5 ways DeFi is changing the future of finance
A user-owned financial system once sounded like a fantasy, but it’s now on its way to becoming reality. Here’s how you stand to benefit.
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From one perspective, the modern financial system is largely off-limits to average people like you and me. Investment banks, wholesale investors and high-net-worth individuals are able to access a wide variety of ways to grow their wealth, while individuals are left to wrestle over an extra 0.25% on their savings accounts.
With so few options, banks are able to charge what they like, with company profits taking priority over the betterment of society (and your finances).
Decentralised finance (DeFi) aims to eliminate the barriers between wealth creation and individuals. DeFi uses blockchain technology to make any sort of financial service imaginable available to anyone, anywhere. ”
It has inspired a diverse ecosystem of services, products and investment vehicles that are now being touted by firms like JPMorgan as potentially having “far-reaching implications for corporate finance”.
But most importantly, it has far-reaching implications for personal finance. In addition to new ways of growing your wealth, DeFi services are largely user-owned, meaning profits no longer reign supreme. Instead, the user takes centre stage.
Let’s take a look at some of the key benefits of DeFi and how it could reshape the global financial landscape.
What is DeFi?
DeFi aims to decentralise financial services by making them available to anyone. Things like banking, investing, savings accounts and wealth management are all being turned into blockchain-based services, with all the benefits that brings. No longer do you need a bank to tell you what you can or cannot do with your money.
By building on the blockchain, DeFi applications are secure, transparent and automated, all without the need for a central authority. This means that you can trust the blockchain to handle complex financial services that once required a trusted-third party like a bank instead of secured blockchains like Ethereum, Avalanche and Polygon.
All transactions are verified through consensus, protecting against fraud, with details recorded on the blockchain for perpetuity. Smart contracts (automated pieces of code) then automate the bulk of the process, eliminating the need for human input.
DeFi applications are accessed over the Internet and look just like any other website, but with the added requirement of using a Web 3.0 wallet to store funds and verify transactions.
Thanks to these unique fundamentals, innovation has exploded. Services, applications and use-cases have emerged that were once not possible or feasible within the world of traditional finance, or otherwise off-limits to everyday people. While DeFi is far from taking over, there are certainly elements from this innovation that could change the future of finance as we know it.
What can you do with DeFi?
DeFi broadly refers to using blockchain technology to enable financial services. Many of the concepts involved might be new to you because they have previously only been accessible by accredited investors and banks. Thanks to DeFi, you can now participate in the same world of high-finance and put your money to work like never before.
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Earning yield on idle cryptocurrency assets has become a cornerstone of success within DeFi. Users are able to deposit their assets into yield-bearing accounts and earn regular rewards paid out in cryptocurrency, which can be collected at any time.
Staking is 1 such method of earning yield. The term is now used for many yield-earning opportunities that require users to lock away cryptocurrency tokens. These tokens are then used as collateral to either support the security or liquidity of an application. In return for staking, users are rewarded with additional cryptocurrency.
Swyftx is a platform that offers Kiwis the ability to stake digital assets in return for rewards. Using a service such as Swyftx greatly lowers the barrier to entry and only takes a few clicks to complete, saving you the need to learn how to navigate DeFi applications. The platform currently offers staking solutions for a range of different cryptocurrencies, including ADA, SOL, ATOM, DOT, KAVA, KSM, ALGO, XTZ, FLOW and TRX.
Take out a loan
Instead, users are required to over-collateralise their loans to protect the lender on the other end. This means that to borrow $1,000 of value, you would need to put down $2,000 worth of cryptocurrencies of collateral. If the value of the collateral begins to drop, smart contracts will automatically sell them on the open market to protect the borrower and ensure the loan is paid back.
DeFi has enabled ways in which cryptocurrency assets can be exchanged without the need for a centralised intermediary or counterparty. While you might read about “cryptocurrency being banned” here and there, DeFi prevents that from ever truly happening.
Once launched, decentralised exchanges hosted on the blockchain allow anyone anywhere to trade assets such as cryptocurrencies, stablecoins and NFTs any time they wish. They do so by using 2 other DeFi innovations – automated market maker and liquidity pools.
5 ways DeFi could change the future of finance
So, what are some of the key implications to come from this new financial disruptor? Let’s take a look over how we think DeFi could turn the finance sector on its head.
The traditional financial system is often viewed as dishonest and crooked. There have been many cases across the years where the system has been used to benefit those within the industry. If you are looking for an example, look no further than the 2008 financial crisis where subprime mortgage-backed securities were sold as AAA-rated.
Due to the use of blockchain technology, the majority of DeFi applications are open source. This means that anyone (with the right knowledge) can see how individual applications function, allowing them to be publicly audited and vetted. Transactions are also recorded on a public ledger, adding a layer of transparency previously unknown to modern finance. Not exactly something banks are known for.
