Blockchain promises to transform how financial transactions are completed by providing an independent ledger that's secure, decentralized, transparent, and has reduced costs. This article explores how blockchain tech will revolutionize traditional financial industries like the world's banks.
Compare Traditional Finance With Decentralized Finance
DeFi isn't run by employees or institutions. Instead, it relies on algorithms in code or smart contracts to operate its applications automatically once placed onto blockchains. Traditional financial systems rely on intermediary banks to manage financial transactions.
Transparency is one of the key distinguishing features that sets DeFi apart from traditional banking software. Anyone can audit the code used to manage DeFi applications, giving users more peace of mind that their contract works smoothly compared to conventional finance, which typically uses intermediaries with limited control over assets.
Traditional financial systems have limited geographical reach. Their localized restrictions limit where you can open accounts, with DeFi services available all around the globe. Individuals now have the power to easily develop and utilize decentralized financial applications, decentralized applications without gatekeepers or accounts limiting them, unlike in today's finance industry. DeFi's crypto wallets enable direct interaction with smart contracts.
DeFi In The Real World
DeFi's rising adoption is having an immense impact on unbanked people worldwide so this section will introduce several key DeFi applications found throughout real-life situations.
Reducing costs
Fees charged to foreign workers who transfer billions back home can be exorbitant, with decentralized financial services offering potential reductions of 50-55% in costs.
Lending And Borrowing
DeFi's advantages have an extremely transformative effect when applied to loans - it makes getting financing much simpler for people without bank accounts due to poor credit histories or no good score; by connecting borrowers directly with lenders on our platform and eliminating credit checks, loans become possible.
Supply Chain Management
As we've previously highlighted, DeFi is an alternative financial model characterized by peer-to-peer financing enabled through decentralized technology built on Ethereum's blockchain that promotes peer-to-peer lending between individuals via peer financing platforms such as Lending Club. DeFi has revolutionized supply chain industry operations by encouraging trustless collaboration and decentralized finance models.
TradeLens, designed and implemented by Maersk and IBM together, allows immediate sending and retrieval of documents, thereby speeding up the supply chain process. Blockchain has transformed the fintech industry significantly and enabled new DeFi use cases by eliminating errors and increasing transparency. As shown above, its impact can only be imagined.
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How Does DeFi Work?
DeFi is a collection of decentralized apps (dApps) founded on Ethereum's smart contract system. It provides blockchain-based services without needing third parties as intermediaries. DeFi relies on three key factors for its successful functioning - Ethereum, blockchain technology, and smart contracts (see our brief discussion below for these topics)
Blockchain
Blockchain technology forms the cornerstone of DeFi and all aspects of cryptocurrency. Blockchains serve as digital ledger, blockchain ledger that permanently store immutable information; data stored within each block is accessible by members of the public for more transparency in this technology.
Ethereum & Smart Contracts
Ethereum, another cryptocurrency, extends the capabilities of blockchain by adding smart contracts using Solidity programming language coding these smart contracts, creating an ecosystem rich with possibilities beyond simple payments for developing decentralized applications or services (apps).
Solidity is a programming language designed to produce self-executing computer code; smart contracts take advantage of it to deliver their contracts autonomously and run according to their programmed instructions, so all Ethereum transactions proceed according to plan. Anyone may examine any smart contract's code for integrity assessments as anyone may read its integrity before accepting it. Smart contracts operate according to this programming and ensure Ethereum transactions take place as planned, thus guaranteeing its safekeeping.
Smart contracts act as neutral intermediaries who facilitate agreements among multiple entities, eliminating the need to trust an otherwise distrustful system; users now rely on smart contracts rather than others' goodwill alone for transactions to go smoothly and more simply than before - eliminating banks and exchanges as central mediators while streamlining financial processes further still.
Ethereum is an alternative permissioned blockchain with added smart contract functionality that enables its users to perform computational logic, as well as additional features not present in prior generations of blockchains.
DeFi Ecosystem And Use Cases
Centralized finance can best be understood through studying its ecosystem and application scenarios. DeFi is an emerging area that meets the diverse needs of users, offering blockchain-powered versions of any financial service or product provided traditionally in finance.
DeFi's ecosystem continues to expand as more projects join its ranks each month and vie for dominance in the market. DeFi Pulse data demonstrates this phenomenon - $55 billion worth of crypto assets are held by DeFi as assets belonging to at least 10 projects with at least $1 billion collateralized value are contained within the DeFi industry. There are countless more compelling use cases worth exploring; we will examine some below.
Decentralized Exchanges
DeFi's core offering lies within decentralized exchanges; their non-custodial, decentralized trading has proven immensely popular with cryptocurrency investors. Market makers maintain order books on centralized exchanges.
