Decentralised Finance (DeFi) needs traditional finance

DeFi is a collection of technologies which circumvent traditional financial institutions by providing services (such as loans) using a smart contract.

Payment Accounts
Xace
Marketing
October 2, 2020
5 mins

Imagine being able to take out a loan without any need to provide collateral – or even ID. At present, this is simply impossible for most people. Unless you can put something of value up to secure a loan, you won’t receive the money. And this means that the world’s 1.7billion unbanked people - not to mention countless small businesses - cannot access financial services which would otherwise improve their lives.

This is the kind of problem that Decentralised Finance (DeFi) aims to resolve, primarily using the Ethereum Network. DeFi is a collection of technologies which circumvent traditional financial institutions by providing services (such as loans, insurance, payments, etc.) using a smart contract built on blockchain technology. By using an open, transparent register and an immutable digital contract, it is possible to circumvent traditional financial institutions with their cumbersome bureaucracy and processes.

DeFi has gained plenty of attention in 2020 and serious money has poured into companies operating in this space. In February this year (2020), there was around $1b worth of value in the DeFi economy. By July this had risen to $4b.

What are the benefits of DeFi, and can it really transform the financial system as we know it?

DeFi to defy traditional finance

To use a DeFi service, you need to have access to cryptocurrency. Next up, you need to find a decentralized app (a ‘dapp’) which offers a service you want. The company behind the dapp will have created a completely transparent set of rules which, once published, cannot be changed (in theory at least).

This means that once the dapp is up and running, the technology manages the entire service – you never have to deal with a human at a bank, don’t have to provide any ID or collateral, and can access the service anywhere in the world. This is a very different method of finance to a crypto friendly bank account.

Let’s see what this looks like to make it a little clearer.

1. Imagine you were a Somalian working in the UK. You decide you want to send £1,000 to your family. Because your family don’t have a traditional bank account, you need to use a high street money transfer service to send them the cash. However, the high street operator will take a cut of the money and your family receives less cash.

2. However, in a couple of years’ time, you might decide to use a dapp instead. Your family back in Somalia may not have a traditional bank account, but they do all have internet-connected smart phones where they can download apps. Using a dapp service, you send them the equivalent of £1,000 in a crypto currency. They can then receive that on their phones. Because the dapp has no human involvement, it costs practically nothing to send and receive the money and everyone wins.

This is just a simplified example, but it demonstrates the benefits:

- Anyone, anywhere can access banking services

- It relies entirely on code –there is no human involvement so no chance of corruption, discrimination or bias

- The system is entirely transparent and flexible

Unsurprisingly, its proponents list many other benefits too.

DeFi is built on Ethereum: Learn the history of ethererum

Beyond the DeFi hype

Despite the enormous amounts of hype around DeFi, it remains very niche (representing about 4% of the crypto market) – which is itself dwarfed by traditional finance.

For DeFi proponents, the vision of a completely self-regulating, independent financial system is highly attractive. However, DeFi is still a young concept and faces numerous major challenges:

Confusing to most people: dive into the world of DeFi and you will soon be overwhelmed by incomprehensible language – from flash loans to slippage to bonding curves. Many experts currently view DeFi as more of an experiment in finance than a viable alternative to traditional instruments

Learn more about crypto: What crypto bank account features do you need?

High risk: DeFi depends on code to process transactions, on the assumption that it is better than humans. Yet code can have bugs and be hacked – these issues need to be addressed before people will opt for a dapp to secure a mortgage rather than their high street bank.

Unregulated: Dapps are unregulated by their nature and Anti-money laundering/Know Your Customer (AML/KYC) laws simply do not apply – you need no ID to use these services. For proponents of DeFi this is ideal, yet if it continues to grow, DeFi will attract the attention of regulators – which could undermine the concept of them being decentralised in the first place.

These, and other challenges, suggest that the real future of DeFi will be less about entirely replacing the traditional finance system, and more about complementing and improving our existing approach.

Combining DeFi and traditional finance?

Today’s DeFi ‘evangelists’ imagine a world where traditional finance is completely swept away. However, for DeFi to grow it is going to depend on traditional finance to begin with. At it’s simplest, DeFi can only grow if people actually convert fiat currencies into crypto currencies, and then use the DeFi services. And, chances are, they will eventually want to withdraw crypto to fiat to buy things in the real world.

Now, perhaps the entire global population will move over to crypto and this vision will come to pass. More realistically, however, we will see a future where traditional finance and DeFi-style services combine.

In a research note published by the Boston Consulting Group, the authors indicate that in future many traditional financial services companies may end up offering DeFi services to cut their own back office costs and improve services. This kind of approach might end up being more likely – especially when we consider AML/KYC issues.

A bank that lets you explore the potential of DeFi

Xace is a fast-growing digital bank which allows you to hold multiple fiat and crypto currencies. Our customers are free to purchase crypto on any major coin exchange and then use this to begin exploring how DeFi services can help them. If they wish to withdraw their crypto to Euro, Pound Sterling or any other currency, they can do so easily and access it right away in their Xace account.

To learn more, read about our crypto-friendly account.

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