The leading financial institutions have been operating on business models from previous centuries. The infrastructure they are built on is centered around decade-old technologies. This aging infrastructure limits the ability to innovate. Over the last couple of decades, almost every industry has been restructured by the digital transformation except finance.
What is Decentralized Finance?
Defi is the alternative for the traditional finance environment. The end goal of DeFi is to enable a more efficient and transparent financial system by taking advantage of smart contracts.
It is more expensive to transfer $300 through Western Union today than it was a couple of years ago. It takes time and there are charges along the way. This structure needs to be improved. Attempts to innovate the system so far has had a little effect. All these set the stage for decentralized finance. DeFi is a growing movement that has the potential to transform how we think about financial services.
The intermediaries are replaced with self-executing contracts known as smart contracts on the blockchain. These allow innovators to imagine everything it goes across landing trading insurance asset management and others. Because there are no intermediaries it is possible to execute basic financial functions quicker cheaper and more flexible in a more flexible way than what was possible in the legacy system.
Room for Growth
The $512 billion market capitalization of DeFi applications represents less than 1% of the total market cap of global financial services companies. If it were to get the same penetration as other disruptive technologies such as e-commerce, then it could become a $15 trillion industry in the next 5 to 15 years. This means that there is still plenty of room for growth.
DeFi has a goal which is to create a more accessible and transparent financial system by leveraging programmable money built on smart contracts. The key innovation that fuels DeFi runs on blockchains and can execute transactions without the need for an intermediary. As an analogy, with a vending machine one can insert money on one end and receive the item on the other without any external intervention.
Defi applies this breakthrough to financial services and it is changing the way we think about the financial system. DeFi has a lower cost structure than traditional finance. This is because first it removes the need for middle-men in financial transactions and secondly it is built on a world of nearly-free money transfer.
Again, DeFi allows for faster financial transactions because it removes the need for intermediaries. It is built on blockchain infrastructure that offers instantaneous settlement of financial transactions. The main segments that makeup DeFi are similar/ mirror images of traditional finance services. They include Asset management, trading, lending and borrowing, and insurance. Lending and borrowing take up a large chunk of the pie in DeFi.
Lending and Borrowing
It are some of the original use cases of decentralized finance. A number of protocols have emerged in an attempt to break the barriers that were characteristic of the traditional finance ecosystem. Brian Brooks defined DeFi applications as self-driving banks. This ties closely to the use of lending and borrowing applications as they are automate banks where users can deposit crypto assets and get returns. They could also borrow crypto assets with collateral. Every liquidity pool has a lending and borrowing interest rate that is determine to ensure that it represents market demand and supply. Therefore, when the demand for capital increases, interest rates increase.
The top three DeFi lending protocols are Aave, Compound, and MakerDAO. Altogether, the protocols received a deposit of $41 billion in October 2021. Even though the protocols differ in the way incentives are structure at the root, they all allow loans to be processe with speed.
Trading of How Digital Revolution is Reshaping Finance
Another key use case for decentralized finance is trading. Decentralized exchanges are the equivalent of the New York Stock Exchange or NASDAQ. They offer users the ability to swap crypto assets without the usual third parties involved. Most of these DEXes do not use order books. They use a new mechanism known as Automatic Market Makers (AMM) to sustain trading activity. One of the benefits of the AMM mechanism is that traders don’t trade against each other. They trade against a liquidity pool that aggregates the supply of assets to the trading pair.
The activity in DEXes is control by smart contracts which execute instant settlement. Unlike traditional trading, there is no corporate headquarters, or trading floor with thousands of employees. However, some of the leading decentralized exchanges rival their traditional counterparts in volume of trade and cost.
Insurance protocols have surfaced to provide coverage against risks in DeFi. This segment is still nascent compare with the traditional system. The leading protocol, Nexus covers less than 1% of the total value locked in DeFi. There is plenty of room for growth in this space when the user experience improves. As of today, users have to get insurance through a separate transaction. Although, this is likely to change in the future.
Asset Management about How Digital Revolution is Reshaping Finance
Asset management is one of the fastest-growing segments in decentralized finance. With the aid of DeFi, asset management services can be automate and executed in a transparent fashion. Protocols in this segment utilize smart contracts to deploy assets deposited on their platforms across the DeFi ecosystem. These strategies are design to seek the most favorable yields. Due to the nature of blockchain, assets under management and strategies use can be publicly audite.
Conclusion of How Digital Revolution is Reshaping Finance
In the global finance industry, there has been a need for innovation in over the past decades. The incumbents in this space have seen no reason to innovate, partly because of the high entry barriers. Along came fintech with the hopes of transformation. That hope has not materialized. However, with decentralized finance, there has been a new lease on life. What started as a domain of crypto has now attracted the attention of the largest financial institutions in the world.