Traditionally the global finance industry, along with the products and services that it provides, has been dominated by vast, centralized institutions that ultimately dictate who gets access to financial services and who does not.
For example, to be approved for a bank loan, the borrower must already have a bank account along with an acceptable credit score. But, in order to acquire a bank account in the first place, the person must have fulfilled the bank’s “know your customer” or KYC procedures.
Anyone who doesn’t have the necessary KYC documentation cannot open a bank account, and therefore cannot secure finance or gain access to other banking services such as credit cards or foreign currency exchange.
Therefore, the traditional finance industry currently excludes a large percentage of the global population, especially in developing countries where identity documents may not be readily available. As a result, these “unbanked” individuals are prevented from participating in activities that result in the creation of economic value and hence wealth.
And, according to the World Bank, there are some 1.7 billion unbanked persons in the world today.
The centralized nature of the current financial system also places a significant amount of power in the hands of financial institutions and as consumers, we are forced to trust these institutions with our most valuable assets including properties, pensions, and savings.
But, in the period leading up to the economic crisis of 2008, banks handed out trillions of dollars in loans on massively overvalued assets, much of it to people who were unlikely to ever be able to pay them back. So banks proved themselves to be far from infallible and this is a reminder that centralizing power in this way itself comes with risk.
As a result, the financial services sector is seen by consumers as one, if not the, least trustworthy of all business sectors. And through their control of banks, unscrupulous countries can engage in currency manipulation and financial censorship, further increasing wealth inequality.
Ultimately, the centralization of power within the financial system leads to individual organizations becoming “too big to fail” whereby, should one actually fail, a fatal blow may be dealt to the whole system. This systemic risk forces governments to prop up failing and inefficient financial organizations, creating ”zombie companies” that consume valuable resources and capital that could be better allocated to more efficient businesses with greater potential.
So what is “Decentralized Finance” or DeFi and how could it address some of the problems with the current financial system?
Well, in essence, DeFi heralds the idea that existing financial products and services can be recreated, utilizing a decentralized architecture, outside of the control of centralized companies and governments.
As such, DeFi has significant disruptive potential.
It could, for instance, replace many of the legacy systems in the finance industry and it is already enabling people to gain access to a wider range of financial services, irrespective of the country of their origin, their financial status and other traditional parameters.
Anyone with an internet connection can access DeFi products built on blockchains such as Ethereum and Bitcoin. As such, DeFi is giving people an alternative to relying on traditional, centralized financial institutions and it’s important to point out that this is a choice that people are increasingly being able to make.
Since DeFi uses blockchain technology at its core, users interact with each other directly, peer to peer, when using DeFi products. This means that the need for intermediary entities that add cost, friction, and delay into the current system is removed or at least vastly reduced.
The result is that DeFi products are cheaper, more efficient, more secure and available to a greater percentage of the population, reducing the number of unbanked individuals. There is also significantly more transparency of transactions in the DeFi ecosystem, as all transactions are recorded on the blockchain and therefore available for public scrutiny – another complaint levied at banks is that they are too opaque and complex for customers to understand or examine.
In a DeFi world, the funds of users are controlled by smart contracts that run on a blockchain and not by companies. This means that, rather than users having to trust financial institutions, trust is written into the code, so that there is far less likelihood of corruption or manipulation within the system.
An example of a market that DeFi could easily address is the global remittance market, in which foreign workers send currency across borders to their families back home. This market is worth some $520 billion annually and the fees charged by the intermediary organizations that currently facilitate these transfers are significant, often amounting to 20% of the amount being sent.
Add to this the delays these companies introduce along with the difficulty of tracking the sent funds and the process is clearly extremely costly and inefficient.
DeFi based services will significantly reduce the cost of remitting funds and increase the speed of transfer by removing unnecessary intermediaries thus improving the process for both the sender and recipient.
DeFi is still very much in its infancy and there are certainly challenges to be overcome. Some of the early products being launched are not fully decentralized and, although blockchains themselves are highly secure, the smart contracts that run on them could be poorly written and therefore insecure.
Using cryptocurrencies, currently required by DeFi products, is still complex and difficult for people to understand and so simpler user access mechanisms are required.
However, as the adoption of cryptocurrencies increases and more blockchains are developed that support DeFi products, we’re likely to see an exponential expansion of DeFi over the next five years into markets such as international remittance, lending and borrowing, derivatives, payments, asset transfer, and many others.
If you want to learn more about how blockchain is disrupting the financial services industry or how o develop DeFi products for your company, contact Welford and we’ll be pleased to help.