I wrote about Trust & it’s importance in the last blog post here. I’ll try to cover more on Open Financial also known as decentralized financial systems AKA DEFI. You can pickup thee term as per your liking but as much they’re interchangeable they’re also subset of each other depending on the reference that you apply.
An open system can be decentralized or centralized depending on your definition of centralization & same with openness where it could have so much high barrier to entry so it’s not truly open. Example is being a bitcoin miner where you can’t participate unless you run a very sizeable operation. Theoretically it’s decentralized but there are couple of entities that control majority of the hashing power.
Trust in finance is super important & that’s the basic of any transaction.
When you look at all the financial system around us, we believe they’re open, but they’re not regardless if they’re in developing or developed country. They’re operating more like silos. They do interact but with permission very inefficiently. If you had to transfer money from one bank to another bank in us, it’s quite doable but you’re at the mercy of bottle necks involved in every party involved in the transaction. I still have restrictions in performing multiple tasks that require branch visit. We do have SWIFT, Interac, SEPA & other systems which are comparable to protocols but they’re inefficient with no visibility into the process. There’s a reason why majority of the world is unbanked because cost of banking is high. There is an argument that unbanked don’t need a bank because they are poor but in fact they’re poor because of barrier to financial tools.
To bring down cost of banking or access to other financial tools, unbundling of the system has to be done & DeFi makes it possible. I’ll give you example of how that can be done. Right now if you look a the process of loan origination, there are mainly 3 parties at a financial institute that make it happen. They’re
- Debt Raiser
- Debt Issuer
- Underwriter
Debt issuer makes the business case for the loan, while underwriter assess & approves the risk & loan, and debt raiser finds the money to fund the loan. Though they all belong to same institutes but there is a friction between them since they’re responsible for their own departments. Now hypothetically what if all three work independently and are able to scout outside their institute, that’ll ultimately benefit the customer. Chances of success are much higher due to participation of more and more players. Now the biggest pain point here is trust. Would they trust each other now that they’re dealing with outsiders ?
That’s where DeFi & protocols become important. Now I’ve simplified it a lot, but this is how it’s supposed to work. E-Mail is based on Simple Mail Transfer Protocol
(SMTP) which is common across the globe so your interface can be whatever you like it be but for transmission it has to follow SMTP standards.
I’ve been particularly excited about Decentralized exchanges & protocols which empower small players to build interesting applications. ERC20 based tokens on top of ethereum were a success which lead to thousands of applications being built serving different used cases. While different chains don’t talk to each other at the moment, but that’s going to change in coming days.
No one size fits all and that’s the case with
financial apps too. Needs are different based on demographics so niche apps are
required to serve them well. While protocols are scary for the majority but there isn’t any neeed to be paranoid about the
utility. What percentage of people around us knows how does SMTP work. They
just use gmail, Hotmail etc.
It wasn’t possible to transact online without using a 3rd party.
Decentralized exchanges make it easy. Now we have tools to hedge, lend, borrow
that are gaining popularity on the internet as well. I am very excited about
this development because it opens up the financial world to everyone with
internet access, which is billions of us. Local, national, international all
can enjoy the tools without any discrimination.
Coming back to trust issue where I laid the importance of trust in financial transactions. Protocols make this job easy & playing field for every participant. As long as you satisfy the protocol rules, you’re in. Your app doesn’t need to have a track record of centuries or decades to participate. Rules of pedigree are broken here.
Status quo enjoys the trust, regulatory barriers & support of the top movers & shakers but soon their kingdom will be challenged. There’ll be a revolt by the millennials where they’ll move to alternative options which probably will be built on decentralized financial system which is open, non-discriminatory and fair to to every one. It’ll be a war where incumbents have to innovate, competitive to a very rare breed of smart and intelligent engineers globally who’re building tech apps to serve the customers much better. I expect majority of the incumbents to give up or find intelligent ways to build partnership & integrate into the decentralized system.
Some of these things might look alien, tails from utopia but there is serious work in progress where transactions are growing with more and more participation from community and institutes alike. Tech companies have tendency to go parabolic once they find market fit & I expect this the case here as well.