Traditional finance is going through difficult times: Haunted by its own past it is failing to adapt to changing customer demands. What are the key problems they are facing? How would DeFi address them?

Our last post was about digital identities. Summary: Tech giants are getting more and more powerful every day posing a threat to privacy and in essence to freedom. Solution: Give power back to individuals. How? A decentralized model, where the users fully own and control their digital identity.

freedom
Image by Myriams-Fotos from Pixabay

The question is: Is it possible to apply the same solution to other parts of our digital lives? Let’s say finance?

How have financial players fared along so far?

Traditional finance has been around since ancient times, and by that I mean pre-digital times. While transitioning to digital world, legacy financial systems emerged as the real winners. Why? First of all, commercial activity has boomed thanks to digitalization. As its identical twin, financial activity has also expanded significantly. However there is more to the story:

Digital life comes with many perks, such as speed, ease of use, accessibility and so on. However, there is one catch: The two sides involved in a digital transaction do not see or even know each other. So, how to trust to the other side? The need for trust - or a better word ‘a trusted intermediary’ - has grown enormously with the new digital era. A financial intermediary, in essence, brings ‘trust’ to the table in a transaction.

Having dutifully performed this core function, financial institutions have enjoyed an enormous growth in revenues, profits and market capitalization over the last couple of decades.

All great, but digital life means speed and constant change. This is where financial institutions failed: Meeting ever changing customer needs and demands.

So, what is the issue here?

As life becomes extremely fast in digital world, financial players got stuck in 20th century. They have become these outsized organizations that are chained with legacy systems and swamped with their own internal bureaucracy. They insisted on operating in silos meaning not a bank’s system works with another.

Regulations do not help either: Branch activities are limited from 9am to 5pm with no weekends. Only certain customers are eligible to do business with bank - which results in exclusion of 1.7 billion people globally according to World Bank.

In short, banks are now catering to regulators, shareholders and their own staff, rather than us, the millions..

Introducing DeFi

DeFi (decentralized finance) has been trying to address these issues since its own beginnings a couple of years ago: As the main use case of blockchain technologies in the financial sector, DeFi focuses on giving the power back to individuals.

So, why use blockchain technologies in finance? How could DeFi possibly help to the individual? Let’s have a closer look:

How does DeFi address these issues?

DeFi as a philosophy aims to give the financial power to individuals. How do they do that? Couple of key principles to highlight:

Non-custodial: Financial institutions, as a general rule, holds custody of their customers’ assets. This is actually the main reason behind many of their problems these financial institutions face today. Why? Holding someone else’s money means a significant amount of responsibility and brings a lot of legal scrutiny and financial regulation.

DeFi platforms, on the contrary do not hold any of their customers’ assets. They are merely financial tools, nothing more. Customers hold keys to their digital assets. They use their assets i) in any platform, ii)) at any time and iii) as long as they would like. They may leave as soon as they are done and never need to look back.

This brings both power and responsibility to the individual. Power, as the individual is the sole custodian of her/his asset. Responsibility, as there is no third party to hold accountable.

Composable: As part of DeFi philosophy, all platforms in the space work with each other. The only thing a customer needs is an electronic wallet to keep assets. Connecting that wallet is all it takes to start using the DeFi platform. That is it.

As there is a certain standard among platforms, it is possible to add platforms on top of each other and create different products (or “building money legos” as they call it in DeFi)

Inclusive: Anyone can access to DeFi platforms. The only prerequisite is an internet connection. Any eligibility criteria used by legacy institutions is totally irrelevant in this new digital world. A novel approach to bring ‘banking the unbankable’ buzzword into life.

Open source: Another key element of DeFi is openness. All the source codes used in DeFi platform are open to public. This brings a significant amount of transparency. Rather than trusting the institutions and their employees that they act honestly, all that is required is to review the code (or “trust the code” as they say in DeFi).

Building on the above principles, DeFi has a solid starting point. But how does it help individuals? We will look at various uses cases and benefits in our next post.

Last word…

Let’s finish with what we said in previous post: All is possible, thanks to technology but mainly to blockchain and crypto. This is coming. Sooner than you would imagine…

This piece is first published in BlockchainIST Center on Feb 6th, 2021. None of the views expressed in this article should be considered as investment advice