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Defining Decentralized Finance (DeFi) - Part 1

Defining Decentralized Finance (DeFi) - Part 1

<style type="text/css"> .title-defi { text-align: center; } .h6-heading { text-align: center; margin-bottom: 30px; font-size: 20px; font-weight: 700; color: #002d9c; margin-top: 15px; } .sub-heading-defi { text-align: center; color: #002d9c; font-size: 26px !important; font-weight: 700 !important; } .sub-heading-defi2 { text-align: center; font-size: 26px; margin-top: 30px; margin-bottom: 35px; font-weight: 700 !important; } .h6-heading { text-align: center; } .defi-img { width: 100%; } .center-defi { display: flex; justify-content: center; margin-bottom: 20px; } .cards-defi { display: flex; flex-wrap: wrap; justify-content: space-around; } .cards-defi img { width: 55px !important; } .cards-defi > div { display: flex; flex-direction: column; justify-content: center; align-items: center; width: 40%; margin-bottom: 40px; background: #eff1f9; padding: 75px 45px; box-sizing: border-box; text-align: center; box-shadow: 25px 20px 20px 0px rgb(0 0 0 / 10%); } .icon-box-defi { display: flex; align-items: center; margin-bottom: 40px; box-shadow: 25px 20px 20px 0px rgb(0 0 0 / 10%); background: #f2efe9; padding: 35px 25px; } .icon-box-defi-icon img { padding-right: 20px; } .icon-box-defi-content p { margin-bottom: 0; } .icon-box-defi-content h5 { margin-top: 0; font-weight: 700; margin-bottom: 22px; font-size: 22px; } .icon-box-defi-content { border-left: 3px solid #d5d6d6; padding-left: 20px; } .h5-defi { font-size: 26px; text-align: center; font-weight: 700 !important; margin-top: 80px; margin-bottom: 50px; } .cards-defi p { font-weight: 700; margin-bottom: 0; margin-top: 10px; } h3.conclusion { font-size: 26px; text-align: center; font-weight: 700 !important; margin-bottom: 55px; margin-top: 55px; } @media (max-width:500px) { .sub-heading-defi { text-align: center; color: #002d9c; font-size: 18px !important; font-weight: 700 !important; } .sub-heading-defi2 { text-align: center; font-size: 18px; margin-top: 0; margin-bottom: 35px; font-weight: 700 !important; } .icon-box-defi { flex-direction: column; } .icon-box-defi img { margin-bottom: 25px; } .icon-box-defi-content { border-left: 0; padding-left: 0; } .h5-defi { font-size: 18px; } .h6-heading { font-size: 16px; } .cards-defi > div { width: 100% !important; } .cards-defi p { font-weight: 700; text-align: center; } } </style> <h3 class="sub-heading-defi">Part 1: Financial Transactions: The Two Eternal Bugbears</h3> &nbsp; <h4 class="sub-heading-defi2">Back in early 20th century:</h4> <div class="content-defi"> Let us do a thought experiment. Turn the clock back a hundred years, and imagine you want to make a big-ticket purchase in the Christmas Season of 1921 – say a car. Since your monthly salary isn’t enough to make a one-shot payment and you haven’t saved enough to pay for a car in full, what would you do? Credit cards are still thirty years away in the future. Ideally, you would go to the car dealer (most likely someone who sells Ford), sit with their finance associate, figure out an instalment credit plan with them, and hand over a ton of documents verifying your tax paying ability, provide a letter of authentication from your bank – and wait for a few days before you were notified whether your instalment credit plan was approved. </div> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73ce42fee66881fc3701_HD_M280_02_02.png" alt="Hero Image" /> <p class="content-defi">Buying insurance, applying for a loan, trading financial instruments, sending remittances, collecting payments, whatever form of financial exchange one chose – intermediation in the first half of 20th century was a Byzantine process, and hence limited to highly trusted parties. One shopped with the retailer who gave them a credit plan; one stuck to the same broker (no matter the brokerage) or hardly traded at all; one sent remittances abroad through relatives or friends; or depended on a Kafkaesque chain of collection and factoring agents if one was exporting goods. Fundamentally speaking, solving for any financial transaction, either at retail or B2B level needs the resolution of two problems:</p> <div class="center-defi"> <ul> <li>Authorization</li> <li>Interchange</li> </ul> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"><img src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b71cd600a251791df9d20_document%20(1).png" alt="Icon Image" /></div> <div class="icon-box-defi-content"> <h5>Authorization:</h5> <div> <p> What is authorization? When two counterparties exchange assets and liabilities, they need to be certain that each party (seller and buyer) has the ownership and possession of the item that they are exchanging. Buyer of an insurance needs to be certain that the seller of the insurance has a genuine license to sell it and honor their obligations. While buying a house, the buyer needs to certain about the ownership of the title deed of the house in the name of the seller.