While cryptocurrencies are often a target for accusations around money laundering, their public nature actually makes them a terrible choice. Instead, the use of public ledgers is more likely to prevent banks like HSBC from helping fund terrorism and drug cartels.
Improve customer service
Ever needed to transfer money to a friend or relative but your bank has closed for the weekend? Perhaps you have wanted to profit from some changes in the market but stocks have ceased trading for the day. With DeFi, standard working hours no longer apply and markets are open 24/7, and can even let you trade without the need for a counterparty.
As DeFi applications run on automated smart contracts, there is no requirement for human interaction. That means that these applications can stay online all of the time. Borrowers can access money at all hours, lenders can earn interest while they sleep and traders can exchange cryptocurrencies any time of day.
Pass profits onto the user
As mentioned previously, part of the driving force behind DeFi has been the number of earning opportunities for users. Users can earn yield (regular reward payments) that is 10, 20, sometimes even 100 times higher than that offered by a traditional cash savings account.
Why are returns so high? Because the liquidity used within DeFi is all user-owned, with profits going straight back to the user. Platforms still charge fees, but typically no more than 1%, so users are entitled to the bulk of earnings. This flips traditional finance on its head and may usher in a new wave of earning potential for everyday people.
In 2017, 1.7 billion adults worldwide remain part of the “unbanked” – global residents that do not have access to a financial institution. When the unbanked were questioned on why this was the case, primary reasons included not having enough money for a minimum deposit and failing to provide the correct documentation. Even in high-income countries, if you don’t have a job you cannot open a bank account.
DeFi could help to lift some of these restrictions. Just like transferring wealth via cryptocurrencies, the only requirement to access decentralised finance applications is a computer and an Internet connection. Apart from getting money onto the blockchain, there are no other barriers to entry.
Greater ownership for users
The sentiment behind cryptocurrency and the blockchain has always been to place financial control into the hands of individual users. DeFi takes this sentiment and applies it to the financial services industry.
Most DeFi services can be used without handing over total control of your funds to the service or application. Instead, you give permission for it to be used in a very specific way and can revoke that permission at any time (provided you don’t have any outstanding obligations, like debt). Modern banking on the other hand uses fractional reserves, which means your money is never truly “on hand” and can lead to events like a bank run.
In addition to managing your own money, many applications now offer you the opportunity to govern the platform. This helps to keep the system as decentralised as possible by letting users collectively decide on how things should be run.
Governance tokens allow users to vote on a range of different aspects within DeFi applications and are frequently awarded just for using the platform. Governance votes may include things such as changing yield rates (APY), the distribution of rewards or hiring staff – not exactly the sort of items that you would expect to vote on at a bank’s annual shareholder meeting.
How to take DeFi mainstream
So what will it take to bring all of this to life?
DeFi already thrives within its own bubble of crypto-enthusiasts, but mainstream adoption is still in its infancy. To mature, the industry will need to accept and embrace regulation, despite how antithetical it may seem to certain blockchain philosophies.
Let’s say it clearly – the future of DeFi relies on cryptocurrency adoption and regulation.
In the past, governments and institutions thought it unlikely that blockchain and DeFi would go mainstream. The space was littered with risks and those looking to exploit the system, most of which can be avoided by implementing the right security techniques. As a result, crypto regulation remains fairly primitive.
However, many governments are adopting an increasingly positive stance. The change has been driven by a critical mass of individuals taking part in the crypto space. As the tipping point has been reached, governments and companies could no longer stand by and just watch.
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“I’m excited to see how DeFi will be regulated in the future. Financial regulation like AML and securities law are important because they are ultimately meant to protect private citizens from harm. Right now, NZ financial regulation isn’t designed to regulate DeFi – regulating DeFi right now is analogous to inserting a fast-evolving square peg into a stationery round hole. NZ regulators (like overseas regulators) also have to play catch up to an industry that’s moving at lightning speed. The decentralised and borderless nature of DeFi projects will make questions like regulatory jurisdiction interesting to explore. I think regulation will be good for DeFi because it will further legitimise the industry and help to protect citizens from harm.”
Our neighbours in Australia have taken a similar position. The Reserve Bank of Australia’s (RBA) has most recent report outlines plans to prioritise the country’s payment policy, focus on digital payments and research the applications of cryptocurrencies, such as using them to digitise central bank currencies like the AUD.
By learning from DeFi and cryptocurrency, governments around the world have the opportunity to build a more transparent, fair and equitable financial system. Everyday citizens will have greater access to financial services and ways to manage their wealth while simultaneously reducing reliance on existing financial institutions.
But whether policymakers, lobbyists and politicians can be convinced to hand power back to the people remains to be seen.
Disclosure: The author owns a range cryptocurrencies at the time of writing
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