Security, privacy, and trust can all be negatively impacted by centralization. Exchanges may become susceptible to data leakage, hacking attempts, governmental restrictions, and misuse of information, as well as other problems that arise as a result.
DEXs, on the other hand, are managed by developers relying heavily on smart contracts for operations management and other key tasks such as trade execution and liquidity management, withdrawal/deposit processing, and performing other essential duties without needing middlemen as intermediaries to deal with or control user funds.
Uniswap is one of the more well-known Decentralized Exchanges (DEXs). Other popular choices are Bancor, dYdX, and PancakeSwap. Some DEXs using Automated Market Makers to trade on behalf of traders (AMMs) can create an experience similar to CEX order books.
Ultimately, there is one main distinction: custodianship. Investors on one exchange can trade directly from their wallet; on the other exchange, they must deposit funds first before switching on it.As this concept is still relatively novel, our focus will be on AMMs.
Automated Market Makers
An AMM (automated market maker) is a smart contract type designed to replace traditional order books by storing on-chain liquid reserves and drawing liquidity from individuals known as liquidity providers who lend out crypto in return for fee-based rewards. AMMs rely on other AMMs, known as automated market makers (SMM), in order to access on-chain reserves as their source.
Users may use smart contracts instead of an order book when conducting trades between themselves, offering both advantages and drawbacks to this approach.
Decentralization Benefits
- Smart contracts execute autonomously. Decentralized Exchanges combined with governance effectively transfer platform and asset ownership away from centralized entities to users of these exchanges.
- Non-custodial DEXs allow trading and liquidity providers to interact directly with DEXs from their cryptocurrency wallets while maintaining custody over all assets held. Smart contracts DeFine and process all transactions.
- DEXs do not engage in market manipulation: While CEXs have long been accused of committing price-fixing practices and insider trades, DEXs cannot alter product prices since no single entity would stand to gain from these strategies.
- DEXs typically host themselves decentrally to protect against potential attacks from hackers; hackers cannot gain entry through individual users on DEX platforms and interact directly with liquidity pools on trading platforms.
- Token Accessibility: Due to DEXs being decentralized platforms, any individual or entity can list an asset without going through a third-party vouching system for verification or listing fees.
Disadvantages
- Decentralized exchanges rely significantly less on liquidity provided by their users to operate. DEXs do not own their liquidity pool and must depend on yield farmers as providers for it. Otherwise, trading services wouldn't exist at all.
- Speed: DEXs tend to be less efficient at order execution due to their limited set of trading tools and technologies, particularly those focused on advanced trading tools like those offered on other exchanges.
- Volume and Slippage: DEXs have quickly grown popular for their volume trading capability; however, due to a lack of an order book or market maker, they also experience considerable slippage with larger orders due to no order book for handling slippage.
- An absence of an order book results in higher transaction fees; on the Ethereum network, all users incur both gas fees and trading charges, which could reach hundreds of dollars depending on congestion levels in the network.
Lending
De-Fi is best known for lending and borrowing. Lending and borrowing account for its second-highest use case.
Banks serve as intermediaries within a centralized system and protect themselves by only lending money to people who fulfill certain qualifications, such as having excellent credit ratings, being employed regularly, and offering collateral of minimal value - individuals without bank accounts are typically not eligible to request loans through this route.
Decentralized Finance (De-Fi) lending protocols eliminate these impediments to access. De-Fi is especially advantageous to those without banks as these decentralized and accessible protocols allow people from diverse backgrounds, cultures, and locations to use it immediately as soon as they provide collateral for borrowing money.
There are no additional requirements, and, notably, lending protocols do not utilize in-depth identification checks such as KYC policies. Compound, Aave Maker, and bZx lending protocols dominate this market and currently hold $26 billion worth of collateralized assets - almost 50% of all De-Fi.
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Flash Loans
In the past, central banks typically granted loans against collateral such as property documents. Now, there are loans offered without this condition attached - known as flash loans - providing fast financing solutions in just 24 hours or so.
However, lending protocols offer an unconventional loan type known as a "flash loan." Unlike conventional loans that require collateral security deposits as security deposits for repayment purposes, flash loans must be returned quickly after being taken out.
Flash loans typically last only one transaction block before their life cycle begins, and their borrower must repay it before moving on to another transaction block. Failure to do so results in reverse transactions being reversed and funds being borrowed back again from your source of funds. They're best used for quick operations like arbitrage and debt refinancing but are especially vulnerable due to their complex structure.
Lending protocols serve as intermediaries that allow lenders and borrowers to interact by exchanging crypto funds directly. Lenders enjoy higher than usual interest rates while borrowers gain instant loans without lengthy paperwork procedures.
