. 8 min read

Decentralized Finance (DeFi) Challenges the Global Financial System

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Juan Villaverde is an econometrician and mathematician devoted to the analysis of cryptocurrencies since 2012. He leads the Weiss Ratings team of analysts and computer programmers who created Weiss cryptocurrency ratings.

Source: iStock/johan10

Do you still think crypto is a scam? That smart contracts are useless?

If so, please allow me to introduce you to a phenomenon you may not know about. Decentralized Finance, or what the crypto crowd calls “DeFi.”

I’m talking about a soon-to-be, separate, parallel universe in the world of finance. One that uses strictly Distributed Ledger Technology (DLT).

To get a quick, big-picture understanding, consider these three fundamental differences between DeFi and the traditional financial system:

Fundamental difference #1: Who or what makes decisions.

The traditional financial system lives or dies based on the strength, stability, authority and trustworthiness of big financial institutions and the governments that regulate them. If a big bank goes under or a government defaults, the entire system can melt down.

Hard to believe? Then ask the customers of Washington Mutual, Bear Stearns and Lehman Brothers. Or talk to the people of Argentina, Uruguay, Greece, Russia and Venezuela.

In contrast, a decentralized financial system lives or dies based on the strength of its protocols, cryptography and smart contracts.

Weak players or shady characters are summarily kicked out.

Fundamental Difference #2: How to apply for a loan.

In the old world of traditional finance, you apply for a loan at your bank (or neighborhood loan shark). You give them info on your credit history, property, liquid assets. Subtly or overtly, they may even consider where you went to school, where you live and what you do for a living.

Then they then boil it down to this simple question: Can you be trusted?

In the new world of DeFi, as I’ll explain in a moment, the process is fully automated and decentralized.

Fundamental difference #3: How credit ratings are created.

Finding the answer to the “can-you-be-trusted” question is a cumbersome process. Even after thorough due diligence, the final credit-rating number is still just a guess.

And in the boom-bust cycles that have dominated the global economy for centuries, it swings from extreme to extreme.

  • In the extreme stage of a boom cycle, lenders go wild with speculation — ignoring risks or, worse, rigging their ratings process.
  • In the extreme stage of a bust cycle, they shut out even the worthiest of borrowers, lending strictly to those who don’t need the money in the first place.
  • In between those extremes, the biggest deal-killer is the fact that most participants know credit ratings are just a guess, leading to ever-present uncertainty in the lending process.

Which leads us to …

The Mandate of the traditional financial system

Traditionally, lenders will err on the side of caution, summarily shutting out billions of people around the world. Whether big or small, they simply do not have the bandwidth to accurately evaluate the credit of billions of would-be borrowers.

At the end of the day, it boils down to an issue of scale:

The traditional financial system is simply unable to scale up to a level that opens capital access to anyone or any company anywhere in the world with a good credit history.

DeFi is.

The traditional financial system sorely lacks mechanisms for …

1. Anywhere-to-anywhere, cross-border lending on a mass scale. Lenders in highly liquid regions of the industrial world can rarely connect with small borrowers in emerging markets.

2. Peer-to-peer lending. It’s almost impossible for small borrowers or lenders to bypass intermediaries. Those intermediaries incur high costs and must charge substantial fees (or spreads). For small — and even large — investors to become lenders, the best they can typically do is buy shares in a bank, specialized fund or hedge fund.

3. Peer-to-peer money transfers. Money is often unable to travel to where it’s needed the most. And when it does, intermediaries often take the lion’s share of any profits generated by these transfers. Liquidity often dries up precisely where it’s most needed, especially in the wake of natural or manmade disasters.

4. Transparency in the lending process. Key facts on where or how to apply for a loan, why you’re accepted or rejected, and what to do next are shrouded under a cloud of secrecy.

DeFi has these mechanisms … and more.

DLT-powered Decentralized Finance (DeFi) is among the only sustainable solutions

As we’ve seen time and again, foreign aid and charity can sometimes help. But they aren’t sustainable or scalable.

