Adoption of permissioned blockchain is growing slowly albeit steadily in enterprises around the globe. Production use cases are increasing, as upcoming Gartner research will show, but the big bang of blockchain has yet to materialize. Value propositions still mainly revolve around process improvement rather than true business transformation.
Enter the DeFi Explosion
DeFi applications, which are mainly built on top of the public Ethereum blockchain, are surging. See DeFi Bubble still growing fast- Data from Twitter Analyst shows For now, DeFi applications are primarily the domain of cryptocurrency speculators hungry for triple digit yields. These high reward seekers tolerate substantial smart contract risk where they can lose all their money, and unfriendly user interfaces that only techno-geeks can use.
But DeFi has the potential to transform financial services and move into the mainstream, assuming regulatory frameworks are clarified and technology platforms mature. In our recent research note What you Need to Know about Blockchain DeFi we explore; the main challenges and opportunities with DeFi, and how traditional financial services players can interact with it.
What is DeFi?
DeFi unbundles the financial stack into financial primitives, such as lending, credit, indexing and payments, which can be assembled, like building blocks, into decentralized applications. When using completely decentralized applications, it is possible to avoid paying fees to banks and intermediaries when onboarding customers and managing multiparty processes
How does it Compare to the Status Quo?
When compared to the status quo — centralized financial (CeFi) applications — DeFi lowers transaction costs and improves process efficiencies. Based on open-source protocols, DeFi unleashes the creativity of global developers and entrepreneurs, who assemble financial primitives into reusable transformational applications that are not feasible using CeFi.
Trust Paradigm: DeFi vs. CeFi
With centralized finance (CeFi) you have to trust the company.
With decentralized finance (DeFi) you have to trust the protocol.
These are the two extreme scenarios, but there are many shades of gray in between, where CeFi and DeFi work in tandem. For example, DeFi can use assets issued by CeFi players, e.g., banks, in which case you have to trust the company issuing the asset used by DeFi (“DeCeFi”). Alternatively, banks may use DeFi to offer financial services to their customers (“CeDeFi”).
Figure 1 below depicts a farmer who is a member of a Food Tracking Permissioned Blockchain consortium, using multiple DeFi applications assembled from the DeFi PBC Marketplace, to get a loan to expand his crops and insure those specific crops against drought. This scenario would not be possible in traditional finance, especially if; the farmer is unbanked, only wants to insure his own small portion of a large crop area owned by multiple farmers, and wants the insurance to kick in based on automated trusted rainfall feeds in his particular geography, rather than based on manual costly audits.
Beware the Risks
Users must tread carefully. The market is immature, unregulated and young. Security risks are real from both a financial and product perspective. Smart contract hacks have resulted in hundreds of thousands of dollars of permanent losses that cannot be recovered. Six documented smart contract hacks have already taken place in just the first eight months of 2020.
Over time, risk mitigation solutions will emerge and DeFi will go mainstream. It is far too potentially transformational, with too many motivated developers creating ever-improving applications, to remain on the sidelines.