- Published on
Defi Through Fiction
- Authors
- Name
- Mabwa Charles
- @mabwacharles
Traditional Finance (TradFi)
In the world of DeFi the term used to refer to the other pre-existing financial services sector is TradFi, which is short for Traditional Finance, or Cefi, short for Centralized Finance. It encompasses a wide range of financial activities and institutions that have been in existence for many years. Traditional finance relies on a network of regulated institutions like banks, brokerages, and insurance companies. These institutions operate under strict regulations and guidelines, providing a sense of security and stability for users. Unlike newer systems like decentralized finance (DeFi), traditional finance is centralized. This means that a small group of institutions controls the flow of money and assets. This is hence a disadvantage in terms of accessibility and transparency. The main types of institutions here are central banks, brokerages, commercial banks, insurance agencies and financial service providers.
Drawbacks of TradFi (Traditional Finance)
The deficiencies of TradiFi are plentiful and range from:
Financial exclusion for the unbanked - As of 2022, approximately 2 billion adults remain unbanked, meaning they lack access to an account at a financial institution or through a mobile money provider, this number represents about 38% of the world's adult population. The situation is however dire in Africa as approximately 340 million adults are unbanked and underserved, this number represents more than half of the adult population in the region, narrowing down to Kenya, approximately 4.8 million adults remain unbanked this number represents 16.3% of the adult population aged 15 and above.
High intermediary costs - Traditional finance is associated with significant transaction costs, including fees for banking services, brokerage commissions, and other charges. These costs can erode returns for investors and make financial services less affordable for some individuals. According to the world bank's remittance prices the average cost of sending remittances through banks and traditional finance is around 6.20% of the transaction amount which rises to 10.53%.
Slow Speeds - The processes involved in traditional finance can be time-consuming. For example, settling securities transactions can take days, and cross border transactions may also require several business days. This slowness can be a hindrance in an era where speed and efficiency are increasingly valued.
Centralized Control: Traditional finance is often characterized by centralized control, where a few large institutions wield significant influence. This concentration of power can lead to systemic risks and poses challenges for fostering a more decentralized and resilient financial system.
- Currency manipulation through unbridled money printing in the economies
Dependency on Intermediaries: Traditional finance relies heavily on intermediaries such as banks and financial institutions. While these intermediaries play a crucial role in facilitating transactions, their involvement can introduce additional layers of bureaucracy, complexity, and potential points of failure.
While traditional finance has been the dominant approach for many years, the financial industry has witnessed significant changes and innovations in recent times. The emergence of financial technology (fintech) and decentralized finance (DeFi) has challenged some of the traditional practices, introducing new ways of accessing financial services and managing assets.
So what is Decentralized Finance?
DeFi alias Decentralized Finance has emerged as a new form of modern finance that aims to create a more open, inclusive, and transparent financial system without relying on traditional intermediaries like banks, brokerages, commercial institutions and other centralized institutions.
DeFi is distinct from fintech due to its open, permissionless and transparent nature.
Defi is part of the broader ecosystem of blockchain backed financial innovations which started with Bitcoins redefining of peer to peer payments and the concept of store of value. Ethereum, through smart contracts, set the foundations for dApps (Decentralized Applications) and DeFi.
DeFi began by replicating services found in the traditional financial sector, such as payments, exchanges, borrowing, and lending, but has since then introduced new innovations such as DEXs (Decentralized Exchanges), Stablecoins, Derivatives, Prediction markets, Identity Management, Fractional ownership just to mention but a few.
DeFi applications are built on top of decentralized blockchain networks. As such it inherits the properties of those systems.
We have introduced another concept, BLOCKCHAIN, so what is blockchain?
A blockchain is an append-only ledger of transactions grouped into blocks, that is distributed between peers in a way that each participant can verify it on their own. Updating the ledger usually requires solving Byzantine Agreements with economically incentivized participation, secured by Cryptography.
DeFi Global Market Size:
The rise of DeFi took the crypto world by surprise during the summer of 2020 so much that we refer to the period as the DeFi summer of 2020. The DeFi market size is estimated to be around 9.4 billion dollars as of 2021, according to BCC Research, however some estimates suggest the market could reach 70.3 billion dollars by 2027, representing a compound annual growth rate (CAGR) of 39.5% over the next few years.