Derivatives
De-Fi offers more than token trading; it also provides complex products available for trade. Decentralized derivatives can be found through more advanced decentralized exchanges. Their value derives from assets like currencies, stock indexes, or commodities that they derive value from.
Yield Farming
Decentralized exchanges provide an ideal way of practicing yield farming.Yield farming offers investors an easy, passive strategy for earning additional cryptocurrency from existing crypto assets. Yield farmers effectively lend out their coins as collateral against loans made to decentralized exchanges - lending out crypto assets as loans is similar to lending them out as collateral against loan payments while earning rewards along the way.
As stated, yield farming involves taking or borrowing tokens and exchanging them through an established trading app in a continuous cycle to initiate new processes of agriculture.
Decentralized exchanges provide yield farmers with fees earned through users trading using their liquidity, creating an ecosystem in which traders and liquidity providers work harmoniously together for mutual advantage.
Yield farming allows each farmer to receive an equal portion of a fee as their contribution to a liquid pool; yield farming can continue inDeFinitely, and users are strongly encouraged to switch pools regularly in order to take advantage of highly competitive rates; yield rates in yield farming tend to outstrip far those offered through comparable activities.
Insurance
Smart contracts may appear decentralized and transparent, but their security vulnerabilities make them susceptible to exploits that can result in millions of dollars worth of losses, even for audited De-Fi projects that appear secure - hackers could drain an entire company into liquidation via vulnerabilities that exist within such contracts.
Decentralized exchanges do not have an obligation or guarantee to compensate or protect their customers in case of security breaches. In contrast, crypto exchanges such as Binance, Gemini, and Coinbase don't possess insurance funds that would cover such events.
De-Fi investors should enact insurance protocols to safeguard their money against technical risks like exploits as well as liquidity and administrative ones. These protocols offer protection not only against technological but also financial, administrative, and liquidity hazards.
Stablecoins
De-Fi's primary mission is to decrease token price volatility; as such, Stablecoins was created as an attempt at stabilization. Stablecoins, or cryptocurrencies with fixed value pegged to fiat currency, have recently emerged on the scene as a means to protect investors against volatile cryptocurrencies and extreme market conditions.
Stablecoins provide investors with protection from this volatility by quickly turning native cryptocurrency into tokenized versions of fiat, providing faster profits to be realized for investors. As the leading stablecoin on the market, the U.S. Dollar stands out. Each stablecoin uses different strategies to secure tokens against this cryptocurrency token.
Governance
In the blockchain space, governance models create an open platform where investors have a direct influence on project designs and directions, similar to shareholders in an established corporation. Community members have the freedom to express themselves freely while actively taking part in decision-making processes.
Governance emphasizes decentralization, with all project planning assigned directly to investors rather than developers - this effectively removes developer-centric approaches from consideration. Vitalik Buterin's paper about Decentralized Autonomous Organizations proposes governance models that function similarly to businesses without executives; smart contracts serve to process, accept, and complete various tasks instead of depending on only a select few for completion.
De-Fi's governance is integral in giving community ownership over any protocol. Most projects use a governance token, which grants users voting rights as well as gives them power to propose governance proposals. Airdropping cryptocurrency supply to users is one way to distribute governance tokens fairly. Uniswap used airdrops at its launch of UNI, during which they spread 60% of UNI's Genesis via airdrop to 400 of their users on launch day.
Decentralized protocols can easily introduce governance tokens by listing them on an exchange without distribution or distribution to their token holders. Investors who believe in the success of the project can purchase this token to gain voting rights; token holders act as voters themselves, so this provides an incentive for making wise decisions.
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Benefits Of DeFi
Traditional banks can be costly, and the transaction processing can take considerable time - often up to one week when sending money abroad. Furthermore, traditional finance requires us to abide by a variety of strict rules and regulations; DeFi has been developed as an innovative alternative that solves a wide range of these problems while offering numerous advantages over its options.
Permissionless
Finance One of the primary advantages of decentralized finance is its permissionless nature; anyone with access to internet connectivity and services of DeFi platforms can use them without approval by central authorities or needing support from any single body. Without permission, platforms are also more secure as there is no single point of failure, making DeFi an ideal way of both storing financial transactions and conducting storage services such as data backup services - making DeFi's permission lessness attractive among enthusiasts who appreciate decentralized finance.
Interoperability
The decentralized account structure gives developers more freedom in designing interfaces and including third-party apps in DeFi conventions - due to their adaptability, DeFi conventions are sometimes known as the financial industry's equivalent of Lego bricks.
