Decentralised Finance or Defi represents a collection of blockchain-based financial services and products built using smart contracts. It is similar to the financial instruments in traditional finance but without a centralised party overseeing and approving the transactions. This blog will start by describing the traditional apparatus of finance and how it evolved over the years.
Traditional Finance(Tradfi) or Centralised Finance(Cefi)
We are accustomed to living in a world where centralised banks and institutions make financial decisions. This kind of financial structuring is known as a legacy or traditional finance. The words legacy finance or traditional finance are also used interchangeably with the term "centralised finance". That's because this kind of financial system is based on centralised control. Many individuals find it difficult to envisage a scenario in which the financial system operates differently. They just accept the current system as the default as the best choice.
Earliest Financial Arrangements:
The barter system was among the first financial arrangements created by humans to facilitate the sale and purchase of commodities. In this system, products and services were directly exchanged with one another. However, as societies progressed, barter gave way to currencies, and economies became more complex. Moreover, the nature of economies became increasingly centralised as the control over resources and issuance of currency rested with the sovereigns and central governments.
Trading was made simpler by the creation of money thousands of years ago. The first financial services, including money lending, were also launched almost simultaneously. Around the 12th century, the first money-lending services came to the fore. Across the world, in different empires, traders and merchants started giving loans to farmers or artisans.
The breadth of banking services grew over time as new forms of financial operations emerged: merchant-banking families began to engage in everything from bond underwriting to the origination of issuing loans. New financial features aided in the expansion of commerce and industry.
The Emergence of the Gold Standard
Towards the end of the 17th century, banking played a significant role in meeting the financial needs of the conflicting European powers thereby prompting the creation of the first central banks—banks that control a state's currency, money supply, interest rates, commercial banking system—and government restrictions. During the 19th century, central banks were founded in several European nations. Most of Europe and Japan's central banks were established under the international gold standard in the 19th and early 20th centuries, even though central banks are typically linked with fiat money today.
Under the "gold standard," the value of a nation's currency was directly correlated to the price of gold. In 1821, England became the first nation to embrace the gold standard formally. The majority of developed nations had adopted the gold standard by 1900.
Countries agreed to exchange paper money for a specific amount of gold under the gold standard. A nation that adhered to the gold standard established a fixed price for gold and transacted at that price. This ensured that the exchange rate between two currencies bound to the gold standard was stable, and the exchange process was easy.
Additionally, central banks were required to use their gold reserves to support the issuance of banknotes.
The Dawn of the Fiat Era
The application of the gold standard was founded on the Bretton Woods Agreement, which, until 1971, served as the foundation for the world's currency markets. All national currencies were valued with respect to the US Dollar under the Bretton Woods regime. The US dollar overtook other reserve currencies. The Dollar may then be exchanged for gold at a set rate. Even if it did so more covertly, the gold standard remained the foundation of the world financial system.
Therefore, it was in the 1970s that the Gold Exchange Standard was invalidated entirely. That officially marked the end of the gold standard and the beginning of the fiat money era, with the US dollar retaining its position as the global reserve currency.
The Need for Decentralised Finance
Since gold reserves no longer backed currencies fiat money system required placing one's trust in the governments and financial institutions to control and manage shared resources. However, with many recent instances of corruption and graft, it is understood that the centralisation of financial control is problematic at many levels.
Defi (Decentralised Finance) presents a more equitable financial system that eliminates the need to trust and depend on a centralised system, thus allowing easy borrowing, lending, and trading of financial products.
Unlike centralised finance, Defi has the potential to create a truly transparent and resilient financial system.
How Defi can be a superior alternative to the established financial apparatus
- There are no mediators or arbitrators in Defi applications. The underlying code describes resolving any potential dispute, and users retain complete control over their assets. It lowers the costs of offering and adopting financial products, thus making the financial system more frictionless.
- Single points of failure get eliminated because the financial services get deployed on top of blockchains in Defi. In addition, censorship or the potential closure of service is brutal because the data is stored on the blockchain and distributed across multiple nodes.
- Blockchain technology safeguards users' financial data. The cryptographic hashes used to send and receive money are pseudonymous, meaning they don't contain personal information.
Another key benefit of an open ecosystem is the ease of access for those who would not otherwise have access to financial services. Defi is borderless, and anyone from anywhere with an Internet connection can have rapid access to liquidity.
Advantages of Defi
- Peer-to-peer transactions: By enabling peer-to-peer transactions between individuals, decentralised finance removes intermediaries.
- Globally Accessible: People can lend, trade, and borrow using software that logs and validates financial transactions through distributed financial databases from anywhere there is an internet connection. A distributed database collects and aggregates data from all users and utilises a consensus mechanism to validate it, making it available from different places.
- More control for users: Through the availability of financial services anywhere, regardless of identity or location, decentralised finance eliminates the need for centralised financial models. Through personal wallets and trading services that are geared toward individuals, DeFi applications give users more control over their money.
Disadvantages of Defi
i) While DeFi's open-door approach has benefits, it also means that illicit money can travel across the platforms without anti-money laundering safeguards. With this in mind, one of the main difficulties in the Defi market is regulation.
ii) There's a fine line between security and openness in Defi. Unlike banks, there is no one in the Defi ecosystem to suspend or revoke transactions if an account has a problem. If not correctly audited, the coding of the mentioned protocols can be defective and lead to vulnerabilities.
iii) Defi has made life simpler for its users in terms of accessibility, with platforms open to anybody who wants to join, although doing so still demands some technical knowledge. On the other hand, opening a bank account requires no special equipment or expertise.
We are witnessing a massive leap in the new functionalities of money due to distributed ledger technology innovation. For the first time in history, the people are shaping a global financial system, not governments or institutions. Everyone can participate in this new global economy and enjoy the fruits of decentralisation. Despite the challenges, we face while working on cutting-edge technology, the world of decentralised finance is on the road to success. When Defi and legacy fintech intersects and integrate, we will reach a flex point where emerging financial technology becomes a component of a new economic system.