Total value Locked (TVL), which is a measure of the amount of capital locked inside DeFi protocols, is estimated at 46.7 billion dollars, according to DeFi Llama as at the time of writing this article which is 16th January 2024. Market capitalization: This refers to the total value of all DeFi tokens in circulation. As at the time of writing this article (January 2024) the market cap of DeFi tokens is around 38.2 billion dollars, according to CoinMarketCap.
DeFi Characteristics:
Decentralized Finance (DeFi), has several unique characteristics that differentiate it from traditional financial systems.
Decentralization: At the core of it DeFi operates on peer-to-peer networks unlike TradFi which is reliant on banks and other centralized institutions. Financial services are offered through blockchain-based protocols, eliminating the need for intermediaries and empowering users directly. Records are kept simultaneously across thousands of computers.
Permissionless: Anyone with a cryptocurrency wallet and an internet connection can access and use DeFi. No one may be denied access on the grounds of wealth, status, geography, credit history, or any other conventional barrier. This encourages equitable access and promotes financial inclusion. Users have greater control over their funds and can access financial services without the need for approval from traditional financial institutions.
Transparency: All transactions on the blockchain are publicly viewable, creating a transparent, immutable and auditable financial system. Users can easily track their assets, observe protocol operations, and hold developers accountable.
Security: For DeFi apps, blockchain offers a high degree of security. To reduce potential hazards, it's crucial to use well-established protocols and proceed with caution while working with smart contracts.
Community Driven: Many DeFi protocols are driven by active communities of developers, users, and investors. This collaborative spirit fosters innovation, governance, and collective decision-making, shaping the future of the ecosystem.
Interoperability: DeFi protocols are designed to be interoperable, meaning that different platforms and applications can seamlessly connect and interact with each other. This interoperability enhances the overall efficiency and flexibility of the DeFi ecosystem.
Programmable: Developers can program the business logic into financial services.
Liquidity Pools: DeFi platforms often utilize liquidity pools, where users can deposit their assets to provide liquidity for decentralized exchanges and lending protocols. In return, users earn a share of transaction fees or interest generated by the platform.
Yield Farming: DeFi users can engage in yield farming, a practice where they provide liquidity to a DeFi platform in exchange for rewards, often in the form of additional tokens. Yield farming aims to maximize returns on invested assets.
Smart Contracts: DeFi relies heavily on smart contracts, self-executing contracts with the terms of the agreement directly written into code.
Permissionless vs Permissioned Blockchains (DeFi vs TradFi)
| Features | DeFi/Permissionless | Permissioned (CBDC, Stablecoins) |
|---|---|---|
| Immutability | Verified transactions are immutable | Transactions can be reversed/canceled |
| Transparency | All transactions are visible | Determined by gate-keepers |
| Openness | No barriers to entry | Access must be granted by Federation |
| Reach | Global | Global but determined by Issuer |
| Trust | Regulated by Code | Centrally controlled (CeFi) |
| Governance | Decentralized, Community based | State Law |
Benefits and Risks of DeFi
| Benefits | Risks |
|---|---|
| Accessible to anyone with internet and a crypto wallet | Internet access is required unlike TradFi |
| Transparency - All transactions on the blockchain are public and verifiable. Users can track their assets, and scrutinize protocol operations | Market Risk - The risk management and understanding market dynamics are crucial, which may range from volatility which is a leading potential for losses for users. Token prices can be highly volatile. |
| Efficiency - Transactions are faster, much cheaper and efficient since intermediaries and middle men are eliminated from the transaction process. | Complexity - DeFi has a learning curve for first time learners which may be intricate for beginners, from learning concepts such as smart contracts, and DeFi protocol intricacies which may be daunting to first time learners. |
| Control - Users maintain complete control over their assets and financial data, unlike traditional systems where centralized institutions control your data | Security Risk - Smart contracts and protocols can be vulnerable to hacks and exploits, leading to potential loss of funds for users. |
| High returns on Investments - DeFi provides access to financial instruments with the potential for high returns, such as liquidity pools and yield farming. | Regulations - With regulations comes benefits and challenges, DeFi currently operates in a regulatory gray area, raising concerns about legal uncertainty and potential limitations in the future. |
| Affordable cross-border payments | Liquidity Risk - Liquidity in DeFi protocols can be volatile, leading to potential slippage and difficulties in executing large trades. |
| Interoperability - DeFi protocols are designed to be interoperable, allowing users to interact seamlessly with various decentralized applications (DApps) and financial services. | Centralization in Decentralized Systems - Some DeFi platforms may become more centralized over time due to governance structures or concentration of assets, potentially undermining the original decentralized ethos. |
| Yield Opportunities - Users can engage in yield farming and liquidity provision to earn rewards, generating additional income on their cryptocurrency holdings. | Technology Risk - Smart contract failures, transactions cannot be processed due to capacity limits of underlying blockchain and Inaccurate oracle information or delayed oracle update |
DeFi Stack
The DeFi stack is a conceptual framework that describes the different layers of decentralized finance (DeFi) protocols. It is often visualized as a pyramid, with each layer building on the one below it. Here's a basic overview of the DeFi stack:
Settlement Layer:This is the base layer of the DeFi stack also referred to as Layer 0. This layer is responsible for processing transactions and maintaining the state of the blockchain. It consists of a public blockchain and its native digital currency or cryptocurrency. Popular blockchains for DeFi include Ethereum, Celo, Solana, Avalanche, and Binance Smart Chain. The settlement layer can also have tokenized versions of assets, such as the U.S. dollar, or tokens that are digital representations of real-world assets. For example, a real estate token might represent ownership of a parcel of land.
