September 19, 2020 / Beginners

Decentralized Finance As An Alternative To Traditional Banks

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Decentralized finance or DeFi is one of the latest trends in the crypto industry. This term combines services similar to classical financial instruments, implemented in blockchains. Most often, DeFi services are created on the basis of the Ethereum blockchain. Among them are cryptocurrencies issue, exchanges, transfers, and lending.

On the one hand, DeFi services declare advantages characteristic of the cryptocurrency industry: decentralization, anonymity, security, lack of regulatory influence, availability. On the other hand, their traditional prototypes – banking services – operate on different principles. This is the possession of extensive information about the client, trust in a particular financial institution, and strict regulation by national central banks.

A Stable Currency Acts In An Unstable World

“Classic” tokens like BTC, ETH, and many others are subject to high volatility. It is often proposed to use stablecoins for transfers, the value of which is stable due to the provision of real assets. For example, the DAI and USDC tokens used by the most popular Maker and Compound protocols always cost about $ 1.

USDC is backed by real foreign exchange assets held in bank accounts. The stablecoin is issued by the developer – Circle – or partners who are selected according to strict criteria. Among the criteria are the availability of licenses, successfully passed AML , regular confirmation of the availability of reserves.

The DAI cryptocurrency, which is released by the MakerDAO service, is provided not by fiat, but by the cryptocurrency – ETH. Since cryptocurrency is significantly more volatile than fiat, excess collateral is used to maintain the DAI rate. Earlier, we talked in detail about the evolution and functioning of various stablecoin models.

Decentralized Lending

The emergence of a stable cryptocurrency has fueled the development of crypto lending. The most popular services (by the volume of blocked cryptocurrencies in their smart contracts in USD terms) are now Maker and Compound. They are based on classic banking mechanisms: raising funds from network users in the form of interest-bearing deposits and issuing loans secured by collateral.

Unlike traditional banks, which can issue unsecured consumer loans, DeFi services only issue loans against excess collateral. Stablecoins are used as the loan currency, and ETH is used as collateral. Moreover, if the value of the collateral falls below a certain level, it can be sold to close the position.

Interest on loans and deposits is demand-driven and variable, and in the case of DeFi instruments, rates change dynamically and act on already issued and borrowed loans. The less funds available for issuance in the form of a loan, the higher the rates on deposits and vice versa. Interest on deposits is also accrued on a regular basis. For example, the Dharma service charges interest approximately every 15 seconds. You can withdraw the deposit at any time – the funds will be returned to the wallet.

DeFi vs. Traditional Banks

The advantages of DeFi products include:

  • high availability of the service: it is available 24/7 from anywhere in the world, it is not subject to failures due to problems in data centers;
  • high operational speed: the absence of loan officers and a due diligence process allows for faster transactions;
  • no influence of socio-demographic factors and credit ratings: loans are issued against collateral, so even an unreliable borrower from the point of view of classical banks can get it;
  • no minimum deposit holding period – funds can be withdrawn at any time.

The disadvantages and constraining factors include a relatively high entry threshold. The level of technical literacy of the population and trust in blockchain technologies make DeFi products inaccessible or unattractive to the vast majority of the population.

Who Will Win?

If we talk about the financial conditions of banks and DeFi services, then the former have better rates, but the conditions are stricter. In terms of the promptness of the provision of services (the speed of receiving funds), banks lose to decentralized services.

DeFi services lose positions significantly in terms of product availability, as they require a higher level of technical literacy and willingness to use such products. Now DeFi services do not look like a real substitute for world banking products. They can only be used by a relatively small part of the population with sufficient knowledge and willingness to work with tools that are outside the legal framework. Classic banks, however, are also unlikely to be able to develop such services until the appearance of an appropriate regulatory framework

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