Transparency
Since most DeFi protocols rely on Blockchain technology - a public ledger technology - all activities can be seen by anyone in the public eye, thanks to blockchain. Records, however, do not link directly back to individuals; accounts are pseudonymous and only list numerical addresses as pseudonymous entities. Open source means users with programming skills can gain access to most DeFi products' source code in order to build or review them - thanks to community involvement, open-source code tends to be more secure and of higher quality than proprietary codes due to community participation.
Control
Traditional banking gives financial institutions considerable control over how users spend their money, restricting what transactions can occur or blocking users when they suspect fraud while using users' data in whatever capacity is deemed fit by those same institutions. Decentralized solutions give users more direct control of their assets: for example, managing and selecting which investments to work with themselves without needing third-party intermediaries, making transactions faster and harder to steal than with traditional finance, allowing people to gain ownership and protect against fraud by taking control of their finances themselves and taking direct control.
The Future Of DeFi
Dune Analytics data illustrates that DeFi customers have seen exponential growth over time - from 93,000 customers up to 1.8 Million, as market valuation climbed from $700 Million to over $58 Billion during that same timeframe.
Decentralized finance (DEXs) has quickly emerged as one of the greatest innovations in financial services despite appearing during an economic crisis and pandemic. Now mainstream, DeFi has long outlived any concerns of becoming another "ICO-like fad," drawing concern among cryptocurrency's central exchanges, which have witnessed much of their liquidity shift to DEXs due to DEx performance.
DeFi's disruptive potential is clear; blockchain industry members should not be taken by surprise by its decentralized future. Before mass adoption can take place, however, several challenges must first be surmounted.
Regulation hangs over DeFi, as smart contracts are vulnerable to being exploited. Anonymous developers will continue launching untrustworthy projects that have the potential to harm DeFi's ecosystem as it stands now; both its creators and users must reach a level of maturity for it to become a credible and respected sector of crypto.
Community behavior will dictate the timeframe it takes for financial services to achieve balance and perfection. However, in an ever-increasing uncertain world, disruptive technologies will increase their presence more frequently and create fundamental shifts that lead to the positive transformation of finance services in general. It may take longer and may pose greater difficulties. Still, decentralization of services remains inevitable for a bright future of financial services.
DeFi Scalability Issues
Scalability can be an ongoing problem for DeFi. Although its market has experienced rapid expansion over the years, existing blockchain infrastructure may limit how large an app may become or limit how fast its decentralized network runs as new people and activities join it.
DeFi may need help to gain widespread adoption if this situation arises; to combat these challenges, efforts have been undertaken to enhance both its scalability and legal clarity of blockchain networks.
Layer 2 scaling for blockchain networks provides greater transactional throughput without compromising security or decentralization, with regulatory frameworks created that support traditional finance as well as DeFi.
As part of its efforts to provide more clarity for traditional financial institutions that wish to enter the DeFi sector, the European Union recently proposed new regulations governing crypto assets.
How Compatible Are Traditional Finance And DeFi?
Decentralized finance (or DeFi) offers an alternative approach to traditional financial practices. While both methods possess strengths and weaknesses, one might wonder whether DeFi is compatible with conventional techniques or vice versa.
Compatibility
Both traditional finance and DeFi offer various products and services, from stablecoins and decentralized exchanges available through DeFi to conventional financial products like mortgages and savings accounts available via traditional institutions. Users may select either system depending on their personal preferences and financial requirements.
One should always pay attention to the immense potential of collaboration between these two systems. Many traditional financial organizations have begun exploring Blockchain technology and cryptocurrency use, which opens new pathways of cooperation between DeFi and conventional finance organizations. Banks could use this form of payment enhancement. At the same time, DeFi protocols would benefit from partnerships between traditional institutions that increase compliance standards.
Incompatibilities
Traditional finance and DeFi are incompatible due to a number of regulations issued in DeFi. Not having one central body to oversee it creates risks of money laundering and manipulation in the market that need to be mitigated. While DeFi protocols have implemented some security measures, increased regulatory oversight is required in order to protect users.
Lack of Interoperability (lack of Interoperability = lack of Interoperability). Blockchain technology does not mesh well with traditional financial institution's centralized systems; therefore, users cannot transfer money between DeFi and traditional finance nor integrate their accounts.
Conclusion
Blockchain technology adoption is vital to shaping the future of the Financial Services Industry as it adapts to digitalization. Blockchain can disrupt traditional financial models - from compliance regulations to payment processes - revolutionizing them all and revolutionizing business practices in turn.
Blockchain technology has the power to promote financial inclusion for individuals, businesses, and society at large. Adopting blockchain will undoubtedly reshape the financial industry over time as its use becomes mainstream.
