DeFi: The Financial Paradigm of the Future
By understanding DeFi we seek to discover potential innovative methodologies that may broaden access to finance both for consumers and Small and Medium-sized Enterprises
The global financial landscape is fast evolving with the use of blockchain technology. This article seeks to explain the technology behind blockchain, understanding where it sits within the Distributed Ledger Technology (DLT) framework, explore the concept of smart contracts, and then discuss Decentralized Finance (DeFi) as one of the evolving pillars in the future of finance. DeFi is expected to transform the financial services market globally. According to a study, the global DeFi market size was $11.96 billion in 2021 and it is projected to reach $232.20 billion by 2030. OECD Deputy Secretary-General, Yoshiki Takeuchi, in the OECD report: Why DeFi Matters and the Policy Implications details, “The OECD and its Committee on Financial Markets have assessed the impact of digitalisation on finance to assess DLT-based applications and are committed to exploring how to foster the benefits of digitalisation for financial markets.” The report goes on to detail, “One of the most important benefits of DeFi is related to financial inclusion and the potential for DeFi to serve underserved parts of the population.”
The technology behind DLT and Blockchain
Before we dive into discovering the use cases and expounding on DeFi, let’s first return to the initial building blocks of the technology.
DLT is the technological infrastructure and protocols that allow simultaneous access, validation, and record updating across a networked database.
With advances in technology and as connectivity improved, databases grew significantly larger. As a result many businesses and governments needed to use multiple computers and servers in different locations to solve complex problems and then return the solution to a central location. Because there were multiple users with access to data, it became necessary for those changes to be verified. The process of updating changes in the database were then recorded through a series of automation of data encryption techniques where a transaction was validated by consensus.
The single biggest concern with a traditional centralized ledger system is that there is one central point of control or failure.
The Solution: Decentralize and Distribute
In contrast to a centralized ledger, a decentralized and distributed ledger stores information in multiple locations across a network of computer nodes. For decentralization to work, there has to be a way for the network to maintain its integrity. Nodes are an extremely important part of maintaining integrity and ensuring security. Each node on the ledger processes and validates each piece of data. Any change to the ledger, such as moving data from one block to another, is recorded across all nodes. Because each node has a copy of the ledger, each node publishes its version with the latest transaction and this helps establish consensus on the validity of the dataset across all nodes.
This makes DLT more resilient to attacks and less vulnerable to system-wide failures. Also, because DLT uses cryptographic algorithms to secure data, DLT is nearly impossible to tamper with or forge records. This enhances the trustworthiness of the data and reduces the risk of fraud.
What Are Smart Contracts?
A current and relevant example of DLT are smart contracts. In the era of digital transformation, smart contracts have emerged as a pivotal component bridging the gap between technology, commerce, and finance. Built on blockchain technology, a type of distributed ledger made up of a series of decentralized servers also known as nodes, these self-executing contracts with predefined rules and conditions enable secure and automated transactions. Smart contracts have the potential to revolutionize the way businesses operate, offering benefits such as efficiency, transparency, and trust.
How do smart contracts benefit commerce and finance?
Smart contracts have the potential to streamline processes and reduce friction in business. Traditionally, commercial transactions involve numerous intermediaries, paperwork, and time-consuming verifications. Smart contracts automate and digitize these processes, enabling parties to engage in direct, peer-to-peer transactions without the need for intermediaries. This reduces costs, speeds up transaction times, and eliminates human errors. By integrating business logic into the contract code, smart contracts automate the fulfillment of contractual obligations.
The financial sector has also been greatly impacted by the advent of smart contracts, enabling the automation of financial agreements, such as loans, insurance policies, and investment contracts. Again, the need for intermediaries like banks, insurers, or brokers is significantly reduced with smart contracts. Transactions can be executed automatically, eliminating the delays and costs associated with manual processes. This automation streamlines financial operations, enhances accuracy, and reduces the risk of fraud. Moreover, smart contracts can facilitate the creation of decentralized financial applications (DeFi), enabling individuals to engage in peer-to-peer lending, decentralized exchanges, and other financial services directly through smart contracts.
One of the key attributes of smart contracts is their ability to foster transparency and trust in transactions. Because of blockchain, smart contracts are stored and replicated across a distributed network of computers. This transparency allows all participants to view and verify the terms and execution of the contract. Every action and modification is recorded on the blockchain, creating an immutable and auditable trail. This level of transparency mitigates the risk of fraud and ensures that all parties have a shared understanding of the contractual obligations. Consequently, smart contracts enhance trust among participants, particularly in scenarios where there may be a lack of trust between parties.
New Business Models and Innovation
Smart contracts have unlocked new business models and paved the way for innovative solutions across various industries. From supply chain management and healthcare to real estate and intellectual property rights, smart contracts offer versatile applications. They enable the creation of decentralized applications (DApps) that operate on the principles of transparency, decentralization, and automation. Moreover, smart contracts have catalyzed the rise of tokenization, allowing assets to be represented and traded on the blockchain. This opens up new avenues for fundraising, investment, and the creation of digital ecosystems.
Smart Contracts are but one use case of DLT and Blockchain. DeFi stands at the forefront of the financial future, with its ability to offer efficient, inclusive, and decentralized financial services. Particularly for emerging markets, DeFi can be the catalyst that revolutionizes access to financial services. It is imperative for stakeholders to understand the potential of this technology and engage in dialogue and collaboration to harness its full potential responsibly.