Decentralised Finance, or DeFi, is an open source financial system that adopts traditional financial instruments in a peer-to-peer network that limits bureaucracy and centralised authorities.
For example, one can buy, lend, borrow, invest, and spend bitcoin and many other such digital assets within the DeFi world without any centralised point of control. The ecosystem is still nascent but its open source nature creates a world of opportunities.
How is it different from FinTech?
FinTech is primarily about digitalising traditional financial instruments or products. For example, Policybazar, Razorpay, Digi Bank, etc. are examples of FinTech firms in India. These are all progressive and important advancements of the traditional financial system. However, they still have the sacred tenets of traditional finance -- centralised decision making and vulnerable to central bank and government policies.
Today, FinTech is more appealing and wider reaching than DeFi, as most of the financial world still follows the traditional format. However, the research and development in DeFi is gathering pace and we as a country will be left behind if we don't pay attention. DeFi could be to finance what internet was to communication, and remember -- Internet is also open source and decentralised.
What are the advantages of DeFi?
DeFi has multiple advantages and it is fair to assume that the ecosystem has not harnessed even a fraction of these advantages yet.
- Owner of the assets is the sole custodian of the assets
- DeFi is open source, so build whatever you want within finance, secured with cryptography
- Lend, borrow and invest into new types of assets, with less dependency on macro events and country policies, and more on software and decentralised applications.
What are the disadvantages of DeFi?
It would be amiss to not point out the current pitfalls of DeFi, although as you will notice, these are not fundamental in nature, and could rectify themselves with more research and development.
- As you are your own custodian, you cannot claim against any losses from a centralised authority
- There is no insurance against bugs in smart contracts
- Volatility in these assets (not applicable to stable coins) is much higher than traditional assets and therefore your capital is at a higher risk (hence higher returns)
Examples of DeFi
DeFi applications are primarily built on the Ethereum network, owing to its popularity, and familiarity and ease developers have with smart contracts. I have only noted a few prominent examples below (check out https://defipulse.com/defi-list/ for an elaborate list):
Maker DAO: Probably the most prominent advert of the DeFi universe. Maker is a mini-ecosystem that includes a decentralised stable coin (DAI), collateralised debt positions (CDP), and community governance (MKR).
While most of the prominent stable coins in the digital assets space are backed by fiat, they are therefore centralised (Tether, True USD, USDC etc). DAI is a crypto-backed stable coin that endeavours to maintain a stable value in a decentralised environment.
Compound Finance: Allows users to borrow or lend Ethereum-based assets, and earn interest, without relying on any counterparty. Interest rates are set real time based on supply and demand. Higher the demand for the asset, higher the interest (over 10 percent in certain cases).
If one owns digital assets then instead of keeping them on an exchange or within a wallet, they can now also earn interest on such assets. So, nothing different to what most of us do with idle cash.
Augur: Allows users to create markets on the outcome of any real-world event. It is a free, open source software, and the Augur protocol is a set of Solidity smart contracts that exist on the Ethereum blockchain.
Using Augur, one can participate economically in the outcome of events, in digital assets.
Lightning Network: A Layer 2 protocol on top of Bitcoin that seeks to improve scalability by moving small and frequent transactions off-chain, allowing for fast peer-to-peer transactions and low fees.
A critical step towards utilisation of bitcoin in small everyday transactions, without relying entirely on the blockchain. Operational evolution.
Final word
The DeFi movement should not be mistaken as a machiavellian scheme that is plotting against the incumbency. Instead one should think of the DeFi movement as an honest attempt at creating a potentially more open, inclusive, and advanced financial system. I do sincerely hope that India doesn't brush this under the carpet and we strongly encourage research and development in this nascent area.
Prashanth Swaminathan is an alumnus from IIT Guwahati and IIM Calcutta, who spent 10 years in investment banking at Morgan Stanley London before setting up an EU cryptocurrency exchange, XDAT.
Read his columns here.
First Published: Sept 13, 2019 3:04 PM IST
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