Why You Need To Care About Decentralized Finance (DeFi)

Cryptocurrency seems to be the talk of everyone these days. However, it is hard to generalize the technology and its potential. On one side you have Bitcoin, the original cryptocurrency that first gained attention with a white paper in 2008. Since then, Bitcoin has grown rapidly as a digital store of value surpassing $1 trillion in market cap and forcing banks, traditional financial institutions and even crypto-skeptics to take it seriously.

On the other side of the spectrum stand smart contracts and Decentralized Finance (DeFi). Still in early stages of their development and years behind mass market adoption and acceptance of Bitcoin, both smart contracts and DeFi have the potential to be even more valuable given their many use cases and potential to digitize, democratize and transform global finance.

But why should you care about DeFi, even if you never intend to care about or own Bitcoin? Because it may change the future of financial services.

Think of how financial products are sold and serviced today: When you go to a bank or lender, you conform to their rules and rates, often with limited transparency. These financial institutions control the gates, and we are forced to trust them and their policies. This trust is easy (and important) to have in some countries but not as obvious in others with high rates of inflation, corruption and monopolistic banking infrastructure. In these markets, people often do not have access to a safe and stable place to deposit their assets, borrow money or even make long term investments.

Enter DeFi, which essentially enables financial services to operate in a fully open, borderless, widely accessible, and transparent digital form – as digital smart contracts hosted on a blockchain that is transparent and secure under a clear set of rules.

The power of such an open, distributed system is often underestimated. However, its potential has proven out in other use cases. Think before the internet or Wikipedia when researching a topic required a trip to the library or a 32-volume set of the Encyclopedia Britannica. Expensive and inaccessible tools that could become quickly outdated.

Today, Wikipedia is visited more than 3 billion times each month and is not only free but has more detailed and real-time information than a library. It is accessible to anyone in the world with internet access. Lastly, it is almost guaranteed to be accurate because, if false information goes up, the community, run by a mechanism of full transparency and consensus, quickly reviews and corrects it.

This is the same basic concept as a blockchain. Wikipedia is a simple example, but digitizing information has led to massive distribution of knowledge and collective intelligence that is much more powerful than any one centralized organization. DeFi protocols are creating this same open ecosystem for financial services by fully digitizing assets of value and decentralizing and automating interaction between these assets.

DeFi is more than just a concept. We are still in early innings, but there are hundreds of protocols in operation with real value locked up that cannot be ignored. In aggregate, DeFi has reached a combined market cap of $148 billion, and these protocols have held more than $90 billion in locked up assets this year in smart contracts. Up from just $18 billion at the beginning of this year. There is real traction and value held in these platforms, beyond hyped up market caps that you may see in other crypto currencies, like Dogecoin. At this scale, DeFi is much more than a passing fad.

The use cases are also very real. Today, there are working protocols that allow you to send money globally, transfer currencies, earn yield on deposits, borrow or lend, all in a decentralized manner.

The backbone of DeFi is a stable coin, essentially a tokenized digital dollar that holds the exact value as its underlying fiat (a United States dollar for example) – giving users the benefits of digital currency without the price volatility. Today, the largest stable coins are Tether (USDT), USD Coin (USDC) and white label stable coins for large exchanges like Binance Coin (BUSD) or Huobi Coin (HUSD), which are both administered by Paxos, a portfolio company of Oak HC/FT. In the future, any financial services, fintech or payments company could offer their own branded fiat backed stable coin to their customers for customized use cases.

These stable coins can be minted or redeemed for their underlying asset at any point. More importantly, they provide a digital representation of a dollar for easy transferability. They are powerful for many cross-border payments use cases. Although, the United States dollar bill is largely in digital form today, it is still controlled by the Federal Reserve and the corresponding banking network, restricting ease of access and transferability to users globally. For example, if you were to send $1 to another country today, multiple corresponding banks would have to transfer that dollar and verify the sender and receiver at every step of the process, which takes up to three days to complete and limits accessibility. With a stable coin, the value of the $1 can be transferred and held anywhere in the world, while the physical $1 stays in a single custodial bank account as backing.

Mass market adoption is already happening in many countries and regions, with Southeast Asia serving as a great example. Tether, a USD stable coin is used in every day P2P payments, remittances and even accepted at 7-Eleven. It has replaced local currency in many use cases. Many global payment and remittance platforms have discussed using stable coins to improve global money movement.

You can also go to a DeFi lending protocol like Compound or Aave, and, at times, earn up to 8% on a USD backed stable coin. The same USD would earn you 50bps in a high yield bank savings account. You can also take out a loan in USD without having to be onboarded and approved by a bank.

Decentralized lending and cross-border payments are just the beginning, but DeFi’s strongest potential is to democratize access to finance in emerging markets, taking down the gates traditional centralized financial institutions have erected. DeFi also promises to let anyone with internet connection globally gain access to any global currency, earn yield on deposits or get access to loans instantly. In some emerging markets, even gaining access to a stable USD-backed currency is revolutionary. Eventually DeFi will create a digital exchange ecosystem where money and value are transferred just as information and data are transferred today, seamlessly in the background from point to point, where use cases are not limited by infrastructure functionality.

There is still a long way to go, particularly in improving the UI and regulatory frameworks. But don’t be surprised if, within the next five years, DeFi is something we may all interact with every day.