to generate passive income by lending out their funds. With DeFi, anyone who owns cryptocurrency can generate income from their holdings by lending.

Challenges of DeFi

While there are many benefits to DeFi, there are also some considerations. SEC Commissioner Caroline Crenshaw argues that the DeFi market may not be as transparent as it seems. According to Crenshaw, venture capitalists and professional investors fund the majority of DeFi, and these institutional investors have significant advantages over retail investors.

Crenshaw says, “the underlying funding deals often grant professional investors equity, options, advisory roles, access to project team management, formal or informal say on governance and operations, anti-dilution rights, and the ability to distribute controlling interests to allies, among other benefits.” These benefits can lead to significantly better investment outcomes for the large investors participating in funding deals.

Additionally, the quality of code for DeFi applications can vary. If the code for a smart contract contains an error, the app may produce unexpected results. While large investors have the means to hire professionals to audit the code, retail investors generally lack the means to audit the code themselves or hire an expert to do so. This can lead to better investment performance for large investors who have the means to choose better performing apps as opposed to individuals or small business investors with more modest means.

Another factor that may impact DeFi in the future is the pseudonymity of transactions. When trading cryptocurrency or engaging in financial transactions via a DeFi platform, users generally do not have to provide their personal information. This means that ‘Know Your Customer’ legislation is nearly impossible to implement. When a transaction takes place, investors are denoted by a blockchain address rather than their name in the ledger. This pseudonymity can also make it difficult to determine if individuals or groups are engaged in market manipulation or other illegal activities.

So far, the DeFi market has remained relatively unregulated. This is not likely to last. Many changes to regulation are being considered by various government agencies. In fact, PWC predicts that at a minimum, regulators will likely attempt to implement anti-money laundering and Know Your Customer rules. That’s why increased regulation of DeFi is a risk that business leaders should not ignore. Future regulations could adversely impact the performance and structure of DeFi products, and it could also impact the value of DeFi investments.

Banking Industry Response to DeFi

In January, Anchorage Digital Bank became the first federally chartered bank for digital assets. The bank seeks to give institutions “easy and efficient access to crypto custody, trading, financing, staking, and governance services.” CEO Nathan McCauley predicts that by the end of 2022, it will be obvious that all banks need to become crypto banks. He says, “Your local bank branch, whether it’s a credit union or a large conglomerate bank, will very likely be offering some sort of crypto investment product.” So far, 55% of the world’s biggest banks are investing in digital currency, either directly or indirectly.

The future of how investments in cryptocurrency and blockchain technology will take shape is still up for debate. Some theorize that banks will make use of smart contracts to augment or replace their current processes. Brian Laverdure, VP of Payments and Technology Policy for the Independent Community Bankers Association [ICBA] said, “smart contracts may one day yield benefits for community banks and other payment system participants by automating functions that currently involve manual processing.” A report by the World Bank supports this claim. The report hypothesizes that DeFi technology, like smart contracts, could increase efficiency in the issuance of consumer credit like home and auto loans which are still labor-intensive manual processes.

Additionally, DeFi technology could help to automate loan servicing. If smart contracts were used by traditional banking and finance companies, it could help these companies reduce cost and cut down on the time it takes to process requests. Taking advantage of these benefits could help traditional financial intermediaries remain relevant as DeFi expands into their markets.

The Future of DeFi

So far, DeFi remains in its infancy and has had little impact on banks’ profitability or market share, though this may change in the future. In November, the total value of DeFi assets rose to over $200 billion – an astounding 1000% annual increase. Despite this significant growth, DeFi assets remain far below those of traditional banks. For comparison, JP Morgan Chase is the largest bank in the U.S. and its current assets are over $3.2 trillion.

There are several ways that DeFi could expand in the next few years. For example, the tokenizing of real-world assets, especially those like real estate that have historically been illiquid, could allow these assets to be used as collateral or traded on a public blockchain. This could give businesses and investors the ability to take advantage of their long-term assets to earn more while investing. It could also make transactions related to these assets faster and more efficient.

DeFi could also lead to digitizing traditional bank functions like lending, borrowing, and saving. Smart contracts can lend funds based on criteria written into the code. They can also facilitate deposits and make interest payments without human intervention. By digitizing these functions, and virtually eliminating overhead, banking could be more accessible to those who have been traditionally excluded.

There are some that believe that DeFi will supplant the current financial system and replace it with one that does not require financial companies or banks to act as intermediaries. Others believe that DeFi and traditional financial companies will coexist but operate independently, viewing each other as competitors. No matter which philosophy you believe in, it is clear that DeFi is here to stay.

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