Author: Lorenzo Primiterra 

Originally published at:

What is Decentralized Finance and why is it a game-changer?

What does a bank do? What are their “essential” services? Mainly, you can lend them your money in exchange for “interest” (which most of the time is close to 0%), or they can lend you money.

These days, the term “bank” is associated with not so nice adjectives such as failure, fraud, selfishness—and, as we all know, the big recession of 2008 was caused by them. Banks like to control the economy and make bubbles even bigger, especially by lending more money than they have in their reserves. So, what would happen if one day we all want to take our money out of the ATM at the same time?

It’s isn’t just happenstance that Bitcoin was created just after the 2008 financial crash—it was a symbolic warning that something might be wrong with our current economic system, and 12 years later the majority of the structural problems from 2008 still haven’t been fixed. In fact, many of those problems have become even worse.

Let’s explore what DeFi is and how it can completely replace a bank, building it piece by piece, starting with the basics: the coins.

We are all familiar with Bitcoin, Ethereum, and the definition of cryptocurrency, but what if I told you that there is more to it? There are coins that are not so volatile, coins that are pegged to gold or stocks, and also tokenized versions of real-world assets.

The first example of this is the stable coin, a stable coin is a cryptocurrency pegged to the value of the underlying asset, like the U.S. dollar, or to a commodity’s price such as gold. Examples of stable coins pegged to the dollar are USDCUSDT, or DAI, and these coins achieve their price stability via collateralization (backing) or through algorithmic mechanisms of buying and selling the reference asset or its derivatives.

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A stable coin pegged to the U.S. dollar

Another example of a stable coin linked to a real world asset is PAXG, a coin pegged to gold. By owning one PAXG, you own a tokenized version of an ounce of gold. Coins pegged to the major US stocks are actually being developed every day.

An NFT or non-fungible token is another cryptographic asset that represents something unique. Fungibility is defined as an asset that can be exchanged for another one of the same type and when no distinction can be made between the two: 1 BTC is always the same as 1 BTC. NFT being non fungible means that every NFT is different and represents something different.

Another application is the “tokenization” of physical assets, which can now have a digital counterpart on a public blockchain. An NFT can be used to tokenize the possession of a physical asset, in order to have a public register on the blockchain. You can tokenize the property document of your car or even your house by creating a token that will replace the public registration document of these assets.

This introduction was to point out that we are moving forward to a digital blockchain-based version of the world and its assets.

Will banks still be needed in a completely digital world?

The final piece of the puzzle: smart contracts

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A smart contract is essentially a digital contract, programmed by some developer whose job is to replace what a human intermediary would do. The code in the smart contract contains the terms of the agreement and enforces the rules all within the same program, no humans required.

Smart contracts as well as their state are stored in a blockchain, so everything is transparent and not able to be tampered with. A smart contract works by checking if certain conditions are met like goods delivered or two parties that have agreed to an exchange, and then they can automate the transfer of Bitcoin, fiat money, or the receipt of a shipment of goods that allows them to continue on their journey.

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Source: Blockgeeks

Now, imagine being able to take out a loan without having to speak to anyone or even open up a bank account. How good does that sound?

Well, it’s already possible! There are plenty of platforms powered by smart contracts where you can deposit your cryptocurrencies as deposits and take out an overcollateralized loan, usually in stablecoin, immediately.

For example, if you put 10 BTC as collateral with a value of $20,000 each ($200,000 total), you can take out a loan of 100,000 USDC, which is half of the value of the BTC you deposited, without having to sell your precious coins. You will then have to repay your loan back plus interest.

Why overcollateralized?—to protect lenders from price fluctuations, because if the price of BTC drops too much, either you would need to add more collateral or you might risk being liquidated.

The other side of this scenario is to be a lender and be able to gain 6% interest on your savings deposit, without a bank, without signing anything, or even having to interact with anyone.

Imagine a tomorrow when a job contract is a smart contract, you can use it as collateral for a loan, or can put down the NFT tokenized version of your house to get a loan.

Last but not least, banks provide a way to exchange different currencies. This is already widely implemented and used in the cryptocurrency world with Decentralized Exchanges where a smart contract regulates these exchanges and an oracle checks for price fluctuations to provide more stability to the entire ecosystem.

So are banks out of business?

No, at least not today. It took more than 10 years for cryptocurrencies to get recognized by mainstream finance as a real thing, and more than 5 years to develop a decentralized finance platform, so it will take even longer for these products to be available to the average person and not only in the niche world of crypto nerds.

In conclusion, we can already see a more decentralized world as the future, giving more power to the individual person who will really own his assets and make transactions without needing any intermediaries. This future started in 2009 with the Bitcoin whitepaper by Satoshi Nakamoto and it has grown a lot since then. In this article, I tried to guess what the distant future will look like, and, in my future world, there is no place for an entity like a bank. That future will take some time to come and much effort will be required to be developed it in the best way, but it will come.