In my last post Change Just Ahead I promoted the idea that we are in the middle of a paradigm shift. The shift is happening from traditional centralized finance to decentralized finance (Defi). What does this mean and how should we think about it? We will explore these questions as well as their impact in this article.
One of the biggest changes is the implied movement of centralized currency (Fiat) like dollars or euros that live in banks, to crypto currencies like Bitcoin and Eth that live in decentralized exchanges and platforms. Money is moving out of traditional banks to decentralized applications (dApps). I will discuss dApps in more detail in another article but for now let’s explore the impact of money moving out of traditional banks to the Defi world.
For centuries, we have used centralized finance for our day to day needs like savings, borrowing, ATM, etc.. Centralized finance is defined as having central authority that controls the flow of money. Banks traditionally play this role for most of us. But not just banks, governments play a role in this too. Together they control it. They control policy such as interest rates and the volume of currency in circulation. They also control if you can borrow, how you may borrow and how much. They can even determine whether or not you can have a bank account. As an example, In the United States, many states have legalized cannabis but the money collected from those legitimate businesses cannot be deposited in banks. This is not an argument for or against marijuana, this example to illustrate the centralized nature of banks and government and how they can exercise control over many matters involving money. This also includes lending and borrowing. Let’s just say that the current model of borrowing is expensive, cumbersome and outdated.
In the Defi world, there are no banks. There is only the blockchain and the dApps that are open to anyone. The blockchain is the open and distributed ledger that records all transactions. The transactions are available on the blockchain for anyone to review. No bank or other central authority needed to perform transactions. There is only the code. The development and maintenance of the blockchain code is open and distributed. This means there is no single point of failure and it is secure.
If there are no banks, how can people save money or borrow money to buy cars or homes? First, the traditional banks are not going away any time soon. The question, however, is relevant in terms of how borrowing and lending works in Defi. To me, this is one of the most exciting aspects of Defi. First, let’s consider savings. When was the last time you saw your savings account and said WOW, I can really retire with that growth. You can save money but the growth is mainly from your deposits not from the promise of interest. Most traditional savings instruments are not designed to grow in any meaningful way. In fact, they can barely keep up with inflation. What if, instead of a traditional savings account you had a way to put your hard earned money to work as liquidity to the market and earn passive income. In that same market you could borrow using your money as collateral. Sure you pay interest for the money you borrow but remember, you have money that is also earning income.
Using simple numbers, let’s say you deposit $1000 in an account that earns you 5% APR. Let’s further say that right now you don’t need to borrow anything and because it is your new method of savings you continue to deposit $50 a month. At the end of 1 year you would have approximately $1650. Because it is compounding, at the end of 5 years you would have approximately $4500. Now, let’s say you now need to borrow $1000. Instead of withdrawing from your $4500, you instead borrow from the same platform. Your deposits serve as your collateral. In fact, one of the key differences in borrowing in Defi vs centralized lending is that in Defi a borrower must be over collateralized. So if you want to borrow $1000 you have to have $1200. While this may seem counterintuitive this over-collateralization protects everyone including you and your growing $4500.
There are many unique and very important distinctions of lending and borrowing in Defi but there are a couple I would like to call out. The first is: there is no fixed period to pay back the loan. As long as the value of your deposit position is greater than the loan, then you can borrow for an undefined period with no penalty. Over time the interest owed from the loan will accumulate but the cost for borrowing in Defi is significantly less costly and less burdensome. Its less burdensome because it is self-custody, more transparent, there are no applications to fill and no waiting period. It is less costly because the net difference in interest owed is offset by the earned interest in the deposit. In other words, if you earn 5% from your deposits and the loan is 6%, the net difference is 1%. The second important distinction is that you don’t have to decrement from your nest egg. Your capital keeps growing, earning interest. You are in fact operating as your own bank.
There are many Defi platforms offering different services, not just lending and borrowing. I encourage you to do your own research and begin to understand how Defi is not just reshaping but replacing our entire traditional centralized financial system.
