DeFi as a solution for a trustworthy financial system?

Every response stimulates a backlash. This is also true in finance: In the wake of the global financial crisis beginning in 2007, central banks established controversial stimulus measures that fuelled the distrust of many market participants in the powerful institutions. There was a growing awareness of the dependence on a few, few decision makers (central banks) who manage the global financial ecosystem.

With the launch of Bitcoin in 2009, there was a countermovement: away from centralization towards decentralized finance (DeFi). Experts believe that mistrust in centralized financial structures is the catalyst that will continue to drive DeFi growth and establish competitive models for traditional banking.

Blockchain financial products — liquid cash flow via smart contract

The term DeFi generally includes all financial transactions and services that are not subject to the management or control of a central actor (e.g. a bank or stock exchange) as in the traditional financial sector. In DeFi applications, these tasks are usually performed by a blockchain protocol. Smart contracts, for example, are used to store the payout conditions of a transaction, which is then automatically executed without the intervention of third parties and without the possibility of manipulation as soon as the agreed requirements are met. In this way, no actor has sole control over transactions, preventing censorship and centralization.

In the decentralized financial system, classic financial products are presented via applications, so-called apps. This includes trading in securities, digital investments in tangible assets or granting and using loans. An example: In the traditional financial world, banks only grant and quantify loans to customers who meet certain requirements. In a DeFi network, on the other hand, anyone can receive a loan that is regulated by a smart contract.

Many of the platforms specializing in crypto loans offer interested parties the opportunity to borrow money in the form of cryptocurrencies or lend it to other network users. A pre-defined sum of stored tokens is usually used as security. Most platforms automatically assign lenders and borrowers to each other, defining interest rates based on supply and demand.

DeFi is booming — investments, loans and insurance

The DeFi market capitalization has, according to the calculations of DeFi Pulse recently reached a new all-time high. On February 21, 2021, the TVL index (“total value locked”) — or the total market capitalization of the DeFi ecosystem — climbed to a peak of 44 billion dollars. By way of comparison, TVL was trading at just 15 billion dollars on January 1, 2021 — an increase of 166% within just over seven weeks.

The current DeFi boom is primarily due to two developments: On the one hand, cryptocurrency speculators are driving up the price and market volume of Ethereum & Co. On the other hand, there are more and more solutions that attract both private and institutional users to the scene.

The majority of DeFi solutions/applications can basically be divided into the following three clusters Subdivide:

• Lending

On DeFi lending platforms, users can borrow or grant loans in the form of cryptocurrencies directly and without a supervisory authority. Decentralized lending protocols offer low entry barriers, a high level of flexibility, prompt processing and — also fuelled by mistrust of (central) banks — are growing in popularity.

• Monetary banking services

This includes the issuance of insurance, mortgages or so-called stablecoins, which are linked, for example, to the value of a fiat currency or an equivalent value that is as price-stable as possible. Similar to Bitcoin, they offer the advantage of simple, digital transferability and could be used as a type of cash in the future.

Furthermore, blockchain-based insurance and mortgages would eliminate the need for (costly) intermediaries or notaries. This could result in lower premiums with the same quality of service and faster processing.

• Tokenised asset trading

Blockchain also offers the option of representing assets such as securities, real estate or other tangible assets as a tokenized asset. In this way, investors can own digital shares in one or more assets for as little as a few hundred euros and thus compile and manage a transparent, differentiated and self-defined portfolio of tangible assets.

Competition and opportunity for traditional banks

In the conventional financial sector in Germany, according to the PwC study “Blockchain in Financial Services 2020" There is already a “positive sentiment” regarding the potential of blockchain: 75% of the surveyed decision makers from banks, insurance companies and asset management companies regard blockchain technology as relevant. However, the blockchain activities of their own companies have so far been limited. Only 22% of study participants have already dealt specifically with blockchain technologies.

The study, on the other hand, confirms “the consistency of traditional use cases” of blockchains. In the long term, German financial service providers will therefore primarily rely on applications in the areas of information security (60%), auditing and data integrity (42%) and peer-to-peer payment systems (31%). On the other hand, lack of budgets, an “unease of digital disruption” and uncertainty regarding regulatory requirements were mentioned as “showstoppers.”

According to the study, many of the current blockchain technology applications are primarily aimed at increasing efficiency. However, analysts see the real potential in developing new business models. They therefore advise financial service providers to explore “cooperative business models” with DeFi providers, which offer several advantages. For example:

• Complete transparency: tracking, monitoring and analysis of all aspects of a transaction
• Automatic compliance: software-controlled, tamper-proof compliance with regulatory requirements
• Easy data collection and analysis
• Cost optimization
• Compliance with legal and tax frameworks in finance, insurance and banking

DeFi is defining the future

By using blockchain technology, DeFi business models can be faster, more cost-effective, more customer-centric, and more agile than traditional financial services. As a result, a DeFi economy has the potential to be disruptive and to transform existing systems in a meaningful way — irreplaceable. 
Financial and financial institutions should seize this opportunity and integrate DeFi applications into their own systems and products in order to offer customers a catalog of future-oriented services via specialized online platforms.