Rewriting the rules of financial services with “DeFi”

By Rahul Singh, President, Financial Services and Digital Process Operations at HCL Technologies

As global banks begin to pepper their conversations with talk of cryptocurrencies, initial coin offerings (ICOs), beacon chains, and other mystifying concepts, they are also noticing a new term — “DeFi” or Decentralised Finance. This new trend has the potential to become more disruptive than crypto.

DeFi holds the key to creating financial products and services for anyone with a smartphone. It permits users to move their funds lying in low-interest bank accounts, where inflation is steadily eroding their value, into funds with smart contracts. From here they can lend, borrow, or upgrade the value through several blockchain-based monetary mechanisms, including liquidity incentives on decentralised exchanges and synthetic derivatives. Annual percentage yields of DeFi can beat traditional savings accounts by as much 20%.

Unprecedented growth

The secret behind DeFi’s extraordinary yield, is that it is digital and bypasses the long chain of brokers, lawyers, lenders, governing bodies and gatekeepers whose fees load an astonishing high burden on transactions. In terms of radical innovation, few technological developments hold the same potential as DeFi.

Current estimates suggest that around five million people currently use DeFi applications, with the total value locked in DeFi contracts exceeding £71.5 billion in November 2021, up from around £732,500 in June 2020. It is clear DeFi is growing at a breakneck pace, thanks to the evolution of blockchain technology and the inability of legacy financial systems to counter or match this new innovation.

Delving deeper

To understand and appreciate DeFi beyond the attractive yields it is unlocking, a quick but simple explanation is called for. Let’s say Alice wants to buy a house from Bob. Does Bob take the money first or does Alice take the house first? When Alice transfers the money to Bob, it could take several hours to be credited to Bob’s account. Meanwhile, Bob may not trust Alice enough to sign over the house without seeing the money in his account. To solve these problems of trust and transaction velocity the financial system has created a host of intermediaries.

Lawyers hold the money within a bond or document, eliminating counterparty risk. However, buyers and sellers want to eliminate the lawyers and their exorbitant fees. With DeFi, they can. The example of Alice and Bob may seem trivial. But when the transaction involves the sale of a company, the fees could run into millions. In such instances, there is an even more compelling reason to eliminate lawyers.

DeFi eliminates the middlemen by creating products that are non-custodial in nature. It takes the work away from buyers, sellers, banks, lawyers, insurers, and regulators, and puts it onto a smart contract that no one has control over. DeFi transactions do not require people to execute it. Software does the job instead. As a result, DeFi innovation, has serious implications for the future of banking and for regulatory authorities.

Rewriting the future

A slightly different example from Alice and Bob shows the staggering impact DeFi will have on legacy financial processes and players. Let’s consider the CEO of a large business. The CEO’s job is to grow the business. This happens by selling more and raising more capital. DeFi helps both.

Normally, were the CEO to issue bonds to raise capital, the company would have to issue a prospectus crafted by lawyers, find support for the bond by paying intermediaries, and have regulators oversee the issue. They would also need to keep the equivalent of the Central Securities Depository informed, find a custodian who holds the bonds, collaborate with brokers and private wealth managers to find buyers. Such a process normally takes months and is expensive. It means buyers ultimately shoulder the burden of these payments to intermediaries.

Instead, the CEO could use DeFi to tap into funds with smart contracts and eliminate the traditional financial chain. This would mean the required funds could be made available at a low cost within minutes.

With DeFi a business may never go to a bank or a venture fund. When a business wants to raise money, it could get it from millions of people that are ready to lend. Lenders can use publicly available information on the business and credit history on the DeFi network to make their decisions. In the end, DeFi means businesses and lenders can bypass the banking system, governments and regulators, to make the process far quicker.

A new world

DeFi also presents a new paradigm in openness and transparency. An organisation’s transaction history are made available, ensuring individuals can decide on how much to trust the business and determine its sustainability. Investors no longer have to rely on the biased choices of analysts.

If DeFi continues to grow in popularity, regulators in the financial services space may not be needed. This may seem like an extreme statement to make, but it stands to reason.

Today, governments and regulators set the rules—and monitor adherence—for financial products and transactions. These rules are written down and lawyers must interpret them. With DeFi, nothing is written down. Everything is programed. Behaviour, rules and conditions are accurately and precisely captured in code that does not require interpretation.

The future of DeFi

In the US, the Securities and Exchange Commission (SEC) is trying to understand and define the participants, assets and activities of DeFi that could fall under its jurisdiction. It guardedly calls DeFi “a shared opportunity and challenge” while calling upon the DeFi community to “help promote responsible innovation.”

Additionally, DeFi is complex to use. Interoperability or cross-blockchain transfers have been a challenge, although they are being solved. The complexity of DeFi apps and protocols leaves much to be desired by way of user experience. Reports of risks and flaws in DeFi systems surface every other month. But DeFi’s innovation will, sooner rather than later, upturn traditional financial systems unless incumbent organisations explore the possibilities presented by DeFi, to re-write the rules of financial services.