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Do DeFi platforms need TradFi experience?

12 Jul 2022 By : Sudeep Saxena
Southeast Asia’s Lar

In recent years, cryptocurrencies have offered customers and businesses new ways to manage money. Now, this transformation is coming for banking, as established firms and startups based on cryptocurrencies are entering the market.

Decentralized finance (DeFi) is gaining popularity as a tool for small businesses in emerging markets, particularly for money transfers and small loans; the transaction banking sector is starting to recognise DeFi's potential to change the rigidity of current processes and the adoption of DeFi in transaction banking could create new capital opportunities for larger businesses and increase liquidity for SMEs(small and medium-sized enterprises.

Decentralised finance experienced a resurgence as a large number of people are already accepting cryptocurrencies like Bitcoin and Ethereum as payment methods, and the stablecoins such as USD Coin (USDC) have made great strides toward becoming a valuable asset that won't lose value in the future.

At the same time, the financial infrastructure that supports cryptocurrencies and the blockchain technology that powers it are on their way to providing a system of rails that runs parallel and are interconnected with traditional financial infrastructure.

Why DeFi?

DeFi maintains financial transactions in a decentralised manner in computer code. Through DeFi platforms, this network is constant for stakeholders. Decentralized Finance transactions are constantly encrypted, ensuring their security and ownership. Contrary to conventional financial systems, ownership in this case is always verified through blockchain and cannot be changed.

Two essential components are missing from traditional banking: a one-to-one exchange with fiat money and interoperability between various blockchains so that counterparties can easily communicate with one another. Cryptocurrency needs the former to provide a reliable store of value that can be used as money and have a user-friendly interface with the established financial system. For transactions to take place at scale in the extremely fragmented blockchain landscape, interoperability is essential.

Two recent DeFi developments have significantly reduced two of these gaps. First, there are an increasing number of stablecoins that are tied to the US dollar, including USDC, USDT (Tether), BUSD (Binance), and Dai (Maker). It is simple to switch from one USD-backed stablecoin to another due to programmes like Curve and reliable cryptocurrency exchanges. Second, for both public and private blockchains, interoperability protocols and the Inter-Blockchain Communication protocol have been made available.

DeFi was initially developed as a transparent ecosystem that aimed to get rid of fees, decentralise ownership, and offer a strong replacement for the existing financial system. In the DeFi industry, innovations and capabilities appear to emerge daily.

However, there is still a lot of space for the development of DeFi, which is still gaining momentum. 

Improvements required in DeFi

DeFi is a new and revolutionary technology with some flaws, particularly in terms of security. Decentralized finance issues can eventually be resolved by taking the experience of the Traditional Banking system. In reality, it can be difficult to enter DeFi without utilising CeFi.

DeFi regulations are not well defined, which causes some current inefficiencies that do not exist in the traditional system. In traditional systems, an entity serves as the primary process decision-maker. In the instance of DeFi, a public blockchain serves as the primary means of process governance, with smart contracts controlling transactions. Only significant stakeholders may change such contracts; other parties are not permitted to do so. Last but not least, traditional finance is now very regulated and has significant entrance hurdles. On the other hand, DeFi is just getting started and strongly supports innovation from stakeholders.

The crypto-economy must reach out to the vast majority of retail consumers and be able to offer them financing choices if it wants to expand to a size that is compatible with any real economy. As of now, Defi lacks regulation and legal compliance.

Here are the key elements that must be developed before the infrastructure for cryptocurrency banking can compete with that of banks.

Credit Score system

For many years, the foundation of risk assessment in the international financial systems has been credit scores.

In the current crypto lending market, customers can borrow any cryptocurrency without having their credit checked as there is no credit score system. This is due to the loan's excessive collateralization with a closely watched loan-to-value (LTV) ratio. As soon as the LTV surpasses the liquidation LTV level, the collateral will be liquidated at a discount to recover the loan. In the event of a sharp decline in collateral value, there is always a significant buffer put aside, and the collateral value is never fully utilised.

Whereas, in traditional banking, a customer's credit score is determined by their past transactional behaviour and financial situation, including their annual income, savings, loan repayment history, and investments.

Since anyone can create as many wallets as they like anonymously in the cryptocurrency loan market, this is practically impossible. Due to this, it is quite challenging to follow transactional activity and develop a credit score.

To change the current structure, users must be rewarded for keeping a thorough record of all their transactions and being loyal to their wallets.

