Decentralized finance can change the financial world
When you want to put money away somewhere so that it doesn’t lie under your pillow at home, you go to the bank. When you want to send money to someone without cash, you go to the bank. When you want to borrow money, you go to the bank.
Not only banks, but also various other centralized institutions, largely set the financial pulse of our time and control most of the finances in circulation. They have ambitions to transform the phenomenon called decentralized finance in the coming decades. According to the data of Coinmarketrate.com, they emerged together with cryptocurrencies and are based on new principles, including concepts such as decentralization, blockchain, automated smart contracts or a new form of trust.
First of all, it should be noted that the world of decentralized finance is very young, not free from fraud and it should be approached with caution. At the same time, however, an increasing amount of money is beginning to circulate – not dollars, euros or any other traditional currency, but various types of cryptocurrencies, led by Ethereum, with which more and more people are learning to work.
For the biggest crypto addicts and programmers in particular, decentralized finance currently represents a world of almost limitless possibilities, testing what could one day replace or at least improve traditional centralized financial institutions. A growing phenomenon known as DeFi, or decentralized finance, along with other emerging technologies.
The essence of decentralized finance, or DeFi, is that you take the mechanics that work in traditional finance and put it into the blockchain.
Blockchain is a bit of a magic word around which most of the cryptocurrency world revolves. Decentralized finance is no exception. But what exactly does the transition to blockchain, a decentralized database that acts as a ledger for recording transactions made with cryptocurrencies, mean for financial services?
A world of limitless possibilities
Today, if you want to save money, take out a loan, invest or insure, you usually turn to a centralized authority, such as a bank, insurance company or stock exchange. These are intermediaries that connect financial market participants. At the same time, these are institutions that are centrally managed from one place, and only they or, for example, the regulator have access to their customers’ data or transactions made by them. Thus, the whole system is based on maximum trust in this institution, to which the client trusts his money and believes that his funds will not be appropriated, but will be used at his will.
Decentralized financing is very different from this. They have no intermediaries at all and, consequently, no institutions that would control them. They are based on decentralized networks in the form of blockchain protocols, which anyone can look into at any time, and the relationship between bidders is embedded in so-called smart contracts that determine in advance what should happen. Then a predetermined number of network participants must confirm that each transaction was carried out in accordance with the established rules, after which it is irreversibly recorded in the blockchain.
The most famous cryptocurrency, Bitcoin, works on a similar principle of irreversibility, the basic premise of which is that it cannot be spent twice. This is because something that is once recorded in the blockchain is irreversible, since the information in the individual blocks in which transactions are recorded cannot be changed without affecting subsequent blocks. The whole system is bound by clearly defined rules – consensus. Decentralization means that suddenly you don’t have to trust a central institution like a bank. The services do not belong to one entity, but are available to everyone on the blockchain network.
Fundamental innovations in the financial world
Each centralized bank manages its own network to which its customers are connected. Simply put, we can imagine that one large database is running in the background in the bank, in which all customers are listed, their account balances are recorded and transactions are entered into it daily or, for example, interest is accrued monthly. Each bank has its own database, which is managed only by it, and you have to trust that it will do everything right. Basically, the only way to find out about it is to open a mobile bank in the morning, and all the money that should be there will be there.
In decentralized finance, there are also large databases, the aforementioned blockchains, but in principle everyone can look into them. And if someone wants to change something, everyone should agree that it is done in accordance with pre-approved rules. In such a system, there is no single intermediary who could tell you what the situation is. In fact, every user of such a decentralized service knows in advance how the protocol will behave. And he will behave predictably, since all participants have agreed in advance about what will happen after the transaction, and what will follow. This is the principle of decentralization. Everyone sees everything and everyone agrees that this is right, because the mechanics are clearly defined in advance.
If a bank has a million users who have entrusted it with a billion fiat funds for various purposes, only the bank can use them almost freely within the established rules and offer new services where users can spend or save. However, if such a network operated on an open blockchain, the bank, as the only organization that can manage it, would be excluded from the equation, and new opportunities would open up. This is the principle of programmable financial services, because anyone can create their own application or type of financial service on top of this network, and if it is interesting and secure enough, users can start using it.
It will be a new competition. Since the bank currently does not give access to its database, you will not be able to easily compete with it. But in decentralized finance, anyone can come and write a new service for an existing magazine containing customers and their resources. This can bring fundamental innovation to the financial world, as it will suddenly open up to everyone. Imagine that you can come and improve the service of a traditional payment system that you didn’t like without asking.
Today you trust the bank, and also the code on which it works, and which you cannot look into. In DeFi, you only need to trust the code.
