The financial system as most of us know it is marked by centralized intermediaries, increased cyber risk and major inefficiencies.1 Three aspects that could be changed by solutions like blockchain technology, automation, and digitization in general. With the emergence of blockchain technology in 2008, the idea of full-fledged financial markets on-chain came up and thus decentralized finance was born. Through these applications not only the financial system is displayed but crypto currencies for the first time can be used actively in financial transactions instead of being hoarded in wallets.

What is decentralized finance?

Decentralized finance, also known as “DeFi”, displays the centralized financial system in a new technological setting. It takes the current structures and products, moves them onto a public blockchain and thus creates a decentralized financial network.1

The meaning of decentralization in this context describes the structural setup of how peers are able to communicate with each other in the system. Contrary to a centralized network, in which one unit is the single point of contact and the single point of failure for all participants, decentralized networks consist of a pool of contact points.2 Thus, the network is not controlled by and dependent on one single unit but can rely on the availability of multiple nodes. Probably the best-known example of a decentralized network is the internet, aside from which not many other decentralized networks of this size have been developed.3

Based on this principle DeFi is structured into the following three layers: (1) the underlying blockchain, (2) the currency and (3) the financial products (see Figure 1). The first layer, the blockchain the system is based on, is the key driver for the decentralized structure and the abilities of the system. The blockchain, mostly Ethereum, is the unit executing the code relevant to the application via the decentralized network.4 In addition, it sets the ground rules for the whole organization by its protocol and is referred to as the settlement layer for the exchange of value by.4

Element of the second layer are cryptocurrencies. Those currencies can be defined as the enabler of the whole system. Through them, it is made possible for actors to us the financial products in the third layer. One of the most famous examples for such a currency is the Dai of MakerDAO. Dai currently is a single collateralized stable coin backed by reservoirs of ETH, mostly ensuring a stable performance of value tied to the Ether.5

The third layer are the financial products themselves. The most known products are probably decentralized exchanges (DEX) since they are most present in the market. Nevertheless, DEXs only scratch the surface of what is possible. Decentralized finance is built on the knowledge of the centralized financial industry and displays current financial products as they are in the new environment but without the middlemen currently in place. Those products reach from loans over trading, up to saving and investment products.4

For the customer to reach the service so-called dApps (decentralized applications) are used. They represent the interface between the user and the underlying layers of the application. Most famous dApps are Compound and MakerDAO. For further automation of e.g. the lending process and other financial procedures AI and machine learning algorithms can additionally be implemented.6This enables partly and fully automated applications that execute tasks based on stipulated terms and conditions rather than human judgment and biases.

Advantages of decentralized finance

Decentralized finance not only connects the old financial world to the technological development of blockchain technology. It also incorporates multiple advantages exceeding those of the technology itself and by that can solve multiple problems the financial system in place is unable to tackle in its current status.

One of the major challenges for the banking sector currently is reaching the unbanked population, accounting for roughly 1.7 billion people in the whole world.1Through the application of dApps in a decentralized finance setting this could be done rather easily.Anyone with access to the internet, regardless of the financial infrastructure, can access the applications and take advantage of the services.5Thus, unbanked or banked, all internet users can access financial products. Of special relevance in developing countries is the access to loans, which, in the traditional banking structure, requires a track record, determining whether or not an individual is eligible for a loan and the specific conditions.1

Besides, currently high fees for cross border transfer could be lowered by up to 50% due to the lack of change in currency.1This is supported by the use of stablecoins, which can be transferred cross-border easily and, at the same time, are less volatile than usual crypto currencies.1Especially the foreign workforce can leverage this advantage when sending money to their families in another country. Additionally, the possibility to create markets for illiquid assets and completely new products with higher effectiveness in hedging, borrowing, arbitrage, and access liquidity arises.5

Why banks are still needed

Despite the great advantages of DeFi it is not probable that banks will disappear entirely in the near future. The construct of decentralized finance is still marked by major disadvantages and inefficiencies making mainstream adoption currently a utopian idea.

According to the Cambridge Center for Alternative Finance, back in 2018, only 25 million people were verified crypto users, which compared to 1.7 billion unbanked habitants is only a small fraction of users.1The rather small number of adopters can partly be issued in the missing product-market fit of current applications.5Most of them target the average blockchain enthusiast rather than the average banking client with UX/UIs not suitable for the masses since they are too complicated.5The second layer, stablecoins, on the other hand, faces a huge distrust from various groups of people.Libra, for example, is criticized by politicians, financial institutes and regulators, which decelerates the rate of adoption by far.1In addition, a threefold tradeoff between decentralization, scalability, and security arises, in which scalability currently lacks behind.7With decentralized finance as it is, mainstream adoption would not be possible since at this point in time the technology is not capable of handling the masses of transactions executed by centralized financial institutes.1

As already mentioned in the previous abstract Libra is facing a serious headwind from e.g. regulators. This is no individual case per se. In India, for example, crypto currencies are banned completely and in most other countries the regulatory environment is still in an early stage and thus it is unclear what the future will bring.5Besides, especially violations of anti-money laundering (AML) and know your customer (KYC) requirements are a huge problem since they expect a certain knowledge about the user’s identity.5A level of knowledge not usually surveyed by the applications.

DeFi also lacks a sufficient level of reliability since currently most applications are issued by smaller companies with less funding and unclear intentions. In case of failure, invested money thus might be lost for customers because it is unlikely that a third party would jump in and save the companies.5Even if this scenario does not turn into reality the capital investment is highly inefficient because most solutions require an over-collateralization between 150% and 300%.<300%>5This over-collateralization is only expected to decrease once effective reputational systems are implemented.

Outlook on future developments

In order for DeFi to be successful in the future certain developments by the issuing companies and other parties have to go on.First of all, the strengthening regulatory environment is key for the long-term success of these applications. The currently high insecurity due to not yet finalized demands makes it near impossible for companies to implement a secured model into the applications. Additionally, to foster the skepticism it is relevant that central bank currencies are being issued. By that users will gain trust in the currency used by the systems. This may also positively impact the process of creating an accepted standard across various solutions and the interaction between various DeFi-platforms making them more usable for non-crypto-natives.

Conclusion

At this point in time decentralized finance offers great advantages but, nevertheless, is not suitable for mainstream use yet. Currently it is too complicated to use for the average banking customer and tied to too many risks to rely on it as a safe environment for all financial transactions. Nevertheless, the current development is necessary as the groundwork for future adaption. Thus, it is not expected that banks and other centralized financial service providers will be diminished by decentralized ones in the near future, but it could possibly happen in the long run.