What is DeFi and will it bring greater financial inclusion?
Decentralized finance or “DeFi” is an emerging technological innovation in the world of blockchain and cryptocurrency. It seeks to make basic financial products and services such as loans, savings accounts, and investments more accessible to the public.
What is DeFi?
There are many problems surrounding modern financial systems, especially in developing countries where such services may not be readily accessible. In the Philippines for instance, where 48% percent of the adult population remains unbanked, problems such as lack of documentary requirements, inaccessible locations of services, and lack of stable employment makes financial services difficult and intimidating for the average citizen.
In order to take out a loan for example, people often have to provide proof of a solid credit score or their ability to make payments in a timely manner. Some people are required to provide collateral that they might not have. These kinds of stringent requirements make it difficult for a lot of people to even consider availing basic financial services.
On the other hand, the increasing internet connectivity in the country presents new opportunities to overcome these hurdles. With over 75.3% of the country’s population with access to a smartphone, digital financial services–especially blockchain-based solutions like decentralized finance (DeFi)–can make financial opportunities available even for the unbanked.
DeFi is an umbrella term that covers a variety of financial services that operate on blockchain networks, and which makes it possible for people to access various financial services such as earning interest, lending, buying, trading, investing, and more–all without an intermediary third party like a bank.
In short, DeFi makes it possible for anyone with an internet connection to directly manage one’s finances and participate in investing opportunities directly on peer-to-peer (P2P) platforms. Whereas traditional banking will require you to avail of the services of a private entity in order for you to access financial products, DeFi is essentially empowering you to “become your own bank” by giving unlimited access to these financial products, thanks to the inclusivity provided by the blockchain.
How does DeFi work and what are the benefits?
DeFi essentially mirrors many of our traditional financial services but lets blockchain algorithms take care of the processes rather than running them by an intermediary or third party.
For example, in traditional banking, a customer can deposit money to a commercial bank into a savings account, and in return is entitled to certain interest rates because the bank also uses that money to fund other investment projects from which it will also earn revenue from.
But in DeFi, you can directly invest your digital assets to support a project of your choice, and also earn interest on your deposits–only this time you are letting algorithms automatically execute all the aspects of the agreement via tools called “smart contracts”.
And since there is no intermediary between you and the project you are investing on, there are a number of benefits one can expect from this arrangement:
Higher yields – Without a third party service, revenue earned from investments is directly channeled to the depositor, which results in higher yield since there is no institutional upkeep. Generally, DeFi yields are significantly higher than the 0.10% to 0.25% annual interest rate offered by most banks.
More convenience – Participating in DeFi protocols is not as tedious as opening an account with a commercial bank. Banks often require a lot of documents and background checks whereas the only requirement for DeFi is setting up a crypto wallet.
Transactions are faster – Smart contracts on DeFi platforms automatically execute once their parameters are met, eliminating the need for people to visit physical locations or to line up in queues for processing transactions.
Transactions are more private and discreet – Instead of dealing with tellers, fund managers, or agents, all parties in a DeFi transaction only have to rely on smart contracts without needing to divulge any personal or private information to each other.
Blockchain security – Since DeFi runs on a blockchain, users can count on the decentralized architecture of the network to guarantee that databases are practically immune to being hacked or tampered with.
As such, DeFi can be seen as a game-changer for the average Filipino, who normally would not have immediate access to many of these financial services that DeFi can make available simply through one’s smartphone screen.
What DeFi instruments are there?
There are plenty of cryptocurrencies and decentralized applications (dApps) that make many traditional financial instrument (as well as newer ones) already available to blockchain users:
Lending and borrowing - Platforms such as Compound (COMP) and Aave (AAVE) allow users to lend their cryptocurrencies to earn interest rates from other users who in turn, need to take out loans.
Trading - Users can trade digital assets on centralized and decentralized exchanges even with minimal amounts. PDAX for example, allows its users to trade cryptocurrencies for as low PHP 200.
Liquidity pools - Platforms such as Uniswap (UNI) and Sushi (SUSHI) allow their users to deposit their cryptocurrency holdings to provide their platform with liquidity, earning passive income in return from the transaction fees paid for by other users.
Staking - Many platforms and crypto wallets provide users the option to stake their crypto to support up-and-coming projects or to directly support the network nodes that run and secure Proof-of-Stake (PoS) blockchains like Solana (SOL) or Cardano (ADA).
Yield farming - Yield farming refers to a broad range of financial instruments which are usually leveraged or “stacked” on top of one another to maximize profits. For advanced and experienced investors, this may involve using tokens earned or borrowed from one instrument or platform and re-depositing them into another instrument. Sushi, for example, allows its reward tokens such as SUSHI or Sushi SLP (Sushi Liquidity Provider) to be re-staked into other instruments on their platform.
All in all, what DeFi has achieved is to come up with an online system of ‘trust’ between multiple entities, allowing them to engage in transactions with one another anonymously, even without the need to provide traditional documents to establish one’s identity or to have a third party vouch for you.
And it's not only average people who are paying attention to this new technology, but even mainstream financial institutions are seeing the benefit of incorporating blockchain solutions to their own existing systems. Traditional assets such as mutual funds, hedge funds and equities are being rethinked for integration with the blockchain, to make them faster, more efficient and more accessible as well.
And with the blockchain able to operate seamlessly across national borders and industries, the economical impact of this innovation is only just beginning to dawn on everyone. And the more cryptocurrency is adopted across the world, and the more people are connected to faster and better internet services, the sooner will the future guarantee for DeFi to level the playing field and change the financial world as we know it.
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DISCLAIMER: The statements in this article do not constitute financial advice. PDAX does not guarantee the technical and financial integrity of the digital asset and its ecosystem. Any and all trading involving the digital asset is subject to the user’s risk and discretion and must be done after adequate and in-depth research and analysis.
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