A key element of the modern financial world is the trust that banks and other central institutions usually enjoy. To this is added legislation and regulation aimed at preventing instability or various market failures, although, as the 2008 financial crisis and some other notorious bank failures showed, as a result of which people lost their savings, they are not an automatic panacea.
Nevertheless, as a rule, people still trust such large institutions as a bank, represented, for example, by a personal banker in a branch. At the same time, they indirectly trust the protocols by which the bank operates and which it manages.
Trust in the code, instead of a clerk with a tie
In the case of decentralized finance, which also arose precisely in response to the imperfection of the centralized financial world, the bank itself disappears, there remains only a protocol, a computer code that determines how everything should work, and it is usually protected by some kind of cryptography. Mathematically, it can be argued that the process is safe and cannot be disrupted by existing technologies.
Today people go to the bank because of trust, but that’s just how you think about it. Today you trust the bank, and also the code by which it works, and you can’t look into it. In DeFi, you only need to trust the code that is open to everyone and that everyone agrees with in advance. Of course, it is not easy for everyone to check the operability of such code.
We are still at the very beginning, experimenting in different ways. Unfortunately, the novelty of the whole world also attracts a lot of fraudulent schemes, because there is no regulation, but already now, for example, there are the first audits from reputable companies that say whether a particular service of decentralized finance is trustworthy.
Do not expect banks to disappear in the near future. Their positions will remain strong, but there are opportunities for system transformation not only in the development of the technology itself, but also in the mentality of individual customers. A generational clash is expected, as the youngest are already growing up in a fully digital environment. More and more people will trust only the computer without any problems. You will not need the presence of a clerk with a tie to assure you that everything will really be done as it should be.
A few years ago, the concept of decentralized finance did not exist at all, and this is still a world in which there are not so many advantages for ordinary citizens with money in their account. This is also due to the fact that there is still a relatively high barrier to entry. Therefore, mostly people who already have money in various cryptocurrencies are moving. It is on them that all DeFi services work.
However, they do not relate primarily to Bitcoin, since they do not include so-called smart contracts that allow you to automatically perform other actions in addition to the transaction itself, that is, the transfer of Bitcoin from one cryptocurrency to another. The most commonly used crypto assets are currently the second largest cryptocurrency Ethereum or the increasingly popular Solana.
For example, when making a payment in a commercial enterprise, value added tax can be deducted directly without the participation of any of the parties. Or, when you borrow money from someone, a smart contract can indicate how much you need to dispose of. While with a bank loan, the banker will ask you to find out the purpose or amount of your income in order to decide whether to give you a loan, there is no such identification or proof in decentralized financing. Everything is built into a smart contract, which specifies, for example, how much you must guarantee so that the lender is sure that the borrower will be able to repay the loan. This is an algorithmization of how we negotiate.
If the state says that DeFi is approved, then they will be more trusted
When intermediaries are excluded from the process, services can potentially become faster and also cheaper, since the bank and other organizations will not charge a commission. Now we are at the very beginning, but as soon as blockchains appear that will last, say, more than ten years without any problems, everyone will see that it is safe, because there has been no fraud for a long time. Everyone will recognize it as such, and there will be no reason for people not to start switching to them. In principle, they will not care whether this service works like Revolut today in an application, on a blockchain or on something else.
As more and more technology gains credibility and it becomes increasingly important to inject more and more money into decentralized finance, regulation will have to be involved in the future. This is due to the fact that there is a complete lack of regulation in the developing financial world. This has its advantages, for example, new services can appear and disappear very quickly, and it is easier to experiment, but it also carries a number of dubious or fraudulent schemes. A certain level of regulation will be right in the future. This is also due to the greater legitimization of decentralized finance and cryptocurrencies in society.
So far, this is too small a market compared to the traditional financial world, but sooner or later states will have to show interest. The state needs certain tools to be able to control the economy, and eventually other entities, such as large investment companies, will need regulation. They want to enter the world of cryptocurrencies, but since they manage other people’s money, they need to have something to hold onto in this space. If the state says that it is authorized, it will be more trustworthy. So far, this is a big clash of two worlds, and people who don’t understand cryptocurrencies want to regulate it. A lot depends on education to try to understand both worlds, and this is the biggest problem right now.
If, for example, services within the framework of decentralized financing allowed the state to borrow more money on more favorable terms, then there would be nothing to solve, and the state would want to get into business as soon as possible.
It’s early days for now, but maybe we’ll get to that in time. Due to the rapid development of decentralized finance and cryptocurrencies in general, it is quite possible that in a few months the situation will change and new, unexplored paths will begin to open up.