Review of Decentralized Finance (DeFI) as an Alternative Financial System (Part 1)
There are currently over 4,000 (four thousand) cryptocurrencies in circulation and approximately 51,200,000 (fifty-one million two hundred thousand) active cryptocurrency traders worldwide. With the proliferation of cryptocurrency and the associated technology that supports it, disruptors and innovators have begun to take advantage of the multifunctional nature of cryptocurrency and have created products that could change or disrupt banking and commerce. traditional finance. Enter decentralized finance or “DeFi” for short.
DeFi refers to an emerging area of finance where financial products are offered to customers using blockchain technology like smart contracts, limiting reliance on the traditional institutional nature of finance where financial products and services are offered by banks and other financial institutions.
Compared to the traditional or centralized financial industry, DeFi is still just a small drop in a big pond. However, DeFi products or protocols have started to develop rapidly and are making monumental gains. In 2019, only $275,000,000 ($275 million) worth of cryptocurrency was locked in the DeFi economy. In February 2020, this number increased to 1,000,000,000 USD (one billion dollars) and in January 2022, more than 78,000,000,000 USD (seventy-eight billion dollars) worth of cryptocurrency was used on decentralized financial products.
Thus, with this rapid growth of DeFi products, it is important to consider whether DeFi as an alternative financial infrastructure is complementary or contrary to traditional financial and banking systems.
In this article, we’ll examine this question by breaking down what DeFi is and conclude with our opinion on the future of DeFi.
Understanding Decentralized Finance
Dr. Usman W. Chohan, an international economist-academic, describes DeFi as: “…an experimental form of financial praxis that is freed from reliance on centralized financial intermediaries, which in this context could include banks, exchanges and brokerage houses. As such, DeFi claims to disintermediate financial activity from traditional mechanisms of finance, and it does so through the use of a blockchain surrogate architecture.
In a nutshell, DeFi is a movement that aims to create an open-source and transparent financial services ecosystem that is accessible to everyone and operates without any central authority such as banks or brokers. Users retain full control over their assets and interact with this ecosystem through peer-to-peer (P2P) applications which are decentralized “Dapps”.
Dapps are used by DeFi protocols or product customers to interact with each other and are powered by “smart contracts”, programs that work like contracts when pre-determined conditions are met and are stored on a blockchain. Smart contracts are self-executing contracts, with the terms of the agreement directly written in lines of code, so that when the pre-agreed conditions are met, the smart contract enforces the execution of the relevant terms of the OK. The code and the agreements it contains exist on a blockchain network. The code controls execution and transactions are traceable and irreversible.
Ethereum.org defines a Dapp as an application built on a decentralized network (blockchain) that combines a smart contract and a front-end user interface. Therefore, the layers of a DeFi product consist of the backend (Smart Contract) which contains the terms and conditions embedded in the line of code and the frontend (Dapp) with which users interact. The Dapp can be programmed to perform various functions to enhance the user experience such as tools to compare and evaluate services, allow users to perform otherwise complex tasks by connecting to multiple protocols simultaneously, and combine relevant information in a clear way and concise.
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Dapps are the means by which customers access DeFi products. For example, Luffy might be looking to get a loan and instead of going to a bank, he might decide to connect to a Dapp which compares and rates the different services offered. Upon selecting one of the offers, Luffy enters into a smart contract, and accordingly, the Dapp stipulates Luffy’s requirements for the disbursement of funds. Once Luffy meets these conditions, the disbursement term of the smart contract is executed and the loan amount is disbursed to Luffy (usually in cryptocurrency) instantly and the parties are bound by the smart contract.
The DeFi product, a loan in the example above, can also be secured by collateral. Subject to the terms of the smart contract, collateral may be deposited in an escrow account (off-chain collateral) or collateral is deposited on the native blockchain on which the Dapp is built, typically in the form of the native cryptocurrency of the blockchain (on -collateral chain). In some cases, there may be no collateral requirement.
The hypothetical loan transaction is just one of many financial services/products available through DeFi. In the next part of our article, we will explore some DeFi products.
DeFi – Financial services and products
While there are many ways to use DeFi protocols today, we will highlight the most important use cases.
Stablecoins: Stablecoins are the most popular use cases of DeFi protocols around the world because crypto holders, traders, and even whales (individuals who own a large amount of a particular cryptocurrency) can protect themselves against cryptocurrency price volatility by buying digital assets that are pegged to fiat currency (currency issued by a government and declared to be legal tender) or commodities.
Stable Coins are digital assets tied to a stable asset such as fiat currency or a commodity such as gold. They tend to stay stable for longer periods of time than those that are not backed by assets, for example Bitcoin (“BTC”) or Ethereum (“ETH”). The issuing entity of the stablecoin usually sets up a “reserve” where they securely store the asset backing the stablecoin and theoretically the holder of the stablecoin can exchange one unit of the stablecoin for one unit of the asset backing it. i.e. 1USD Coin (“USDC”) for $1.
There are also complex forms of stablecoins backed by other stablecoins. For example, the NGN token (“NGNT”) is a collateralized digital currency issued by Token Mint that is pegged to the value of the naira and is non-volatile. Apart from being pegged to the value of the Naira, NGNT is also backed by the USDC. USDC is issued by regulated financial institutions in the United States, backed by fully reserved assets and redeemable on a 1:1 basis against US dollars. Therefore, a holder of NGNT can redeem the USDC equivalent of NGNT they are holding and exchange it for US dollars.
However, criticism of the stablecoin as a DeFi product remains. Critics argue that stablecoins are only as stable as the asset that backs them; thus, they are always affected by the volatility of the underlying asset. They also believe there is counterparty risk that investors need to consider, as most stablecoin issuers do not specify where they store their “reserves” and what value is actually stored. In cases where the value of the issuer’s reserves is lower than the value of the issued stablecoin, this impacts investors’ ability to exchange their stablecoin for the underlying asset.
Despite these criticisms, stablecoins remain one of the most popular DeFi products and are even used in countries where their fiat currencies are losing value, for example in Brazil where hyperinflation, poor economic factors and a host of other problems caused a crash. in the value of the Brazilian real. Now, most of its citizens use Tether Coin, a dollar-pegged stablecoin, to transact and have more stable economies.
In the second part of this article, we will look at other financial products and use cases for DeFi.