Decentralized finance is a form of finance that does not require traditional intermediaries such as banks, brokerages or exchanges. All of the work that would normally be handled by these institutions is instead performed by technological solutions including smart contracts and blockchain.
The legacy banking system and DeFi are markedly different. While traditional finance is slow to develop and adapt, in just a few years, companies operating in the DeFi sector have built a parallel financial system from the ground up. There are payment systems, lending protocols, exchanges and more. There is also a growing stablecoins market of fiat-pegged assets including Tether (USDT) and USD Coin (USDC).
One of the headline differences for DeFi is the potential returns on capital/savings that retail users can expect. The average bank interest rate for a checking account in the United States today is a mere 0.06%, and the average savings account offers only a marginally improved rate of 0.09%. Compare this with holding your money in a DeFi protocol such as Yearn.finance vaults, and you can expect to receive an 11.4% annual percentage yield on dollar-pegged stablecoins. From the perspective of financial return, DeFi beats traditional banking out of sight.
Slow to innovate
Another key factor propelling DeFi forward is its culture of innovation. The banking sector, on the other hand, is notoriously slow to adapt. Try to think of the major improvements that banks have delivered over the past few years, and you’ll probably draw a blank.
That’s not to say that banks haven’t delivered any innovations. In the last half-century, they’ve incorporated card payment technology, internet banking services, telephone banking and mobile apps. That’s not nothing, but it’s not a very long list either. You may think I’ve forgotten to include ATMs, but those date back to 1967, making that particular innovation more than a half-century old.
One of the key differences between legacy banks and DeFi is in how and where they lower barriers. Decentralized finance is focused on lowering barriers for consumers, making banking more inclusive and available to all. At the same time, brick-and-mortar banks are closing down branches in an attempt to save money. In the past five years, 3,500 high-street banks have permanently closed their doors in the United Kingdom, a number that equates to roughly 55 per month.
With in-person banking being eroded by the banks themselves, they have evened the competitive landscape for DeFi to compete. While DeFi attempts to lower barriers for consumers, the legacy banking system has unintentionally lowered the barriers to competition. As Bill Gates said in 1994: “Banking is necessary; banks are not.” Nobody has taken this more to heart than the legacy banking system.
More to do
Although DeFi has made great progress in recent years — with 2020, in particular, being a standout for the sector — there is still a huge amount of work to be done. One of the biggest sticking points for the industry is that it has largely been reliant upon the Ethereum blockchain. Last year, as the popularity of DeFi grew, transaction speeds slowed to a crawl while transaction fees rose.
There are some emerging players reaching critical mass at just the right moment to offer an alternative. Polkadot in particular is often touted as a contender for Ethereum’s crown, with a host of developers now working on products for the network. In the 12 months ending with the second quarter of 2020, Polkadot’s “next-generation network” witnessed a 44% rise in active developers. With over 250 projects now building on Polkadot, it is likely that the upstart could take a significant slice of the DeFi pie. At the same time, there are projects attempting to mitigate Ethereum’s growing pains with sidechain solutions.
Distrust and resentment
The decision of governments to bail out private banks with public money may have kept banking institutions afloat after the financial crisis, but resentment for the failure still bubbles just beneath the surface. That crisis is also intimately tied to the story of Bitcoin (BTC) and decentralized money, as Bitcoin’s genesis block bore the inscription: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
A DeFi protocol is only as good as the person who programs it. There have been a number of high-profile exploits and hacks of DeFi protocols, which has highlighted weaknesses in the sector. With growth showing no signs of slowing down, it’s clear that the future of banking and financial innovation belongs to decentralization.
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