The Banking Executive Magazine - May 2022 Issue

Will DEFI Take Over Banks? DEFI HISTORICAL EVOLUTION Cryptocurrencies witnessed a history of innovation that goes back to the 1980s, with advancements in cryp- tography. A series of events have shaped the crypto space. The first cryptocurrency, Bitcoin, was the most prominent. Despite its spectac- ular growth in the past 12 years, mainstream institutions did not ac- cept a Bitcoin loan because of its sig- nificant price volatility. This makes Bitcoin a poor asset to plan any in- vestment accurately. Things changed quickly in the crypto space, and de- centralized finance (DEFI) is the emerging current trend. Historically, central authorities have issued currencies that underpin economies and gave them more power as more people began to trust them. However, trust has been bro- ken from time to time, which ques- tioned the centralized authorities' ability to manage money. DEFI was developed based on the idea of cre- ating a financial system that is open to everyone and minimizes the need to trust and rely on a central author- ity. The launch of Ethereum and, more specifically, smart contracts, in 2015 made DEFI possible. The Ethereum network is a second generation blockchain that encouraged busi- nesses and enterprises to build and deploy projects that formed the ecosystem of DEFI. DEFI brought a plethora of opportu- nities to bring about a transparent and robust financial system that no single entity controls. The turning point for financial applications started in 2017, with projects facili- tating more functionalities in addi- tion to money transfer. Financial markets can enable great ideas and drive the prosperity of so- ciety. However, power in these mar- kets is centralized. When people invest in the current financial system, they relinquish their assets to inter- mediaries, such as banks and finan- cial institutions. This keeps the risk and control at the centre of these sys- tems. Historically, bankers and institutions failed to see risks in the market, as in the case of the 2008 financial crisis. When central authorities control money, risk accumulates and endan- gers the system as a whole. Bitcoin and early cryptocurrencies, which were initially developed to give individuals complete control over their assets, were only decen- tralized when it came to issuance and storage. However, providing ac- cess to a broader set of financial in- struments remained challenging, up until the emergence of smart con- tracts that enabled DEFI. DEFI has grown into a complete ecosystem of working applications and protocols that deliver value to millions of users. Assets worth over $30 billion are currently locked in DEFI ecosystems, making it one of the fastest-growing within the public blockchain space. DEFI TECHNOLOGIES DEFI technologies include: • Blockchain: DEFI consists of appli- cations and peer-to-peer protocols developed on decentralized blockchain networks that require no access rights for easy lending, borrowing, or trading of financial tools. • Ethereum network: Most DEFI ap- plications today are built using the Ethereum network, but many alter- native public networks are emerg- ing that deliver superior speed, scalability, security, and lower costs. • Smart contracts: DEFI utilizes smart contracts on blockchains. Smart contracts are automated enforce- able agreements that do not need intermediaries to execute and can be accessed by anyone with an in- ternet connection. • Token: A token represents a set of rules encoded in a smart contract. Each token belongs to a blockchain address. It is essentially a digital asset that is stored se- curely on the blockchain. Tokens are most often known to be cryp- tocurrencies such as Bitcoin or Ether tokens. However, they can be anything from votes to licenses to ownership of a song. DEFI APPLICATIONS There are several applications of DEFI. DEFI platforms allow people to lend or borrow funds, speculate on price movements using derivatives, trade cryptocurrencies, earn interest on funds, and more. DEFI applica- tions revolve around the functions of providing peer-to-peer or pooled lending and borrowing platforms, enabling DEXs (Decentralized ex- changes), tokenization, and predic- tions markets. Below is an overview of the most popular DEFI applica- tions and protocols available in the market today: DEFI lending and borrowing: DEFI gave finance a new direction by en- abling lending and borrowing. Widely regarded as ‘Open Finance’, decentralized lending offered crypto holders lending opportunities to gain annual yields. Decentralized bor- rowing allowed individuals to bor- row money at a specific interest rate. The aim of lending and borrowing is to serve financial service use cases while fulfilling the needs of the cryp- tocurrency community. Top DEFI lending and borrowing platform is Compound Finance. Launched in 2018, Compound Finance project is a lending protocol developed on the Ethereum blockchain that allows users to gain interest by lending out assets or to borrow against collateral. The Compound protocol makes this possible by creating liquidity for cryptocurrencies through interest rates set using computer algorithms. Users of Compound earn interest by depositing cryptocurrencies. Once cryptocurrencies are supplied on the Compound platform, users can use ISSUE 161 MAY 2022 the BANKING EXECUTIVE 9