FinTech

In 2020, Will Decentralized Finance Finally Flourish in a Centralized World?

By Ruaridh O’Donnell, Director of Information Systems and Co-Founder at Kava

In straddling the peripheries of emerging technology and legacy finance, decentralized finance has fast-emerged as one of blockchain’s more palatable offerings. As an open ecosystem that anyone from anywhere in the world can access to both utilize and build new products and services, DeFi is envisaged to accelerate the pace of innovation. With the potential to completely transform existing financial products, the movement has naturally come to the attention of mainstream enterprise players who look to capitalise upon its emphasis on operational efficiencies, cost-savings, and disintermediation.

From decentralized prediction markets to Facebook’s foray into digital currencies as a means of achieving financial inclusion for the underbanked and unbanked, the applications for DeFi are widening their reach and investments are steadily pouring in for new decentralized financial solutions. The ecosystem as a whole achieved a milestone in June 2019 when the value locked into DeFi projects reached a peak equivalent to nearly USD $700 million. With 2020 on the horizon, we can hope to see even greater recognition of DeFi’s potential, highlighting the technology’s ongoing journey toward maturity as we see more and more applications with real-world value.

A Trustless Ecosystem

Traditionally centralized by design, power within the global banking system has largely been held by legacy institutions, be it central banks, law firms, or regulatory bodies. Unsurprisingly, financial services are viewed as the least trusted of all the major industries, after the global recession of 2008 and high profile data breaches showed the weaknesses of centralization and intermediation. What DeFi brings to the table is a way to take the matter of trust out of the hands of a few main players, and write it into the very code on which it runs.

Transactions on decentralized systems can run largely automated through automatically-executed smart contracts, removing the need for go-betweens and their fees. Built out across a digital landscape, DeFi services are open to any person globally, regardless of the extent to which they have access to traditional banking services. According to the World Bank, 1.7 billion people globally remain unbanked, yet two-thirds of this population own a mobile phone, gesturing toward the equalizing effect of technology when it comes to accessing financial services. No longer limited to legacy infrastructures, these technologies can be tested in the market at a far more rapid rate, allowing for valuable real-time feedback on the actual efficacy of a given solution. In the case of remittances, specifically, DeFi has the potential to significantly reduce the global average cost to somewhere below three percent, opening the door for instantaneous and secure cross-border payments across developed and emerging markets.

Faster, Fairer Lending

Though crypto-backed loans and peer-to-peer lending are in their nascency, their popularity has been growing with the demand for more accessible facilities for borrowing and lending. With a proven track record built over the course of the past few years, existing solutions such as MakerDAO have risen to prominence, demonstrating high interest rates and returns for users that gesture towards the technology’s success.

Beyond that, the use of smart contracts to allow for a non-custodial format with more configurable credit obligations, also implies greater operational efficiencies. DeFi eliminates the need for human-performed due diligence and removes the opportunity for human error, leading to significantly faster processing times. Human bias is also cut out of the equation, as capital allocation is done on the basis of real-time transaction data to ensure the market is always balanced. With DeFi, lenders and borrowers anywhere in the world can be digitally connected, and a cryptographically enforced protocol will ensure the terms of the loan agreement are met at all times.

The Value of Choice

As DeFi applications continue to mature and push the boundaries of financial services, crypto holders will be looking to use decentralized platforms to create collateralized debt positions (CDP), locking their virtual assets into them as collateral to obtain loans. Currently, crypto investors have little more to do than hold their assets and await long-term returns, but CDPs present a way for them to grow their holdings while still being able to use a portion of it for purchases and payments.

With today’s DeFi applications currently limited to ethereum, the new year is likely to see a far more varied landscape of crypto assets, giving users a broader range of choice when it comes to maximising the value of their holdings. As this pool widens, we can hope to see a far more liquid and financially mature DeFi economy.

The Dawn of a New Era, Challenges and Potential

Underlying value is in direct proportion to utility, and should DeFi platforms look to flourish as we approach the future, barriers to mass-adoption and user acquisition will need to be addressed. DeFi applications are limited by the maturity of the wider blockchain industry — they will need to develop in accordance to how protocols mitigate existing scaling challenges. For projects offering peer-to-peer payments or remittance systems, it will mean having the capability to handle large transaction volumes and at a low cost. With traditional players such as Visa claiming a transaction throughput of 24,000 transactions per second and the world’s most prolific DeFi platform, Ethereum, limited to a mere 10-30 transactions, much more needs to be done in this area.

Amid the gradual maturation of the market, traditional players may begin shifting their mindset (and their regulations) as they realize the potential that decentralization holds for reshaping existing financial instruments in the face of macrotrends like the gig economy and globalization. Decentralization itself is a spectrum, so we can expect that future and current DeFi projects will differ in the degree of decentralization they adopt, depending on their ultimate function. Regardless, the DeFi ecosystem is and always will be characterized by a need to empower the everyday individual with accessible and transparent financial services, and it holds the power to bring our markets closer than ever before to a new era of network-based finance, one that is trustless, efficient, affordable, and secure. These are very early days for DeFi, but there is much to look forward to.

About the Author

Ruaridh O’Donnell is the Director of Information Systems and Co-Founder at Kava, a technology focused startup expanding the reach of DeFi and bringing access to underserved assets. An expert in blockchain interoperability, and an entrepreneur with a track record in research and innovation, Ruaridh led machine learning groups before working on fraud analytics. He holds a Masters in Physics, and is a published researcher and has collaborated in multinational research.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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