Throughout history, the emergence of currencies in various civilizations was often simultaneous with the emergence of basic financial services, such as banking. And it couldn’t be different: from the moment we decided to index our wealth in high-quality currencies, keeping all this wealth in safer places than our homes seemed a sine qua non condition for the monetary system to succeed.
The emergence of financial intermediaries, like banks, was an almost natural process, caused mainly by the lack of trust we have in each other as a society.
Of course, with the passage of time, financial agents stopped being simple depositaries of money. They began to issue deposit notes, make loans, and assist in the full range of services that the average citizen needs. This is because, although it is possible to do all this between people (eg, borrow money), these operators have a structure of regulatory bodies and supervisory entities that guarantee more reliable operations. So they appear more trustworthy.
It so happens that this entire system – created based on the crisis of trust between people – is composed of several intermediaries who, of course, charge for their services.
The problem is, many of these services are there merely to ensure a trusted third party is present in relationships between people.
These services don’t add effective value and, worse, they can increase transaction costs considerably. This impacts all of us – it costs all of us.
But that’s about to change, and we’ll all benefit…
Financial Services Are Packed with Expensive Middlemen
Today, we have an abundance of technology, with Internet access in practically all parts of the world, smartphones, computers, etc.
Of course, the traditional financial system was quick to adapt its services to all available technology: finance apps, cashback systems, digital banking and the open finance movement have been growing exponentially in recent years.
However, the operators of this legacy, millenary financial system are often merely providing old services in new formats, as opposed to uncovering new ways to add value. It lacks efficiency and transparency and is geared toward generating fees for those who act as mere intermediaries of transactions.
Only a true revolution could break these old paradigms. After all, some of the richest, most well known “trusted third parties” in the world benefit from them.
The good news, for us, is that revolution is at hand. It’s beginning right now. It’s called decentralized finance – “DeFi,” popularly – and it’s going to completely upend these old paradigms.
The revolutionary technology enabling this sea change is the blockchain, and the application is known as a Smart Contract.
The Best Way to Eliminate Costly, Inefficient Middlemen
Contracts have been part of people’s daily lives since the dawn of society. Agreements are made, deals closed, and countless activities revolve around and are dependent on them. They’re nothing more, and nothing less, than the formalization of the will of two or more parties.
It so happens that, to guarantee the execution of a traditional contract, a third trusted party is needed: be it a bank, which can issue some type of guarantee to be executed in case of default, or the judiciary itself.
This is because, in traditional contracts, it is impossible to guarantee that what has been designated and agreed upon will be fulfilled. To increase the degree of security as to enforceability, the parties can turn to these third parties, who charge (expensively) to provide additional guarantees to the business.
This is exactly the problem that smart contracts solve.
With them, self-execution is pre-established, as they are nothing more than pre-programmed computer code so that, once the specified conditions are met, the will of the parties is automatically executed.
Soda and vending machines, like you’d find in any gas station or subway, are a practical and easy-to-understand example of what this self-enforcement is all about.
They’re machines with computers, properly programmed via a programming language, 100% oriented toward executing an action. They receive a banknote or a note or coin according to the value of the product, weight that against the consumer’s choice of product and its specified value, and, when all conditions are met – correct payment for the correct product – they dispense the product.
In this case, there is an agreement of wills – a contract. A certain person decides to buy a Coke for $2 and the machine decides to sell that same Coke for $2. With the contract requirement fulfilled ($2 payment), the machine automatically releases the Coke, right into the buyer’s hands. This happens automatically, without the need for a counter attendant or cashier (middleman). It is a self-executing contract.
This feature is key to understanding smart contracts which, as they are self-executing, can result in the elimination of business intermediaries that add little or nothing to the service provided, thus reducing transaction costs.
Let’s use the same Coke example above…
Imagine if, instead of using a machine, the buyer decided to buy that Coke from a store. Therefore, in addition to the cost of production, the costs of renting the establishment and the salary of store employees would also be reflected in that Coke.
Because of this, chances are the same Coke would cost $2.50 in a store – that’s 25% more. And why would it cost more? Because there are intermediaries associated with this same service – the sale of the Coke – that increase the costs associated with the transaction.
When we think about the traditional financial system, we can envision countless service intermediaries who, just like the store that sells the exact same Coke as the vending machine, add little or nothing to the final product. And yet, they’re remunerated and increase the price of the service.
It is precisely these trusted third parties that smart contracts are intended to end.
And that’s where decentralized finance comes in…
What You Need to Know About DeFi
DeFi refers to an “ecosystem” of financial applications that are built on top of blockchain networks.
