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DeFi is an ‘internet’ in the making

DeFi, or Decentralized Finance, has all the potential to become a disruptor, the way internet did in a short while ago:

Many experts advise that when you want to understand what DeFi, or Decentralized Finance, is, then it is necessary that you keep aside your knowledge about traditional banking. For, they argue, DeFi is bringing about disruptive changes in the way we handle money. In the first instance, it is making the role of banks and financial services institutions redundant. Then, there is no need for any regulations or regulators in their current definitions. Thirdly and most importantly, it is users who are in control of their money. And the whole ecosystem is claimed to be most secure and transparent. An Utopian fantasy?

Really not. DeFi has come to stay and it is kicking too.

BLOCKCHAIN-BASED

DeFi is very much linked to blockchain, or distributed ledger technology. In fact, it is the basic building block of DeFi in maintaining transaction records. The other aspects are tokens, which constitute digital assets, and smart contracts that facilitate process automation.

DeFi is also linked to cryptocurrency Bitcoin. But, Bitcoin’s disadvantages of wild price fluctuations and very high transaction costs led to the development of stablecoin, which offered the benefits of highly decentralized digital asset. So, stablecoin as digital assets and smart contracts combined led to the development of decentralized applications, or dApps, and decentralized exchanges, or DEXs. DEXs are today highly developed and the basis for DeFi. DeFi platforms can do mass-scale trading in cryptocurrencies without the presence of any central exchanges.

SIGNIFICANT ADVANTAGES

DeFi holds huge advantages in money transactions. For example, the transaction costs are negligible, transactions happen in near real time, there is total transparency and better accessibility for users to the platforms. Yet, there is some lack of trust in the minds of users. For, they consider absence of any regulations or regulators, lack of any known security systems and uncertainty about its future as disadvantages.

The creation of DEXs is a major development not just in DeFi, but for the whole of financial services. They facilitate transparent trading using DLT and smart contracts with users having total control. Smart contracts in fact replace financial institutions in controlling all DEX components. This eliminates intermediaries and offers transparency throughout the trading process.

Another significant related development is the creation of automated market makers, or AMMs, which take over the role of order books in the centralized exchanges. In this system, there are on-chain liquidity pools, which are filled by liquidity providers who lend their cryptocurrency in exchange for a share of the trading fees. The pools become the counterparty to every trade. Users interact directly with the AMM’s smart contract, bypassing the need for order matching

FINANCIAL INCLUSION

The other major component of DeFi is the lending and borrowing process, which is unlike the lending models in the normal financial system. The lending protocols in DeFi system eliminate the barriers and promote financial inclusion because of the open and permissionless access to credit. Anyone with the necessary assets can borrow funds without any regulatory hassles. Most of the underlying systems work without the painful process of identity verification procedures.

Today, there are decentralized lending platforms that connect lenders and borrowers directly so that lenders can earn attractive interest rates on their crypto assets and borrowers can gain access to instant liquidity without any paperwork and very securely and anonymously.

These platforms also offer flash loans without any collateral. These loans are intended for operations that bring in quick profits like arbitrage trading and debt refinancing.

STABLECOINS ARE KEY

In the world of DeFi, stablecoins are key. They are tokens designed to maintain a fixed value. They are tied to a currency or a commodity in order to reduce the impact of market volatility. Users can thus protect their capital during periods of uncertainty. They also afford locking in profits by converting volatile cryptocurrencies into a more stable asset.

There are fiat-collateralized stablecoins, backed by fiat currency reserves held by the issuing entity. For example, Tether, which is one of the most widely used stablecoins, is said to hold one US dollar in reserve for every Tether token issued.

Then, there are crypto-collateralized stablecoins, which use other cryptocurrencies as collateral. However, the volatility of the underlying crypto assets is a risk.

In DeFi, users can independently verify the collateralization ratio, the value of the locked assets and the mechanisms governing the stability.

