How does DeFi solve for this?
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As global financial markets evolve to streamline the adoption of new financial products, it is critical to reflect on how the dynamic landscape positions itself to explore diversified markets. The role of Decentralized Finance (DeFi) in the next stage of the evolution of financial instruments will be critical.
Traditionally, lending and borrowing are facilitated by the involvement of a third-person intermediary, but in the DeFi industry, transactions are governed by one’s own. Building on the advantages of blockchain technology, DeFi has revolutionized an era of lending and borrowing. It has simplified fund transfers, therefore, creating transparency, a key feature missing in traditional banking.
Addressing many of the shortcomings of the current financial system, DeFi challenges the old order by offering new possibilities:
Globally available and transparent - all you need to participate is an internet connection, a device, and a cryptocurrency wallet.
Decentralized - Removes the need for reliance on central banks and governments.
Accessible - Allows increased access to financial services to those currently excluded from the financial system, due to physical location or resources.
Trustless - Does not rely on third-person intermediaries, such as banks and arbitrators, since users interact on P2P networks.
Automated - No company or employees manage it. DeFi runs based on smart contracts deployed on the blockchain. Designed to be self-executing, they require minimal to no human intervention.
Interoperable - DApps are interoperable with other DApps, much like connecting Lego blocks or entire Lego sets that are interoperable with each other.
DeFi has exploded in popularity during the COVID-19 crisis. Loans on such platforms have risen more than seven-fold since March 2020 to $3.7 billion, according to DeFi Pulse. Investors are hunting returns at a time when central banks across the world have slashed interest rates to prop up economies battered by the pandemic. Some jurisdictions, such as the Eurozone, are now in negative interest rates territory. Others, such as the US and the UK, could follow.
In this climate, DeFi offers the potential for much higher returns to savers than Wall Street institutions. Compound, for example, has been offering an annualized interest rate of 6.75% for those who save with stablecoins such as USDT and USDC. Not only does a user gain interest in this example, but they also receive governance tokens. With two thirds of people who do not have a bank account but are in possession of a smartphone, DeFi also has the potential to open up finance to this unclaimed market.
2020 witnessed the DeFi landscape crossing a total value threshold of USD 13.5 billion spread across various DeFi protocols – yet this represents only a fraction of the total potential. Certainly, with the continued momentum, the DeFi ecosystem promises a sustained growth of over USD 100 billion over the course of next few years. As current DeFi applications have barely scratched the surface of what is possible, it is estimated that the next engine of growth will be to pick drive mass adoption. The ultimate goal lies in banking the unbanked 1.75 billion people globally to resolve prevailing issues of the traditional financial landscape.
The same is expected to be achieved by constituting attributes, such as a more user-centric approach, cost-effectiveness, financial inclusion, seamless transaction mechanisms, and financial awareness. Currently, the DeFi industry is in its beginning stages; thus, there is a lack of intuitive infrastructure for novice users to engage in the ecosystem actively. This can create a navigation challenge for potential users. Its prerequisites constitute a steep learning curve and a proper command over technology, which contrasts with traditional financial systems.
“High volatility and information asymmetry are a few of exceptional challenges that lead to lower adoption of DeFi among novice users, with millions of potential users waiting on the sidelines for better infrastructure. The DeFi ecosystem needs to be made more accessible.”
The vast majority of countries’ laws and regulations envision centralized businesses or structures with a singular seat of control and responsibility. Deviating from this arrangement poses a challenge from a legal and regulatory perspective and raises enforcement issues. This is particularly true when it comes to regulated sectors like financial services. In this sector, there has traditionally been some form of central counterparty, often regulated. Within a particular system or process, that central party is accountable. It takes responsibility for providing services to all the other participants through a contractual framework underpinned by the legal and regulatory structure. An example of this is the role of a central bank or other institution in clearing and settlement processes.
However, in many blockchain uses, such as DeFi, no such centralized party takes responsibility for providing services or controls the associated data sets. This, therefore, presents jurisdictional issues and challenges in the following ways:
Cross-border transactions involving participants in different sectors at different geographic locations is not unique to new decentralized technologies. Still, legal and compliance risks could arise around the question of which laws and jurisdictional authority apply to a given set of transactions.
Enforceability of digitally signed contracts - This may vary across jurisdictions, as might the available tools to resolve disputes. Consensus on the designated location may be more difficult to reach if the network scales up quickly. The novelty and subsequent unclear legal value of smart contracts in many jurisdictions may lead to disputes. This is especially true in P2P lending in a DeFi system, where the location of parties is unclear. Thus, the regulatory frameworks applying to P2P platforms can vary by jurisdiction.
Our leadership team’s vast experience foresees that there would be teething issues of traditional finance which might extend to the decentralized ecosystem and due to the anonymity of users it can become challenging to pursue the defaulters.
In consideration of future concerns, there would be a mix of centralized and DeFi aspects in specific products to ensure that the platform is able to withstand anomalies and grow with stability. Hence non collateralized loans may have some form of KYC to minimize the risk for the investor.
Most DeFi applications to-date are representations of existing financial instruments or systems built using smart contracts. Smart contracts are encoded in hardware and software that bind parties to enforce automatically the terms of the agreement. DeFi actually places the technology in the position of the typical counterparty and decentralizes the power to control and modify those technology systems.
The decentralization of financial services can vary in the degree to which it affects different segments of financial services, but generally takes three broad forms:
Decision-making: This means veering away from a single trusted financial intermediary or infrastructure toward systems in which a broad set of users is able to make decisions about whether and how to undertake financial transactions.
Risk-taking: This represents a shift away from the retention of risk (e.g., credit and liquidity risk) on the balance sheets of individual traditional financial intermediaries toward more direct matching of individual users and providers of financial services.
Record keeping: This involves a move away from centrally held data and records toward systems in which the ability to store and access data extends across broader consortia of users. Verification of such data and records may also be more distributed, for example via consensus mechanisms.
Regulators are lagging behind, and DeFi has been able to flourish in this vacuum. For instance, in traditional unsecured lending, there is a legal requirement that lenders and borrowers know each other’s identities and that the lender assesses the borrower’s ability to repay the debt. In DeFi, there are no such requirements. Instead, everything is about mutual trust and preserving privacy.
Regulators must weigh the delicate balance between stifling innovation and failing to protect society from such risks, as individuals put their money into an unregulated space, or as banks and other financial institutions potentially become unable to make a living as intermediaries.
In summary, individuals or entities looking to establish a disruptive new DeFi application often find they do not fit within any existing regulatory frameworks.
