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Defining Decentralized Finance (DeFi) - Part 3

Defining Decentralized Finance (DeFi) - Part 3

<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; 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} .cards-defi span ,.cards-defi p { color: black; font-size: 16px; line-height: 25px; margin-top: 20px; } } </style> <h3 style="margin-bottom:40px;" class="sub-heading-defi">Part 3: The real-world application of DeFi,<br> Are you tellin' me, this is the future?</h3> <div class="content-defi"> As we have mentioned earlier in the <a class="brand-blue" href="/post/defining-decentralized-finance-defi-part-2">previous articles</a>, the rise of programmable blockchains like Ethereum has played an important role in creating a use case that helps DeFi emulate the functions of traditional finance. <br>There are numerous DeFi applications being developed by Quants across the world, but here we discuss five that have the seen the <span class="brand-blue">greatest traction over the past few months</span></div> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/6200bb4219a334d1796e5455_Hero-defi%402x.jpg" alt="Hero Image" /> <h3 style="text-align:left;">Stablecoins</h3> <p class="content-defi">A Stablecoin, instead of being a DeFi application in the purest sense, is rather a <span class="brand-blue">gateway into the ecosystem of DeFi applications.</span> As its name suggests, <span class="brand-blue">it is a crypto coin that maintains a fixed exchange rate against a currency or a basket of currencies</span> So far, stablecoins have proven to be an attractive staging point for first-time investors in the digital asset world. </p> <h3 style="text-align:center;margin-top: 30px;margin-bottom: 30px;">Why are stablecoins gaining popularity?</h3> <div class="cards-defi"> <div><img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca3405a22d54c7198802_trading%20icon.png" alt="Icon Image"> <span>Given the inherent volatility in new cryptocurrencies as their user bases grow, stablecoins help first time users lock-in gains from trading</span> </div> <div><img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca32319ebde9bbbf6780_funds%20icon.png" alt="Icon Image"> <span>It helps users move funds between exchanges and wallets </span> </div> <div><img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca3392b74d5dd7f1577c_safe%20icon.png" alt="Icon Image"> <p>It is often perceived as safe havens (like Swiss Franc or Japanese Yen) of the crypto world when risk aversion towards crypto assets rises.</p> </div> </div> <p class="content-defi">Furthermore, using stablecoins as a <span class="brand-blue">store of value in the DeFi world</span> makes sense for crypto-focused trading desks and financial institutions transacting frequently across borders. This is because a number of DeFi exchanges do not have direct banking relationships that allow them to accept deposits and clear withdrawals instantaneously, whereas they do currently have this relationship with stablecoin issuers</p> <h3 style="text-align:left;">Lending</h3> <p class="content-defi">A number of DeFi apps are built around <span class="brand-blue">automated lending and borrowing of digital assets without the need of a credit score.</span> The motivation behind these applications is to <span class="brand-blue">democratize crypto ownership by allowing small asset owners to earn a yield on their crypto assets, and access liquiditywithout selling them. </span></p> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca34d5018119b14b7570_lending.png" alt="Icon Image"> <p class="content-defi"><span class="brand-blue">BlockFi</span>, Kraken Bank and Compound are <span class="brand-blue">prominent service providers</span>in this space. Such companies pool crypto holdings from retail clients and lend them out to market makers (hedge funds, prop trading desks) in the crypto world.<span class="brand-blue"> The DeFi aspect of this transaction comes from the pool lent out and the collateral posted against it both being locked into a smart contract.</span> For instance, if the value of the collateral falls below the minimum margin requirement, the smart contract would liquidate the borrower s position and compensate the lenders. Given the recent upswing in crypto asset prices, the demand for pooled crypto assets from market makers has been robust, and lenders through DeFi apps are earning between 5-9% interest on their crypto holdings.</p> <br> <h3 style="text-align:left;">Payments</h3> <p class="content-defi">Another potential DeFi application is in payments, where <span class="brand-blue">large banks,</span> from Europe (Santander) to Asia (Siam Commercial Bank) are <span class="brand-blue">exploring the potential of blockchain technology for global B2B payments.</span>While much smaller in scale relative to the traditional currency settlement systems such as Swift, <span class="brand-blue">blockchain based Ripple has shown a significant improvement in operating metrics when it comes to cross-border B2B payments.</span></p> <div style="margin:30px 0;"> <h4>How is enabling payments using DeFi different from the traditional mechanism?</h4> <p style="text-align:center;">Integrating payments via the DeFi ecosystem has certain advantages:</p> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"><img src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca32e330bb132b7311ef_faster.png" alt="Icon Image" /></div> <div class="icon-box-defi-content"> <!-- <h5>How does DeFi solves the problem of authorization?</h5> --> <div> <p>They are <span class="brand-blue"><b>faster</b></span> - 3-5 seconds for real time gross settlements against 2 3 business days</p> </div> </div> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"><img style="padding-right: 10px;width: 125px;" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca325861a54345be9f2b_cheaper.png" alt="Icon Image" /></div> <div class="icon-box-defi-content"> <!-- <h5>How does DeFi solves the problem of interchange?</h5> --> <p><span class="brand-blue"><b>Scalable</b></span> - 1000+ transactions per second as compared to 100 per second through conventional global cross-border payment providers.</p> </div> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"><img style="padding-right: 10px;width: 100px;" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca33ef6fd9239e5382eb_scalable.png" alt="Icon Image" /></div> <div class="icon-box-defi-content"> <!-- <h5>How does DeFi solves the problem of interchange?