And as we saw in the U.S. subprime crisis of 2008-’09, when government and private lenders pushed out trillions in loans or mortgages to high-risk borrowers, the consequence is catastrophe.

Although still possible, these challenges and disasters are far less likely in a DLT-powered, decentralized financial system.

Here’s why …

First, DeFi uses massive amounts of real-time data processed with sophisticated algorithms to continually balance itself — much like a highly liquid, global foreign-exchange market.

Second, DeFi helps replace much of the time-consuming background checks for borrowers and most of the expensive due diligence by lenders. In fact, if you’re a lender, you don’t even need to know who — or what — the borrower is.

Third, DeFi makes it possible for lenders and investors to entrust their money to proven smart contracts. That money is then aggregated into a pool of liquid funds available to borrowers.

Fourth, DeFi securely stores the funds on a global distributed ledger that can be viewed by anyone with an internet connection.

Think of it as a global bank: You make a deposit. Then, once the institution has your money, it’s free to lend it out.

The critical difference here is that there is no bank. Instead, it’s on a global network, where all the relevant information — and the liquid funds themselves — can travel across the planet as quickly as an email or text message.

Fifth, DeFi supports a more efficient credit market. Interest rates are not distorted by big spreads for intermediaries. Nor are they directly affected by central bank manipulation. Instead, they’re determined by algorithms that automatically adjust interest-rate levels based on supply and demand.

If supply dries up, rates go up. If supplies are abundant, they go down.

This also can help resolve a major current challenge: In North America, Western Europe, Japan and other developed economies, yields are at record lows. But in emerging markets, they’re still very high. And even in the richest countries, many average citizens can’t get a mortgage to buy a new home.

Sixth, DeFi handles collateral more fluidly. When you wish to borrow using a DeFi protocol, you post your assets on a smart contract. Those assets are earmarked as collateral for any funds you wish to borrow. And, if you fail to repay the loan, the protocol will automatically assign your collateral to the lender.

As on the Bitcoin network, there is no human intervention in this process. And there’s also virtually no way to cheat the smart contract.

Does this system already exist in the real world?

Although still experimental, yes!

In fact, what I just described is, to a large extent, what’s already being tested by protocols like Compound, one the first DLT-based lending platforms. (Read more: Decentralized Lending Soars, Staking Gains Traction)

Protocols like these — typically built on Ethereum — are beginning to step away from Bitcoin’s traditional use-case as a store of value. And they are starting to realize Ethereum’s vision of a new financial system.

Their goal: A world in which most rulers are replaced by rules; a world in which those rules are enforced automatically and fairly.

From 30,000 feet, banks and a protocol such as Compound perform a parallel function: They pool assets and make them available to borrowers.

The difference is that with Compound — or any other DLT-based lending application — there is no counterparty risk at the institutional level. Nor is a single company or individual aggregating these assets.

Meanwhile, removing manual, human intervention in the process helps reduce two critical things:

1. Human error in processing loan applications, and

2. Human bias in capital allocation.

Lenders and borrowers meet one another directly, and a cryptographically enforced protocol ensures the rules are observed by all at all times.

But please understand: Just because humans are not involved as intermediaries in day-to-day decision-making doesn’t mean humans aren’t involved at all.

On the contrary, the rules governing how these protocols operate are decided by an aggregate of lenders and borrowers.

It’s the users of these platforms who set the rules, and it’s the Distributed Ledger Technology that enforces them.

It’s almost impossible to cheat the system; the smart contract treats everyone equally. It allows for no priority access or one-off exceptions. The system operates exactly as it was programmed to operate. And if it’s flawed in any way, those flaws become readily evident, mandating prompt fixes.

At the end of the day, the system’s big strength lies in its ability to cut out the middle man, eliminate most fees, and treat everyone equally.

DeFi protocols are also inherently global. You can be anyone anywhere in the world. If you meet the requirements for participating, you’re free to do so. Geography is simply not a criterion.

DeFi cannot discriminate and cannot cheat. And ultimately, that is the future of finance.