DeFi is evolving so fast that information can become outdated within hours rather than days. No country in the world has yet fully formed a legal framework for decentralized finance, and new rules are constantly being introduced and existing ones clarified, which can noticeably influence existing trends. The spring of 2022 has been a challenging time for DeFi: the market capitalization has declined sharply, and some of its established foundations have been shaken. No one knows yet with what losses or acquisitions DeFi will emerge from this crisis and what it will look like in a year or two. The most recent and reliable sources of information at the time of publication were used in the preparation of this article.
There are still roughly 1.7 billion people on Earth who are not covered by financial services. And many of those who are formally considered bank customers cannot get a loan or open a deposit. Why not? Because they are not of interest to traditional financial institutions. Decentralized Finance (DeFi) gives these people and organizations the opportunity to access financial services and therefore become customers of a DeFi-based business.
Let’s imagine a budding entrepreneur. He has created a startup with 20% profitability. He needs a small business development loan. To get it, the financial institution needs to spend as much effort as it would for a large borrower, and it will make much less profit. It is much easier and more profitable for a bank to spend assets on credit cards, where the interest rate is often higher than 20%, and there is less hassle than with startups. Besides, the demand for credit cards is still very high: the need to borrow a small amount of money before the paycheck has not disappeared. Add to that the fact that our young entrepreneur can live somewhere in a village in Bangladesh or on Easter Island, that is, he is limited by the offer that the local financial institutions provide. As a result, the banks will not get him as a client, he will not find a lender and will not start his business – he loses, the financial sector and the economy.
It is clear why our humble entrepreneur is of no interest to banks, but why does he qualify for DeFi? Firstly, for decentralized finance, it does not matter what country the client is in (attempts to close access to resources for residents of certain territories turn into the appearance of applications that allow to bypass these bans), it does not matter how trustworthy he is.
A token is a unit of account that has a value and is intended to represent a digital balance in some asset. Tokenization is the process of replacing valuables (money, stocks, and others) with tokens that reflect those values.
The ERC-20 standard defines a set of rules necessary for a token to be accepted on the blockchain network. ERC (Ethereum request for comments) is the official protocol for making suggestions to improve the Ethereum network. 20 is a proposal identification number. Tokens meeting this standard are called ERC-20 tokens. ERC-20 tokens exist only within a smart contract and are compatible with all services that support this standard. ERC-20 tokens can be used as cryptocurrency, project shares or a certificate confirming ownership of assets.
Security tokens are securities: stocks, bonds, physical assets and often provide the holder with a stake in a particular commodity. Security tokens are often used to raise funds.
Utility tokens are not backed by anything. They can be used as in-game currency, fuel for decentralized applications.
Today’s DeFi lending is like a pawn shop. Let’s say you have a few bars of gold, you believe they will go up in value, and you don’t want to sell them, but you need cash. You go to a pawn shop and borrow money against your bars. At DeFi, instead of gold, you pledge tokens (the digital equivalent of stocks, bonds, or promissory notes). In this case, you don’t have to go anywhere (or sail from your Easter Island) to find a suitable pawn shop, just log on to the Internet. There is also no need to impress the owner of the “pawn shop” and prove that the gold (tokens) is your own. Thanks to blockchain, tracing its path is not very difficult. Instead of a normal contract, you enter a smart contract. This is nothing more than computer code prescribing the sequence and conditions of transactions on the network (if event A occurs, event B must occur). For example, a smart contract will require you to increase the collateral if it falls in value. If you ignore this demand, it will automatically trigger the sale of part of the collateral or even liquidate your wallet if you get completely out of hand.
It is a continuous chain of blocks of information about transactions in which, thanks to special technology, previous entries cannot be changed; every participant can read the information within the blocks, but no one has the power to change or destroy it.
Since the value of collateral on DeFi sites is usually one and a half times the size of the loan, those who finance it feel secure. Because there is no need for expensive bank offices or an army of employees, the cost of services in DeFi is much lower than in the traditional banking system, they are provided faster, and they are not restricted by national or any other borders.
Of course, legal entities are not the only ones interested in DeFi. Mariano Conti, the executive in charge of smart contracts at the Maker Foundation, shared his experience with DeFi as an individual at the Devcon conference in October 2019. He lives in Argentina, a country with very high inflation – in 2019 it reached 53.8%. As such, the value of the local currency almost halves each year, and Conti asked management to pay his salary entirely in DAI (stable coin, or stabilized cryptocurrency, in this case pegged to the U.S. dollar). Argentines appreciate dollars and would prefer to keep their savings in them, Conti said, but the government restricts access to U.S. currency. Residents can buy a maximum of $200 a month. In addition, Argentines who work for foreign companies and are paid in dollars must exchange them for Argentine pesos within five days. On the black market, the exchange rate is about 30 percent higher than the official rate.