</h5> --> <p><span class="brand-blue"><b>Cheaper</b></span> - a fraction of a cent per transaction versus 1-4% fees </p> </div> </div> <p class="content-defi">Furthermore, another significant feature of such DeFi applications is that they use their <span class="brand-blue">utility token as a mark of trust to facilitate payments.</span> Usually in a traditional system, a bank in Thailand making a payment in the US needs to have a pre-funded destination account (nostro account) in the US to meet its obligations. However, in the DeFi paradigm, a US bank that accepts the same DeFi payment protocol will honor the payment order in utility tokens issued by the DeFi provider, meaning that the Thai bank doesn t need to lock its funds in a USD account to meet its daily forex settlement needs. <span class="brand-blue">DeFi payment protocols have an additional appeal when it comes to facilitating cross-border trades, specifically in less liquid currency crosses between emerging markets exchanging Philippine pesos for Mexican pesos for instance, without converting and reconverting back from USD.</span></p> <h3 style="text-align:left;">Banking operations</h3> <p class="content-defi">Other than its application for real time cross-border gross settlements as described above, some aspects of DeFi are also finding a <span class="brand-blue">ready acceptance in the world of conventional finance.</span> Modern DeFi protocols can inexpensively perform <span class="brand-blue">computational functions such as data reads and writes and sending messages to other smart contracts on the chain.</span> Such contracts can be potentially used for managing agreements between users, executing an action when a certain number of users agree and maintaining an immutable record of ownership.</span></p> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca340bbf7c199e0107a5_banking.png" alt="Laptop Image" /> <p class="content-defi"><span class="brand-blue">Banks in Asia-Pacific</span> such as Nomura, MUFG and Commonwealth Bank <span class="brand-blue">are already tokenizing their bond platforms</span> to utilize such functionalities of blockchain, largely to cut down on the post-trade processing in the settlement of bond and bond derivative sales. <span class="brand-blue">In asset management, banks are exploring potential applications in automated payment of dividends, stock splits and custodian services.</span> As early as 2017, banks in Singapore (OCBC and HSBC) have been experimenting with a prototype of a blockchain-based <span class="brand-blue">smart KYC platform</span> for retail customers, that records, shares and accesses customer information on a single, protected platform.</p> <h3 style="text-align:left;">Exchanges</h3> <p class="content-defi"><span class="brand-blue">Exchanges,</span> centralized or distributed, <span class="brand-blue">perform three basic functions – transaction, settlement and custody of the assets exchanged between counterparties.</span> In the centralized, non-tokenized exchanges – these functions are separate. There is a lag between transaction and settlement that involves credit and counterparty risk. Additionally, engaging a custodian for asset safekeeping, trade processing and collection of economic benefits on the inserts an element of time-delay.</p> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca34b73914d27fe69f57_exchanges.png" alt="Laptop Image" /> <p class="content-defi"><span class="brand-blue">The DeFi paradigm promises to conduct all these three functions on-chain, making the three functions instantaneous, and reducing the risks in the process.</span> As we have mentioned earlier, in the DeFi based smart contracts, what is a security token to one party, is a coin to another party. Therefore, <span class="brand-blue">exchange of smart contracts enables transaction and settlement in a single step.</span> Also, since the tokenized securities stay on chain, there is no need for a separate custodian. Furthermore, unlike a centralized exchange, a user doesn’t deal with a centralized counterparty, but rather with a pool of assets contributed by multiple users which facilitates the exchange using a pre-determined set of rules or dynamic algorithms.</p> <br><br> <div class="cb"> <p><img src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca320ea0b52f2b4c32ce_icon1.png" alt="left image" style="width:170px;float: right;margin-left: 15px;"> Different kinds of DeFi exchanges over varying levels of automation and distribution. Some, like Ox and AirSwap, need price discovery and identification of counterparty to happen off-chain, but enable execution and custody on chain.</p> <p><img src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca3209414f143b63d453_icon2.png" alt="right image" style="width:170px;float: left;margin-right: 15px;"> Others like Curve, UniSwap, Balancer and Kyber are fully automated DeFi exchanges which have algorithm driven pricing mechanisms CFMM, CPMM which ensure that price discovery happens on-chain and markets are always made.</p> <p><img src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca325861a54b2bbe9f2c_icon3.png" alt="right image" style="width:170px;float: right;margin-left: 15px;"> Two other points are relevant here. First, Coinbase and Binance, though cryptocurrency exchanges are centralized. Unlike DeFi exchanges, custody and intermediation here happens through a single counterparty that is the exchange. Second, almost all of the DeFi exchange function has focused on facilitating the exchange of digital assets.</p> <p><img src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61fcca33de71b712df57b81c_icon4.png" alt="left image" style="width:170px;float: left;margin-right: 15px;"> Progress on enabling tokenization of conventional financial assets (equities, bonds, commodities) and trading them through DeFi exchanges is in very early stages, and any accompanying procedural pitfalls in scaling DeFi exchanges up to include traditional financial assets remain unknown.</p> <p style="margin-bottom: 30px;">With the wide range of usage of cryptocurrency such as stablecoins, payments, lending and as an exchange that a user can utilize with DeFi, it presents a strong case for the world to adopt and benefit from the DeFi universe.</p> <p>But what about the challenges DeFi needs to address? More on this in our next article.<br>Stay glued! Keep reading..</p> </div>

By

Shailesh Jha

February 4, 2022

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