What is DeFi and its use cases?
People are using “decentralized” in front of every aspect of human interaction to tag it to web3. At this point, I won’t be surprised if we have a decentralized ESPN. Yes. The live scores are now fed to you through a network of distributed individuals who get rewarded for publishing the correct score each time. Okay. Maybe I went a little overboard with this example.
But not today. Because today, we are going to talk about Decentralized Finance or DeFi. Unlike a lot of fluff plaguing the industry, DeFi does offer some real-world value. And while we are on it, did I mention that it intends to disrupt our ‘favourite’ government organization: BANKS?
Yes. In another episode of ‘Bash-the-Banks’, today we are hosting the new era of banking the bankless. We are going to talk about how banks, despite being extremely popular, have a wide scope for improvement. Also, we would talk about how DeFi can be that next incarnation and its existing use cases. Stay with us till the end.
DeFi or decentralized finance is the domain of cryptoverse that aims to replace all the functions of a bank with code. Not only this makes it more secure and less prone to subjectivity but also removes the intermediary between the user and financial services.
Unlike banks, these pieces of code would operate 24x7 and in a trustless way. This means that you do not have to escrow your trust to a third party like a bank. It is built into the design of the system.
Decentralized finance is built on three pillars:
1. Cryptography: To make it secure
2. Blockchain: To enable trustless, decentralized infrastructure
3. Smart Contracts: To code ‘if/but’ conditions in a code.
Yup. If you belong to this clan of people that feel everything is okay, I empathize with you. Before you decide to make a human sacrifice out of me, hear me out. Here are a few reasons behind this thinking:
Well, if the banks did their job well, why are approximately 2 Billion people in the world unbanked? Strangely, 1.3B people out of this have access to smartphones and the internet. So what could be the reason for not having access to essential financial services?
Closer to home, banks get to decide if you are eligible for a specific type of bank account or not. They can also decide if your dream business is worthy of a loan.
2. Abusing Trust:
A lot of us deposit our money in the bank assuming that it is completely safe. However, a subtle deep dive reveals that banks are using our money to lend it to someone at their discretion for profits.
While this shouldn’t be a problem, the system is prone to corruption yielding in cases like Vijay Mallya and Nirav Modi.
3. Weird Rules:
Have you ever been charged for NOT maintaining a minimum balance? Why is that? What is the additional expense incurred by the bank if you keep your A/c empty?
Apart from that, banks are really good at imposing maximum withdrawal limits, capping on specific tools like UPI/IMPS etc.
4. Cost and Time:
Even in the age of the internet, most of the banks take forever to process loans. Adding to the agony, these loans are often quite expensive, especially in India. Some Centralized Finance products like Credit Cards also charge upto 30% APY from the customers.
Now that we have somewhat established the shortcomings of traditional finance, lets look into how DeFi can solve for them.
For starters, DeFi is decentralized. Which means you are now placing your trust in the code instead of a subjective human/organization.
And because there are lesser players required to run the infrastructure, you can afford to have a cheaper ecosystem.
This also paves the way for it to be faster as you don’t have to wait for multiple audit trails.
Best part? All of this does not require endless document trails. All you gotta do is have an internet connection and that’s it. You are ready to roll.
On that note, let us dive into some key use cases of Decentralized Finance:
1. Stable Coins:
Stablecoins are essentially a bridge between traditional finance and crypto. A stablecoin can be thought of as the crypto version of fiat money. Typically, a stablecoin is backed with a real version of money in 1:1 ratio.
Unlike other coins that should go to the moon, stablecoins remain flat throughout their lifetime. Whenever you need stablecoin, you deposit dollars and mint a stablecoin.
On the other hand, when you want real dollars, you burn your stablecoin.
Most common examples are USDT, USDC, DAI etc.
Stablecoins can be really handy if you often switch back and forth between your trade positions. Selling your crypto assets for dollars attracts taxes and exchange fees. Stablecoins are a safe haven in volatile times where you need not switch to actual dollars.
Stablecoin also provides you with an opportunity to get exposure to foreign currency at cheaper fees and 24x7x365 tradeability.
2. Lending and Borrowing:
Lending and borrowing are in fact a huge part of our current financial system. Why this works seamlessly is because banks usually ask you to put something like collateral on the line. If you default on your loan, banks liquidate that collateral to recoup the money.
There could be other legal consequences involved too if you fail to pay back. All this is possible because there is a whole set of documents and KYC involved before disbursing the loan.
How do you deal with the problem of defaulters in cryptoverse? There is no KYC. Anyone could make a small down payment and run away with the loaned amount.
The answer lies in overcollateralization and smart contracts. For borrowing fiat money worth Rs. 1000 you may have to put Rs. 1200 worth of cryptocurrency as collateral.
One may ask why would I borrow if I already have the money? Well, say you hold BTC worth Rs. 1000 and you strongly believe that it is going to jump higher in the coming days.
In such a case, you would not sell your holdings and instead borrow money using that crypto. You can use that money to trade elsewhere and make some money, only to come back and repay your loan.
3. Decentralized Exchanges:
I traveled to Istanbul a few months ago. After running out of cash, I decided to convert some of my EURO into LIRA. The physical exchanges were merrily charging me something to the tune of 10%.
Now imagine we move to a world where USDT (Or say a Turkish Lira Stablecoin) is accepted all across the country. I could have used a decentralized exchange like Uniswap could have done this for 0.3%.
Let’s zoom out and think. What is insurance at a fundamental level? Nothing but a series of ifs and buts right? If X event occurs, pay Y amount to the beneficiary. Insurance companies use algorithms and ML models to evaluate the past history of a driver and come up with a fixed cost of insurance called premium.
Why can’t we just automate this thing using smart contracts? Say a farmer wants to purchase crop insurance. We could code a smart contract that would say if the rainfall for the entire year was less than an average of 90mm, the farmer will be paid a sum of 1L. Farmers could be charged Rs. 5000 for this insurance.
At a very fundamental level, Decentralized Finance offers cheaper and faster alternatives to banking infrastructures. You see, Blockchains are best for smart asset lifecycle management. Why? Because it can offer features like minting, burning, escrow, issuance without any intermediary. On top of it, we have smart contracts to program it the way we want. Now if you apply this to different elements of traditional finance, we are definitely up for a disruption.
What use case could you think of?