With the rate it is going, many have asked, is DeFi the future?
And yes, DeFi is the future. It is the future of fintech. There are so many reasons why it is so much better than traditional finance.
But apparently, it has a few shortcomings that prevent its complete takeover. This explains why centralized finance (CeFi) still dominates the world today.
DeFi is still fairly new. But given time, its potential is far greater than what it currently delivers.
What is DeFi?
Decentralized Finance (DeFi) is a broad financial environment composed of decentralized protocols and applications running on blockchains.
Instead of relying on centralized third parties like banks to handle financials, DeFi exploits the power of smart contracts. That way, it cannot be tampered with since no one has full control of the system.
Since it is inherently better than CeFi, DeFi will likely become the new fintech standard. And the trillions of dollars that sit on traditional finance will eventually get sucked into Ethereum. At least, that’s what most of us are hoping for.
How fintech companies became the new banks
Fintech entered the scene in the 21st century and has generated tons of excitement from VCs and the younger generation. What enticed everyone about it was the promise of lower fees, user-friendly interfaces, and less bureaucracy.
From mobile banking apps to online payment processors to peer-to-peer lending platforms, fintech managed to quickly proliferate in the market. Several fintech platforms aimed to beat the banks at their own game.
And to some degree, they have succeeded. But it turns out that instead of beating the banks most fintech companies ultimately merged with them or become banks themselves.
John Backus of the Bloom Protocol and Cognito was on point when he said that “Every fintech company is just a disguised strategic growth hack where the real goal is to become a bank.”
Do you remember a time when Binance didn’t require KYC? There was. But like every fintech company that became big enough, they had to acquire a banking license.
And perhaps there is nothing wrong with obtaining such a license. But they do come with the same regulatory constraints and red tapes that hamper banks from providing open financial products and services to the world.
And if fintech platforms were to simply transition into becoming digital banks, can they really be called innovative? Does the concept of a fintech revolution still hold true?
Why DeFi is the future of finance
It seems that DeFi just might be the missing piece necessary to revolutionize the financial services sector. DeFi platforms offer far more advantages than CeFi platforms.
And this is the reason why a lot of people conclude that DeFi is the future of fintech. And that DeFi platforms will eventually replace fintech companies.
Instead of having Paypal, Stripe, etc., we’re going to have Uniswap, Curve, etc.
Most fintech companies are centralized, and thus, have targets in which regulators can run after.
DeFi, on the other hand, is permissionless and decentralized. Nobody is in charge. Therefore, regulators and other governing bodies have no one to persecute when the financial app doesn’t go exactly the way they want.
And this brings a myriad of possibilities like never before. As government agencies can’t censor transactions, developers can innovate freely without fear of getting arrested.
Without the impediment of regulators, open financial applications could flourish allowing anyone in the world to freely access financial products and services.
Imagine a goat farmer from Bangladesh who previously had no access to traditional financial products for lack of identity records. Most of the people in third-world countries are in this situation. They can’t put money in a savings account let alone invest in the stock market.
But with DeFi, they could buy ETH with cash and participate in yield farming schemes and other services using only a smartphone. And smartphones are becoming cheaper and more accessible more than any bank account ever will.
Blockchain-based applications are inherently transparent because most of its important user information is available to the public. You can easily check any transaction data by searching through a blockchain explorer like Etherscan.
This enables users to seamlessly shop around for the best DeFi products and services. Furthermore, they could also identify risks like when a stablecoin platform is severely undercollateralized. That’s extremely difficult to do when dealing with traditional finance.
Current problems with DeFi
And of course, as expected from a nascent market, DeFi has its own shortcomings.
Most people are in DeFi only because of the yields
Most of the users involved in DeFi today are rather short-sighted.
And who could blame them? The reason DeFi is so hot right now is because of the extremely high earnings people are generating from these platforms.
Protocols like Balancer, yEarn, Compound, etc. have attracted hundreds of thousands of users to their yield farming schemes. Some of the interest rates could add up to 100% beating any CeFi products available on the market.
The thing that concerns visionaries and developers is that they know this won’t last.
Overly high interest rates are here for the time being but there’s no way that they could be significantly higher than traditional finance forever. That would violate the laws of economics.
Unfortunately, as Vitalik points out, it’s the “most boring” parts of DeFi that bring the most value. The fact that anyone in the world can access a tokenized US dollar with an interest rate that matches inflation is already a big deal.
And we already have that. We just need to improve.
Ethereum needs to scale
Ethereum scalability is a hindrance to DeFi simply because the gas fees are high when the network becomes too crowded. Right now, Ethereum can do about 14 transactions per second (tps). With thousands of cryptocurrencies and dapps running on it, gas fees can skyrocket.
As DeFi exploded in popularity, gas prices started to rise again recently. This needs to be addressed quickly.
The most promising scaling solution is Ethereum 2.0 as it would allow the network to scale to 100,000 tps, thereby, eliminating all conceivable scaling issues. The problem is, it won’t be ready for a couple of years from now.
Luckily, we do have a short-term fix in the form of off-chain solutions. Protocols like ZK and Optimistic Rollups enable Ethereum to scale to around 1,000-3,000 tps. And they are already here.
The problem now is that not all DeFi apps, or most apps in general, have adopted it. But some already have like Uniswap for instance.
The more Dapps adopt off-chain protocols, the less congested Ethereum becomes. And a less congested network equals less gas fees.
DeFi may have some obstacles in the way, but none of them is a serious hindrance to reaching its full potential. In time as gas fees become cheaper, people can participate in DeFi with lesser fees. This gives them larger profits and more incentive to stay.
Users may be drawn to DeFi because of the yields, but they will likely stay once they realized that it’s just so much better than CeFi.
And although the high yields won’t last forever, the real value of DeFi, which is an open financial ecosystem, will remain. And that’s what matters.
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