Decentralized finance paves the way for a more democratic financial system

About a decade ago, the global decentralized finance (DeFi) movement began developing financial applications that no longer required traditional central financial intermediaries such as banks and exchanges.

The DeFi movement is based on the disruptive perspective that existing financial products and services can be recreated, using a decentralized architecture, which operates without the control of centralized companies and governments. Instead, products and services rely on existing technology protocols, smart contracts, and cryptocurrencies. Indeed, DeFi can offer anyone with an internet connection access to a global and open peer-to-peer alternative to the current financial system. As such, DeFi has significant disruptive potential and is poised to impact the current financial system and its players in markets such as international remittances, lending and borrowing, derivatives, payments and transfer of assets.

Examining the total value locked (TVL) in smart contracts across all projects – which is the common measure of success for DeFi – indicates that the movement seems to be accelerating. LTM has grown 20x to around USD 16 billion in 2020, and this growth clearly continues to accelerate rapidly as TVL currently stands at USD 66 billion (as of April 30, 2021[1]). To put that into perspective, that’s about 6% of Bitcoin’s valuation.

The main added value of DeFi is that users no longer have to trust financial institutions, which are often accused of being too opaque and complex to be scrutinized by customers. With DeFi, trust is an insoluble part of the code that is often open source and therefore transparent. This greatly reduces the likelihood of corruption or manipulation within the system. Therefore, DeFi could be described as a shift from “institutional trust” to “infrastructural trust”.

Additionally, DeFi could enable people to access a wider range of financial services regardless of their country of origin, financial status, and other traditional parameters. In terms of regulation, the focus is simply on “on-ramps and off-ramps,” i.e. where fiat currency is exchanged for crypto tokens. Typically, it is institutional exchanges (e.g. Coinbase, Gemini, Kraken) that have been regulated in recent years.

Due to the underlying technology and infrastructural trust, DeFi-based products are in principle more affordable, more efficient, more secure, and more readily available to a larger percentage of the population. This reduces the number of unbanked individuals and makes it a more inclusive and digitally sustainable monetary system than the traditional system. For example, unlike the 0% interest rates for savings accounts in the mainstream financial system, savers with DeFi products can currently earn 5-15% annually on their digitized dollars. Likewise, through the removal of unnecessary intermediaries, DeFi-based services can offer much faster and cheaper money transfers, opening up benefits for both senders and receivers.

However, decentralization is not without risks and challenges, especially at such an early stage in the product lifecycle. For example, although blockchain technology itself is secure, a proper and adequate approach to governance, security and quality of code and smart contracts is essential. Additionally, access to DeFi products requires the use of cryptocurrencies, which many people still struggle to understand. Nonetheless, DeFi is expected to continue to grow exponentially as cryptocurrencies become more widely adopted and more blockchains are developed.

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Don F. Davis