Decentralized finance refers to a financial system that merges the services offered by traditional banks with next-generation technologies such as blockchain and cryptocurrency.
With these unique foundations, DeFi is able to serve the needs of businesses and consumers, giving them access to credit, savings and checking accounts, trading, interest generation and more, all without the involvement of a centralized third party.
The popularity of DeFi has grown fast and today it offers competing services for almost every facet of the traditional banking sector. One reason is that DeFi helps people living in remote areas access money and credit through a secure and trusted medium. It has also created new and unique opportunities for people to make a profit that they cannot make elsewhere.
One of the biggest challenges with traditional financing is access. In order to open a bank account, a person must provide official identification. To be approved for a loan, one must have appropriate credit history, income, and other requirements. This individual may have a lump sum of cash needed to cover this loan, but will not be approved if they do not meet the bank’s strict requirements. For anyone deemed eligible by their bank, that means they are out of luck.
Being without a bank account is uneconomical
What is shocking is that in this day and age there are billions of people around the world who cannot open a bank account due to the strict rules of the traditional financial system. A 2017 World Bank Index report suggests this is the case about 1.7 billion adults around the world who don’t have a bank account. While people living in underdeveloped countries make up the bulk of this number, there is an alarming number of unbanked people living in developed countries who also do not have access to a bank account.
Admittedly, not many people enjoy working with the bank. They cause a lot of headaches and make a lot of money from their clients, but very often not having a bank account is worse for someone’s financial health. Without a bank account, people cannot perform financial transactions that many take for granted, like cashing a check, saving money, and getting a loan. They are forced to carry cash everywhere and bear the risk involved, including higher fees.
For example, in the US, only 40% of adults hold a passport, while only 75% hold a driver’s license. As a result, many people there lack the ID to open a bank account. According to the FDIC, about 25% of American households are either without or with insufficient bank details.
From an economic point of view, this can have devastating consequences. Although prepaid cards have reduced the impact, about 70% of US payroll is still with paper checks. Those unable to deposit this into a bank account are forced to use a check teller service that charges heavy fees for the privilege of turning it into cash. Given that most unbanked people tend to be in the lower income bracket, these fees can eat up a large chunk of their income.
Those unbanked in the US are also subject to more predatory lending practices. While someone with a bank account and a good credit score can borrow at around 3% to 6% interest, those forced to rely on so-called payday loans can pay something between 300% and 400% to borrow much-needed cash.
Meanwhile, in the developing world, the ability to emerge from financial difficulties is closely linked to access to affordable credit. In South Africa, access to credit can: a Dramatic twist on a person’s economic prospects by allowing them to borrow money to buy farmland and grow crops, buy a car to commute to work, or pay for an education. But for many, that’s a non-starter as they don’t have access. Very often, not having a bank account creates financial inequality at worst and can have a devastating impact on people’s quality of life.
How DeFi can make finance more accessible
The reason so many people are unbanked is primarily due to systemic issues within the traditional banking industry. Banks are for-profit institutions and they have a financial incentive to make their services available to anyone who can afford them. At the same time, banks are discouraged from offering their services to people without ID and credit.
Since decentralized finance eliminates the middleman and instead relies on blockchain technology, it can facilitate transactions between two parties in a secure and very cost-effective way. Traditional finance has significant barriers to entry, such as: For example, their costly fee structure and ID requirement, while DeFi does accessible to everyone with a smart phone. DeFi also requires little infrastructure. While a bank would need to build a physical branch to make its services available in remote regions, all that is needed to access DeFi is a basic WiFi service. Additionally, DeFi can operate 24/7, unlike traditional banks that only open their doors from 9am to 5am. This means transactions can be made at any time and are processed much faster than traditional financial transactions. Since DeFi is automated, transactions are also much cheaper. So while DeFi offers many of the same services as traditional finance, it is also vastly superior in many aspects.
These characteristics make DeFi accessible to everyone without the need for a bank account, KYC checks or other proof. Combined with the transparent rules enforced by smart contracts, this creates new opportunities for non-banks to tap into the global financial ecosystem.
Besides simply depositing and saving money, people can use DeFi products to send money to other countries get a microcreditor engage in micro investments and create a passive income stream. What is particularly clever about DeFi is that the infrastructure reduces the risk of these investments, such as e.g. B. providing capital for a loan, is carefully distributed among several investors who fund it so that nobody has to take on all the risk.
DeFi is therefore particularly attractive to an unbanked entrepreneur in a developing country, as they can use its services to get funding for their burgeoning business from investors around the world.
Why regulation will be the enabler
DeFi’s potential is clear, and yet at this point it still has its shortcomings. One of the biggest challenges is the lack of regulation – a problem that discourages many investors from getting involved in DeFi ecosystems.
A lack of regulation is often associated with a lack of security, and there have certainly been a great many incidents within the burgeoning DeFi sector. In most of the published security incidents, investors lost money due to problems with smart contracts, validators, or other issues. Some recent examples include the violation of the mirror protocolresulting in $90 million in lost user funds, or the Saddle Finance smart contract exploit that resulted in another loss of $11 million. Then there are also exit scams like BreedTech, where the founding team simply $9.4 million stolen of the early investor’s money. The big problem with such incidents is that there is no way for investors to recover their funds once they have been stolen, and there will be no way until DeFi becomes more regulated.
Therefore, there is much hope for projects such as phree, an emerging decentralized and compliant liquidity ecosystem that aims to bring regulation to the DeFi space. What Phree aims to do is bridge the gap between DeFi and compliance in traditional finance, to make it more attractive to the massive amounts of liquidity held by institutional investors and banks.
As Phree points out, while DeFi’s growth has clearly demonstrated its potential, it will only achieve its ambitions of banking the unbanked if it can tap into mainstream funding. But that won’t happen unless issues related to risk, security, fraud, price manipulation and the lack of KYC and AML are addressed.
Phree promises to solve these problems with a compliant DeFi ecosystem-as-a-service platform and a licensed asset manager that can create permissionless and transparent protocols that will attract mainstream investors. It has also made great strides, working with partners like Parity Technologies, the company behind the Polkadot blockchain, PwC Switzerland, and Mastercard to prepare for the launch of its platform in 2023, which will include its own regulated asset-backed stablecoin.
By building a compliant DeFi platform, Phree hopes to be able to answer questions about what happens when theft occurs as a result of smart contract vulnerabilities and fraud, and give users more peace of mind. At the same time, regulation will reduce the frequency of rug pulls as non-compliant DeFi protocols will struggle to attract investment.
While many continue argue against compliance and regulatory control In DeFi, which claims implementation is impossible due to its decentralized nature, there is in fact always an entry or exit ramp to traditional finance somewhere. Therein lies the opportunity, and that’s where companies like Phree are developing solutions.
For DeFi to go mainstream, some sort of regulation is both desirable and necessary. DeFi represents the best hope for millions of unbanked people to gain fairer access to finance and improve their financial prospects. That alone is reason enough to do what is necessary to ensure DeFi fulfills its potential.