Decentralized Finance (DeFi) and the Future of Banking

Most consumers have heard about the rapid rise of cryptocurrency over the past decade or so.  It has intrigued investors by being decentralized and transparent, using blockchain technology.  In this digital realm, blocks of data are added to a chain, which is viewable by all users and significantly reduces the ability of anyone to hack or tamper with the data.  Any attempts to edit data in a blockchain can be witnessed by all viewers.  This technology has been around since 2009, after being described a year earlier in a paper by Satoshi Nakamoto (a pseudonym).  

The emergence of blockchain, which makes cryptocurrency possible, has also allowed for decentralized finance (DeFi).  Distributed ledger technologies (DLT) make it possible for individuals to trade, lend, and invest directly with other users rather than going through a centralized institution, such as a bank.  As with cryptocurrency transactions, financial transactions as part of DeFi would be viewable by all members of the blockchain, reducing the risk of hacking or tampering.

How Does DeFi Work?

Decentralized finance uses an algorithm to make loans and trades from money (cryptocurrencies) pooled by other users of the blockchain.  Those who own cryptocurrency coins, or tokens, can choose to lend them out for interest, thus making them available for DeFi transactions.  Those with crypto to lend place those assets into a pool that is governed by a lending protocol, or program, while those who wish to borrow must do so under the rules of that protocol.  Contributors to the lending pool receive a portion of the interest paid back by the borrowers, similar to depositors at a bank receiving interest from their savings.

Why Use DeFi?

Lenders

A major benefit to lenders is the overcollateralization of loans.  To borrow through DeFi, borrowers must put a greater amount than they intend to borrow into collateral, or assets to be forfeited (given to the lender) in the event that the loan cannot be paid as promised.  This overcollateralization essentially reduces the lender’s risk to zero.  If the borrower defaults (cannot pay) on the loan, the lender receives back his or her loaned amount via the collateral.

Additionally, the lender can receive more interest through DeFi than through a bank.  Depositors into a bank receive only a small fraction of the interest generated by loans made from their deposits; the bank takes most of the interest as revenue.  This arrangement is typically accepted because depositors are fully protected from loss, including through government deposit insurance.  Lending pools, however, typically provide more return on one’s deposits and can be easily accessed via smartphone app.

Borrowers

Borrowers can receive funds, in the form of cryptocurrency, automatically once they provide the necessary collateral.  Although the collateral requirement is high, borrowers do not have to go through the tedious process of being approved for a bank loan.  This can advantage younger borrowers who have not yet built up a high credit score.  It can also benefit those who have traditionally struggled to borrow from banks due to perceived high risk, such as start-up firms.  Basically, those willing and able to put up digital collateral can borrow up to that amount, regardless of their financial history or perceived risk status.  

DeFi funds are available almost instantaneously due to lending pools’ automated processes, while banks often have various holds that can take days to process.  This can make bank loans disadvantageous for entrepreneurs and investors who need to seize opportunities quickly.  Things move swiftly in the digital world, making the ability to receive near-instant loans invaluable.

Economic Advantages of DeFi

Efficiency is the name of the game in terms of decentralized finance’s economic benefit, and is achieved through automation.  Lenders put up the amount they are willing to lend, borrowers put up the collateral they are willing to stake, and loans are made automatically according to pre-established lending pool protocol.  The lack of need for financial intermediaries like banks allows for greater efficiency as well, with profit going directly to the lender and likely facilitating more future lending.

The ability of any crypto owner to become a DeFi lender increases efficiency through competition, as the greater number of lenders drives down interest rates.  Conversely, the banking industry has consolidated in recent decades, meaning there are fewer banks competing for borrowers.  This increases the likelihood that the remaining banks can raise interest rates, as prospective borrowers have fewer substitutes from which to choose.  

Economic Risks of DeFi

A key benefit of decentralized finance is also a key weakness: lack of centralized oversight.  The decentralized nature means more people can participate in the market, but also means bad actors like fraudsters and hackers have easier access as well.  Although blockchain is public, hackers can still exploit lending pool protocols or other software that moves crypto between digital wallets.  Typically, hackers change the destination of the money so that it routes into their own account instead of that of the genuine borrower.  

When problems do arise, the anonymous nature of crypto and blockchain use make it extremely difficult for authorities to pursue justice.  By the time theft is discovered, the hackers have likely moved the funds several times, often into jurisdictions not accessible to law enforcement.  And, due to the decentralized nature of DeFi, there is no central institution to which law enforcement can ask questions.  Unlike a bank hack, there is no reimbursement protocol for depositors, nor is there government insurance. If this lack of government regulation leads to a mass rejection of decentralized finance lending due to wary crypto holders, it could depress economic growth.

Should You Engage in DeFi?

Deciding to engage in decentralized finance depends on your level of risk tolerance.  

As a Borrower

Borrowers should compare the interest rate they would have to pay to a DeFi lending pool with that of a loan from a bank.  If the interest rate of DeFi is lower, are there other risks with the lending protocol, such as liquidation (sale) of your collateral without a chance to seek an extension?  Borrowers should understand all aspects of the protocol before taking out the loan, as the automated nature of the market means little or no opportunity to seek changes due to unexpected circumstances.

As a Lender

Similarly, the lack of a centralized authority and government regulation can affect lenders as well.  Many scams exist, with prospective lenders duped into placing their crypto into a fake lending pool or new cryptocurrency that is then stolen by the scammer.  This rug pull scam is a new twist on an old con: take the money and run.  By contrast, depositing with a brick-and-mortar local bank, one that has government deposit insurance, is zero risk of loss.  However, profits of depositing excess funds with a brick-and-mortar bank are very low, making it an unpopular investment.  

Anyone with excess funds that can be invested should do research on the investment opportunities in front of them: stocks, bonds, cryptocurrency, commodities like precious metals, real estate, or luxury goods.  Is the seller reputable?  What is the historic rate of return on that particular investment over the last ___ years?  Is there a regulatory authority to which disputes can be taken?  How liquid is the investment in the event that cash needs to be taken out?  And, finally, does the investment seem too good to be true?  Any investment opportunity that promises great profit with zero risk is likely hiding at least one key piece of information.