More specifically, the term DeFi can be understood as a movement that aims to create an open source, permissionless, and transparent financial services ecosystem, available to all and operating without any central authority.
Users maintain full control over their assets and interact with this ecosystem through decentralized applications (called DApps), in a peer-to-peer (P2P) model.
The explosion of DeFi started in 2020 – what insiders call “DeFi Summer.” In May 2020, the Compound protocol launched… and brought terms like “liquidity programs” and “yield farming” into the lexicon. These new ideas have provided a new way of earning with cryptocurrencies, in addition to just leaving tokens on hold waiting for future valuations.
Projects like AAVE, MakerDAO, Compoud, Synthetix, UniSwap, and others are all poised to disrupt and replace legacy financial systems. These aim to replace exchanges, banks, stablecoins, insurance, investments and several other traditional financial applications.
How DeFi Is Reinventing Finance
The main benefit of DeFi is easy access to financial services, especially for those who are isolated from the current financial system or want to escape its high costs. Nearly 8 million U.S. adults are un-banked or under-banked, frozen out of the system. Worldwide, that number jumps to more than 1.7 billion adults – each one a potential beneficiary of DeFi.
Another potential advantage of DeFi is the modular structure it is built on – interoperable DeFi applications on public blockchains can create entirely new financial markets, products and services.
Let’s take a practical example of how a DeFi application works…
On the Compound platform, we can quickly, securely, and intuitively obtain a cryptocurrency wallet, connect to this protocol and obtain passive income that can provide us with financial returns between 3% and 14% per year, whereas the S&P 500 is down more than 14% this year.
And how is all this possible?
In the case of loans, for example, the smart contract unites those who want to lend money with those seeking to borrow money, providing higher returns than traditional investments and lower interest rates. That’s simple. No intermediaries or bureaucracy.
There’s no doubt how revolutionary this is – and we’re just at the beginning.
DeFi Projects Are Already Creating Solutions
Financial services are being redesigned, one by one, in decentralized blockchain environments, with self-enforceability guaranteed by smart contracts. Among the various market initiatives, there are two solutions that represent DeFi products and services very well:
- Lido Finance: Basically, it is a staking platform that supports to networks like Ethereum, Solana, Kusama, Polygon.On this platform, it is possible to deposit Ether (ETH) and receive a passive yield of around 4% per year, in a process called staking.The difference here, in the case of ETH, is that when we lend our ethers, we receive in exchange another token called stETH which is basically a kind of staking “certificate”. With this, we can move this received token and allocate it on other platforms, thus enhancing our returns.
Currently, the platform has a TVL (Total Value Locked) of approximately $7.6 billion, one of the largest in the ecosystem and DeFi.
- UniSwap: This is a decentralized exchange protocol built on Ethereum.More specifically, Uniswap is an automated liquidity protocol. To make trades, there is neither an order book nor an entity that centralizes orders and trades: Uniswap allows users to make trades without intermediaries and with a high level of decentralization.In addition, the platform also offers the possibility of staking with different cryptoassets, with different returns. The interface is very intuitive and easy to use, leaving behind the idea that dealing with smart contracts is a difficult task.
What’s Next for DeFi
To be sure, we’re still talking about a very new technology; several improvements need to be made, and there are some challenges that need to be overcome. Performance, for one, and the risk of user error needs to be addressed, and improvements in the user experience, to be more intuitive, are still ahead.
Anyway, looking to the future, we see a growing institutional demand and new protocols with the objective of creating disruptive financial services emerging and being tested: there are already protocols that basically function as an insurance company, such as a project called Nexus Mutual, and projects focused on create a credit score and solutions for uncollateralized loans, on blockchain.
We also cannot fail to mention the tools that are being created with the aim of linking DeFi with non-fungible tokens (NFTs), using the latter as collateral, such as the nftfi.com platform.
And finally, another example with a promising future, is the project called dydx, a DeFi platform with an interesting differential: focus on contracts whose value is derived from the performance of the underlying assets, that is, synthetic assets based on cryptocurrencies.
As we have seen, the DeFi ecosystem is rapidly evolving and expanding to recreate the range of traditional financial services in the form of decentralized technologies, proposing cheaper, faster, and more comprehensive alternatives.
In addition, new products, never made available before, promise to revolutionize financial services and put in check the high fees and bureaucracy of traditional companies in the financial market.
In the future, finding loans at very low interest rates and taking out insurance for specific risks or for very short periods of time will be not only possible, but available to everyone. This is because, since they are permissionless, blockchain technologies promise to democratize access to solutions, being incredibly inclusive.
So, make no mistake: although there was already a DeFi summer in 2020, this is a market that is still in its “prehistory,” promising to be the great revolution of financial services in the future.