As more jobs are created in the cryptocurrency industry and more people are paid in cryptos, wallets that have a long history of healthy behaviour, such as a steady stream of cash inflow, a persistently stable balance, or timely repayment of a crypto loan, should be rewarded. The incentive could come in the form of getting access to bigger loans with cheaper interest rates, getting access to loans with longer terms, or even in the form of airdrops of governance tokens.

Most significantly, a credit scoring system could support the development of a vibrant, transparent market for cryptocurrency loans and draw more users to the crypto-economy.

Range of products and services

One of the most common queries from newcomers seeking to enter the crypto-economy is "what can I buy". There isn't much in the infrastructure right now besides NFTs, DeFi products, staking, and liquidity provision.

In a traditional economy, currencies perform the function of enabling transactions of goods and services because trading things for services or vice versa typically does not have a 1:1 ratio. In the crypto economy,  currencies exist before products and services are readily accessible to customers. Because of this, cryptocurrencies are unstable and difficult to judge.

For consumers to be able to utilise currencies to exchange for these products and services, and economy must have enough goods and services accessible to generate a sufficient supply and demand. It is very difficult to get an average Person into the economy when the only financial goods available to them are NFTs and DeFi, as there is just not enough for them to consume.

A strong and efficient banking system also depends on an adequate supply of liquidity from client deposits and a strong enough demand for borrowing from consumers. The banking system will be able to use more digital commodities and services, particularly non-financial ones like art, music, real estate, or gaming equipment in the metaverse, as collateral to offer a variety of secured loans.

Customers in the cryptocurrency world will be able to own these things by making recurrent payments in the future, much like with loans or mortgages.

System for collateral evaluation

Because of cryptocurrency's extreme volatility, the collateral value needs to be evaluated more often than in a traditional bank loan. The collateral in the crypto world, such as NFTs or cryptocurrencies, could experience abrupt downward fluctuations in just one day, as compared to natural collateral like cars or houses, whose values are more predictable and do not shift substantially during a short period. As a result, lending platforms must have reliable algorithms for evaluating collateral that can constantly determine the market value of any asset.

Evaluating the market value of NFTs or cryptocurrencies minute by minute is not that difficult. However, having a high-frequency collateral evaluation system can be expensive as more products and services enter the crypto ecosystem and more types of assets become acceptable as collateral.

Instead of using a high-frequency collateral evaluation system, lending platforms can develop something similar to the idea of risk-weighted assets (RWA) in the banking industry to provide higher risk weights (lower liquidation LTV criteria) to riskier collateral and less to safer ones.

User experience

The primary goal of bitcoin and blockchain was to create a decentralised financial system, however, sometimes that system isn't as decentralised as it should be. The likelihood of fraud is significantly reduced by decentralisation.

“Sushiswap” was a DeFi project. On September 5, 2020, the Sushiswap project's anonymous founder will convert all of his Sushi tokens to ETH. After the SUSHI token branched from the Uniswap protocol, its value increased, but it later decreased. This gave us an illustration of how a single point of failure is still conceivable in DeFi.

Freedom comes with a lot of responsibility. Even if DeFi is risk- and problem-free, it wouldn't be accountable for your errors. DeFi shifts accountability from intermediaries to end-users. In the DeFi space, developing some solutions to prevent human errors and blunders is crucial because if you lose your money accidentally, no one will be liable. Many users are not familiar with carrying the burden of themselves in this way, which can result in their losing money or falling victim to scams.

When it comes to traditional banking, Bank is the central authority accountable for any errors. If we accidentally lost money, the banks are liable.CeFi banks usually verify transactions to make sure that money is flowing where it is supposed to. Since they are centralised, they have processes to reverse transfers or address issues.

Resolving these issues might be more difficult for DeFi in comparison to a CeFi bank, which is more likely to have a customer support team to assist you

DeFi and cryptocurrency wallets need to be protected with private keys just like your bank account. The issue is that there is no way to get your money back if you lose your private key. To know more about the significance of Defi in Crypto wallets read our Blog on the Role of Defi Crypto Wallets in Decentralization of Crypto and NFTs.

Conclusion

Innovation and technology have propelled economic advancements throughout history and the potential of cryptocurrency technology is enormous.

When more goods and services are made available in the crypto economy, a reliable credit scoring system and an actively managed collateral evaluation system will enable the crypto banking infrastructure to provide more financing choices in addition to token-collateralized loans.

Prospects for cryptocurrency financing are reliant on the types of products and services offered by the crypto economy, and they can only compete on a level with the scale of conventional banks until the crypto economy develops into a more varied and consumer-friendly marketplace.

In short, both industries are required to create a comprehensive ecosystem. The future of finance will be shaped by both traditional and decentralised finance.

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