</p> </div> </div> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"><img style="padding-right: 10px;" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b71cdf41e1f63948c301c_trading%20(1).png" alt="Icon Image" /></div> <div class="icon-box-defi-content"> <h5>Interchange:</h5> <p>The challenge of interchange is – whatever is transacted (a remittance, a loan) is settled for in a satisfactory manner. That is, at the end of the transaction, the counterparties get what they wanted to, in the fastest, cheapest, most accessible, most accurate, and the least cumbersome way. That is, if I want to send money to a friend living abroad, I can find a FX payment service provider that allows me to do it the fastest, with the lowest fees, with the largest network [ Annotation] of partner banks and currencies, with a low failure rate and with minimal paperwork.</p> </div> </div> <h5 class="h5-defi">How did centralization helped in solving these two problems?</h5> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c9bf004553ff6e0270_Group%203507.png" alt="Laptop Image" /> <p class="content-defi">Beginning with the 1970s, as the age of computing and internet dawned, the solution to the problems of Authorization and Interchange was centralization. For instance, if you are a small merchant in Singapore worried about accepting payments from tourists from all over the world, Visa will help you manage it. Or if you are a retail bank fighting for market share in consumer loans segment in India, you can quickly look up credit scores and perform KYC by accessing a centralized Aadhar and Income Tax database. Until just about five years ago, the ideal model for simplifying financial intermediation was for a private company or non-profit to invest heavily in building a software and cybersecurity infrastructure, act as a central repository of records and provide a large network of third-party clients authorization, and interchange services at scale. Visa, Mastercard, SWIFT, Depository Trust and Clearing Corporation and NYSE- all these had business models which were successful manifestations of this same basic blueprint. However, over the last 3-4 years, with the maturation of blockchain technology, an alternative has emerged to such centralized financial intermediation business models – called Decentralized Finance or “DeFi”.</p> <h6 class="h6-heading">DeFi proposes to create a system in which the core functions of financial intermediation can happen without a centralized counterparty i.e.,</h6> <div class="cards-defi"> <div> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c842fee6365efc36d9_credit-card.png" alt="Icon Image" /> <p>Credit</p> </div> <div> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c85f9d07ebcf72a5cb_payment-method.png" alt="Icon Image" /> <p>Payments</p> </div> <div> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c8801ad15df454c0c3_insurance.png" alt="Icon Image" /> <p>Insurance</p> </div> <div> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c8b7b0f00bf50dc46a_trade.png" alt="Icon Image" /> <p>Trading</p> </div> </div> <h6 style="margin-top: 45px;" class="h6-heading">In the “DeFi universe” there are so many possibilities one can explore:</h6> <div class="cards-defi"> <div> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c6cf61265596dc86ad_borrow.png" alt="Icon Image" /> <p>Borrow without banks</p> </div> <div> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c828711414a52a45d1_cryptocurrency.png" alt="Icon Image" /> <p>Trade without a centralized exchange</p> </div> <div style="width:80%;"> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b73c83ad917e444a27dac_global-network.png" alt="Icon Image" /> <p>Send money anywhere without relying on a nodal infrastructure provider like SWIFT. </p> </div> </div> <h3 class="conclusion">Conclusion:</h3> <img style="margin-bottom:50px;" class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b7764f935431a12751450_coin.png" alt="Coin Image" /> <p class="content-defi">DeFi has emerged as a natural use-case of programmable blockchains, which were pioneered by Ethereum in 2015. A programmable blockchain allows triggering of an action based on certain rules, only when specific conditions are met (the programmable part), while maintaining the immutability of record on a distributed ledger (the blockchain aspect). These rules are agreed upon by a consensus of distributed actors (nodes in the blockchain parlance), which make it possible for a decentralized system to act as a financial exchange, payment processor, lender or authenticator, with lesser need of capex outlays for a centralized IT infrastructure. That said, DeFi is yet to prove its eligibility as a substitute for centralized IT infrastructure for finance at scale and continues to raise profound ethical issues around distribution of information and control in any institution. We will explore these aspects of DeFi in the upcoming parts of this series.</p>

By

Shailesh Jha

December 6, 2021

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