DeFi has payment gateways, which use DLT to allow businesses to accept cryptocurrency payments directly, bypassing intermediaries and avoiding the costs thus incurred. Smart contracts automate the payment process and ensure faster transaction speeds, reduced fees and increased transparency. These payment gateways can integrate with different blockchain networks, promoting interoperability and expanding the reach.

CHALLENGE TO BANKS

How is DeFi impacting the traditional banking system?

As discussed earlier, using smart contracts, DeFi platforms allow peer-to-peer transactions with no intermediaries like banks in the core functions like lending, borrowing and payments processes. DeFi platforms are known to offer higher interest rates on deposits and charge lower fees on loans. There are instances of banks introducing DeFi systems in their core systems by using DLT. This leads to improvement in efficiency, transparency and security of transactions. Some banks have even introduced specialized DeFi-enabled products and services.

DeFi proponents claim that DeFi platforms have the capability to ‘democratize’ access to financial services – by reducing fee and transaction costs, and by increasing efficiency. Even financial products and services can be tailor-made to the specific needs of the users. Use of DLT also virtually eliminates the chances of cyberattacks and frauds.

NO REGULATIONS NOW

At present, there is no known regulatory framework designed specifically for DeFi. However, in view of the popularity of the system and the large scale adoption by non-traditional players, governments are keen on evolving standards. For example, the European Union is known to be working on what is called ‘Markets in Crypto-Assets Regulation’, or MiCA, meant to regulate crypto assets, including those used in DeFi. Governments are also hugely worried over cybersecurity issues that concern DeFi as the core of DeFi is smart contracts and any breach in its code can be exploited by hackers.

Whether it is sans regulators or intermediaries, there are significant disadvantages in the absence of any centralized supervision. Frauds and scams are easy to be perpetrated; unscrupulous players can make use of the anonymity and decentralized structure of the system to fool the users and decamp with the cash.

Many keen followers of DeFi compare it to the internet. Like how internet disrupted the traditional media by giving everyone access to information that was once the privilege of a few big corporations, DeFi is today allowing people to lend, borrow, trade and invest directly without an intermediary and shattering the entry barriers and creating opportunities for the previously excluded lot. There are platforms like Aave, which has created non-custodial liquidity markets so that users can earn interest on supplying and borrowing assets with a variable interest rate. Likewise, there is Uniswap, which uses a protocol to enable users to provide liquidity and trade digital assets. UNI is the cryptocurrency that the platform uses and anyone can earn UNI by agreeing not to sell or trade their crypto holdings. These platforms are known to handle billions of dollars in transactions without involving a bank.

MAJOR CONVENIENCES

DeFi enables near-instant fund transfers that cost a fraction of the price that customers now pay. There are protocols like Stellar or XRP of Ripple that allow remittances without correspondent banks and at a nominal cost. Since DeFi platforms are built on DLT, all transactions are open and visible to anyone who wishes to verify them. Users get insight into how funds are managed, how pools of liquidity are created, and how contracts are executed.

There are no geographical limitations, credit checks or minimum balances requirements. All that is required is an internet connection.

Yet, DeFi cannot be seen as a replacement for the traditional banking system. At best, it can complement it. As mentioned earlier, some financial institutions are already partnering with DeFi platforms to offer decentralized financial services. Decentralized protocols in lending can be used by banks to extend DeFi loans under more strictly regulated frameworks, providing customers with the security of traditional banking and the flexibility of DeFi.

INDIAN CONTEXT

There apparently is no clarity on the adoption of DeFi in India. While the country does not ban cryptocurrencies and blockchain technology, the policy is vague as far as DeFi is concerned. There is no specific legislation or regulatory framework governing the use and trading of cryptocurrencies though the Cryptocurrency and Regulation of Official Digital Currency Bill was introduced in Parliament in 2021 to create a regulatory framework for cryptocurrencies.

The Reserve Bank of India has its own concerns over cryptocurrencies and it has often taken strong stand against unregulated digital assets. It has also highlighted the high volatility of crypto assets.

Nevertheless, the large unbanked population in the country and the need for greater financial inclusion, make DeFi an attractive option for India.


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