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Cryptocurrency: What is DeFi and how is it replacing traditional finance?

14 June 2022 Jonty Sacks, Partner at Jaltech

With the creation of cryptocurrencies and the underlying technologies that come with them, one of the biggest developments and most feared by the financial sector is the rise of Decentralised Finance, commonly known as “DeFi.”

DeFi is a broad term for alternative financial systems and services which are built on top of blockchain technology. This new digital universe is modelled toward building a new, internet-native financial system using blockchain technology to replace traditional [archaic] financial systems.

In layman’s terms, DeFi is financial services that are completely internet-based, uses blockchain as its backbone and can be implemented and executed in real-time without any middlemen. This provides users with greater efficiency and lowers costs to transact.

Defi systems follow specific protocols (a set of rules for transacting and regulating token supply) executed via smart contracts. DeFi competes with existing financial services by offering global access and exploiting the limitations of traditional banking systems. For instance, cross-border payments take anywhere between 2 to 3 days to settle, whereas, in the DeFi environment, settlement can occur within minutes. DeFi protocols compete across multiple financial sectors including lending, insurance, and exchange.

Traditional finance vs DeFi

One fundamental difference between traditional finance and DeFi is that traditional finance is largely dependent on human resources to process and approve decisions and perform tasks (for example, the approval of a home loan) whereas within the DeFi ecosystem all activities are fully automated through smart contracts.

AAVE is a prime example of an automated DeFi protocol. AAVE allows customers to deposit their cryptocurrency as collateral when applying for a loan. The process of applying and receiving approval/rejection is all done online and takes a few minutes. To date, AAVE has received deposits of more than USD 200 billion in cryptocurrency.

The efficiencies within the DeFi environment are enhanced given that there is no need to engage with a human gatekeeper. The obvious reason for the rapid growth of DeFi is centred around the competitive advantages it has over traditional financial systems, a few examples can be summarised below:

 

DeFi

Traditional Finance

Operating hours

24 hours a day

Business hours

Operating days

365 days a year

Business days

Settlement delay

Within minutes

Up to 3 days

Transaction Costs

Very low

Moderate to high

Accessibility

Anywhere with an internet connection

Limited to the financial institutions’ capabilities

Customer onboarding

Within minutes

Longer than 24 hours

Permissionless

 

No permission access DeFi protocols

Long-drawn out applications processes, including FICA, credit approvals etc

 

Although DeFi offers ordinary people the ability to transact globally, 24/7, 365 days a year, the majority of consumers are years away from adopting this technology in their everyday life. However, given the efficiencies and low transaction costs, it’s highly likely that cryptocurrencies linked to protocols will continue to appreciate over time, the question is which protocols will be the next Goldman Sachs of the DeFi world.

Quick Polls

QUESTION

A recent discussion on the ‘successful intermediary of tomorrow’ offered some tips to help financial and risk advice practices to thrive through 2022 and beyond. Which of the following do you think will give your practice an edge over the competition?

ANSWER

Achieving cost and scale through digitalisation
Offering customisable product solutions to meet customers’ unique needs
Specialising in one advice discipline only
All of the above
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