Asset Layer:The asset layer sits on top of the settlement layer and consists of the various tokens and cryptocurrencies used in DeFi. These tokens can represent different types of assets, such as stablecoins, governance tokens, and security tokens, I.e ERC 20, ERC 721, ERC 1155, Tokenized real world assets etc
Protocol Layer:The protocol layer is where the core DeFi protocols reside. These protocols are smart contracts that enable users to interact with DeFi applications. Some popular DeFi protocols ; include Uniswap (decentralized exchange), Aave (lending protocol), Synthetix (derivatives protocol), and Compound (interest rate protocol). The protocol layer provides Liquidity to the DeFi ecosystem.
The Application Layer: The application layer sits on top of the protocol layer and consists of the user interfaces (UIs) that users interact with to access DeFi protocols. These UIs can be web-based, mobile-based, or desktop-based. This layer is crucial as without this layer, only those who are really good at blockchain and know how to program will be able to interact with DeFi. Some popular DeFi applications include MetaMask (Wallet), HaloFi, Valora (Wallet), Jia (Lending) etc.
Aggregation Layer:The aggregation layer sits on top of the application layer and consists of services that aggregate data from across different DeFi protocols. This allows users to compare rates and terms from different protocols before making a decision. Some popular DeFi aggregators include CoinGecko, DeFi Pulse, and DappRadar.
DeFi Composability:
Composability is one of the core features of decentralized finance (DeFi) that makes it so groundbreaking. It essentially refers to the ability of different DeFi applications and protocols to seamlessly interact and "talk" to each other. Think of it like Lego blocks: you can snap various protocols together in countless ways to create entirely new and innovative financial services.
Heres a breakdown of DeFi composability and its significance:
What it is:
DeFi protocols are built on open-source code and utilize shared standards, allowing them to connect and interoperate with each other.
Developers can leverage the functionalities of multiple protocols in one transaction, creating complex financial strategies.
This modularity enables rapid innovation as new protocols can be built upon existing ones, without starting from scratch.
Types of composability:
Morphological: The ability to reuse components like smart contracts across different applications.
Atomic: Transactions are isolated and self-contained, ensuring no interference between protocols.
Syntactic: Standardized interfaces enable building new applications by combining protocols like Lego blocks.
Benefits of composability:
Increased capital efficiency: Assets can be used in multiple applications simultaneously, maximizing their potential.
Enhanced flexibility: Users can design custom financial strategies tailored to their needs.
- Faster innovation: New DeFi products and services emerge rapidly, driving market growth.
More inclusive finance: Anyone with an internet connection can participate in the DeFi ecosystem.
Challenges of composability:
Security: Integrating numerous protocols increases complexity and potential attack vectors.
Complexity: Understanding and navigating complex DeFi strategies can be daunting for new users.
- Systemic risk: Issues with one protocol can cascade through the interconnected ecosystem.
Examples of composability in action:
Earning yield on your stablecoins: Earn interest on USDC by depositing it in a lending protocol, then borrow DAI against it to invest in another DeFi application.
Leveraged yield farming: Use borrowed funds to amplify your returns in yield farming strategies.
Flash loans: Borrow funds for a specific transaction (e.g., arbitrage) and repay them within the same block, minimizing risks.