Traditional finance is on the brink of evolution. Even before the pandemic hit, global banks were looking for ways to enhance efficiencies and reduce costs. In this endeavor, many central banks studied the role of blockchain technology and digital currency with a vision to improve their economies. As the cracks in traditional finance continue to widen, there’s an innate need for some serious changes. Decentralized Finance (DeFi), if implemented properly, has the potential to transform the traditional financial system and the way we all manage our wealth in the future.
The intent of starting this new financial system is simple — to help 1.7 billion people who lack access to basic financial services. And to introduce an open banking system through decentralization — making it open for everyone and easily accessible.
How Will DeFi Apply to the Real World?
Open finance platform and processes are being rapidly adopted as it offers the possibility to transform the lives of everyone who is unbanked, and offers to those seeking innovative financial solutions to stay ahead in the modern digital times.
Simplified Monetary Banking Services
DeFi applications are financial applications, and hence, monetary banking services are one of the most apparent use cases. This includes issuing stablecoins, mortgages, insurance, and more.
With the blockchain industry growing and maturing rapidly, there’s also a special focus on creating stablecoins. Decentralized stablecoins can be adopted for everyday use as digital cash which isn’t monitored by any central authority.
If you’ve had trouble getting a mortgage in the past, you’re not alone. With all the intermediaries involved, it can be a time-consuming and expensive process. But with the use of smart contracts, legal fees and underwriting fees can be drastically reduced.
In case of insurance, as an example, premiums could be lower with the same quality and service as it eliminates the need for intermediaries and distributes the risk amongst participants.
More Money for Migrant Families
When foreign workers send billions to their families across the borders, they end up paying heavy fees to banks and financial institutions. DeFi services aspire to cut these costs by 50% — thus increasing not just productivity, but also helping in growing economies.
Easier Lending and Borrowing
Open lending protocols are lucrative applications of DeFi ecosystem. Currently, the unbanked cannot borrow money as they lack a good credit score or have a bad history with banking institutions. With DeFi, borrowers are connected to lenders, eliminating the credit check process. There are more advantages, like the ability to collateralize digital assets, reduce counterparty risk, making borrowing cheaper, faster, and readily available.
Growing Decentralized Marketplaces
DeFi offers much room for financial innovation, and there’s a lot you can do if you can think out of the box. Decentralized Exchanges (DEXes) are a crucial application as the platform allows you to trade digital assets without needed an intermediary or an exchange to hold their funds. Smart contracts help direct trades between user wallets.
Owing to the lower maintenance work, DeFi also offers lower trading fees compared to centralized exchanges.
With the help of blockchain technology, you may also get access to issuance and ownership of conventional financial instruments. And since they work in a decentralized ecosystem, it will eliminate custodians and single points of failure.
Some of the other possible projects include decentralized prediction markets, synthetic assets, and creating derivates.
The Role of Smart Contracts in DeFi
All the existing and potential applications in DeFi involve creating and executing smart contracts. Just like a traditional contract, this too uses legal terminology to specify the terms of the business between entities of the contract. However, in this case, it uses a computer code.
As all terms are written in computer code, smart contracts can even enforce all terms using code. As a result, there’s reliable execution and automation of various business processes that may need manual supervision today.
Smart contracts make business easier, faster, and ensures lower-risk for all parties involved. However, the computer code also poses threats like bugs and vulnerabilities, potentially putting confidential information at risk.
Challenges Associated with DeFi
Every high-return financial product comes with its own set of risks and challenges. Naturally, the DeFi ecosystem will bring along certain risks as well.
It is a user’s responsibility to secure their key and holding and use multi-factor authentication for confidentiality. As a DeFi user, it’s essential to stay updated with the changes in the contract terms between exchanges, wallets, and other crypto assets to avoid any security risks or discrepancies.
Another challenge that users may face is that in the traditional financial system, investors have access to historical data or benchmarks before they make an investment decision. That privilege may not be there for DeFi users, and lack of insights or historical numbers may make it difficult to assess and evaluate the associated risks. But with the right research, it is undoubtedly possible to gauge the risk factors and make smart investment decisions even in the DeFi ecosystem.
New users may also be overwhelmed trying to find the application that’s best suited for a particular use case, and they must have the ability to make the right choice. Enhanced user experience will help users to switch from traditional systems to DeFi at a faster pace.
In the future, crypto wallets will become your portal of all digital assets and activities. It could be a dashboard that not only shows your owned assets, but also how it is locked up in various protocols like pools, insurance contracts, and loans.
The DeFi community is working to enable stakeholders to vote on decisions and bring about a more comprehensive range of DeFi use cases.
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