While many people still view cryptocurrency with some scepticism, the use of blockchain within certain industries and for specific processes has gained general acceptance. One of the offerings of blockchain that has attracted much hype is Decentralized Finance
(DeFi).
While the adoption of DeFi has not reached the heady heights that were predicted for it in 2019, there is a steady increase in all slices of the financial sector pie, experimenting and using Ethereum and Dapps (DeFi apps) that are already available to build
one or more financial applications.
From small startups to behemoths like Barclays and J. P. Morgan, DeFi is providing a ready platform for getting things up and running swiftly. This is because it is really simple to engineer an MVP (minimum viable product) using pre-existing Dapps and pre-defined
smart contracts for activities like the act of funds being transferred, and only focusing on what will be your unique selling proposition.
New Opportunities for Small and Medium Businesses
While most banks are locked into huge and cumbrous legacy systems, which make it difficult to transform, DeFi has removed many of the barriers to entry that prevented SMEs and startups from entering the market. While many institutions regard this as a threat,
some large banks have had the foresight to rely on the agility of small businesses and run incubators and accelerators to get their blockchain solutions to market.
The first challenge of joining the DeFi universe is to select an appropriate offering that will fill a gap in the target market. There are many use cases, ranging from traditional financial models, such as payments, to new instruments that have evolved because
of the capabilities of decentralized ledgers, like tokenization and stablecoins (tokens that are linked to a fiat currency, such as dollars). Let’s look at a few of the potential use cases.
Peer-to-peer Transactions and Payments
Distributed ledger technology (DLT) eliminates the need for trusted third parties, or intermediaries, like banks and agents. The approvals and processes performed by these traditional players are replaced by smart contracts. We at Itransition have seen how
this reduces costs and complexity of transacting. It may also speed up the transaction, although the high velocity of traditional financial platforms cannot be matched currently due to the mechanics of proving the validity of a transaction.
While most people still maintain fiat accounts, there is a move to using crypto for peer-to-peer payments, especially for cross-border payments, where the costs of money transfers and the time it takes disadvantage both the sender and the recipient. Acceptance
of the major cryptocurrencies by traditional retailers is also growing.
The ability to transact without an intermediary has the potential to unlock financial services for the unbanked. More recent figures for how many unbanked exist globally are unavailable, but the World Bank estimated the number of people without a bank account
to number
1.7 billion people in 2017. Part of the reason for this is that most of these people also lack an identity (over 1 billion), which precludes them access to health and educational services, as well as inability to open a bank account.
Digital Identity
The need for every human being to have a unique identity has been mentioned above. The only viable way of providing everyone with an ID in the minimum of time is via a digital ID, rather than conventional methods of issuing identity cards or physical passports.
This is why digital identity is an essential component of DeFi.
The ID2020 Alliance has been formed that supports and certifies digital identity initiatives, and solutions are being developed using blockchain as a platform, but there is still a need for more innovation in this space if the Sustainable Development Goals’
Target 16.9 is to be achieved.
Digital Marketplaces
The development of marketplaces that link buyers and sellers is one of the most popular DeFi use cases, relying on smart contracts to enable direct exchanges without having to go through an intermediary or a broker. The scope is very broad, from community-based,
localized markets that support small businesses by rewarding customers with tokens for buying local, to markets that give sellers access to global markets without being subject to brokerage from companies like Amazon and eBay. There are also special interest
markets for collectors and investors, notably in the art world.
The potential for disruption is not limited to products; services that are themselves relatively new business models, for instance, gig platforms Upwork and Fiverr, are seeing blockchain competitors like Anytask arising. The latter do not charge sellers a percentage
of their fee and can also support the unbanked in developing countries, as they pay in tokens.
The Energy and Data Marketplace
Although energy and data can be regarded as merely alternate forms of currency, the development of the smart grid and the growing need for data to power communications via mobile and other devices has made this a critical market for consumers, especially in
the developing world. The majority of these consumers rely on prepaid data and electricity, and Electroneum is a pioneer in offering top-up capabilities via an app supported by a DeFi platform.
There is also an opportunity for peer-to-peer energy trading and for consumers to sell surplus capacity back to the grid. Providers in this space are generally focused on renewable energy, in deference to the planet’s need for a carbon-neutral future. This
market is known as “DeEn” (Decentralized Energy).
Borrowing and Lending
Financial markets have traditionally made their money by the differential between interest they pay to investors and savers and the rates at which they lend this money to borrowers. Stringent credit criteria exclude many borrowers from accessing funds or require
guarantees in the form of collateral.
DLT allows borrowers who would not qualify for a loan from a traditional financial institution to access funds from one or more investors directly, with a smart contract defining and monitoring the loan. There are a variety of other models who will lend fiat
against cryptocurrency collateral and even pay interest, many of them in the mortgage market, such as BlockFi. This is a rapidly expanding DeFi domain, fuelled by the Covid-19 pandemic.
Tokenization
Originally, blockchain was all about cryptocurrency, but as the technology matures, the value of blockchain as a platform has been recognized. There are benefits to tokens beyond their use as a form of currency:
- They are fractional. With the current value of Bitcoin in the region of $23,000, a whole coin is beyond the reach of most would-be investors. However, anyone can invest in a few Satoshis, or 100 millionth of a Bitcoin.
- The design of the token and the purpose it fulfils can be tailored to fit the needs of its market.
- An Initial Coin Offering is an alternative way to raise funds for a startup, rather than approaching traditional lenders and markets.
There are still risks attached to cryptocurrencies, notably the volatility of the market. This has given rise to variations of tokens, such as stablecoins, which are linked to major currencies, such as dollars or euros, providing stability against market
fluctuations.
Understanding the Risks of Smart Contracts
While the future of blockchain looks very promising and it is expected that many current business models will migrate to the blockchain in the future, it is still a young market. At first glance, DeFi looks like a great opportunity to quickly roll out a new
financial product, but a deep understanding of the potential hazards of smart contracts is critical.
These can include:
- Incorrect structuring of the contract via inaccurate coding and/or requirements
- Insufficient cybersecurity protection to prevent hacking
- Changes in legislation. Many governments are still working out the legislation to manage the crypto market, and changes can be applied that affect the contract structure.
- Inefficient use of contracts creating unnecessary costs. While Ethereum is not the only platform to offer DeFi, it does have 80% of the market. Smart contracts use “gas” which is due each time a contract executes. This can result in unintended costs which
make the DeFi application uneconomical and as a result unattractive to potential customers.
Most organizations that have already implemented blockchain solutions now recognize the value of smart contract audit in mitigating these potential risks. Specialized smart contract auditors help optimize smart contracts and identify threats and anomalies in
the smart contract code.