This year, decentralized finance has become a hot topic in crypto communities. As protocols become more available, activity and volume in the DeFi space are beginning to increase. Consensys has found that the amount of Ether locked on DeFi platforms has increased significantly since the release of Compound. This is in contrast to the rest of the year, where activity was fairly stagnant.

People have been talking a lot about DeFi tokens recently, as they have been doing better than Bitcoin on the price charts week after week. Compound’s COMP token soared 233% in value in its first week of trading, while Aave’s LEND token has seen a staggering 1000% increase in just three months. This comparison is between decentralized finance and centralized finance. Both centralized and decentralized systems have their advantages and disadvantages, so even if DeFi becomes popular, both types of financial products and services will still be available.

Here is a closer look at some of the advantages, disadvantages, challenges and problems of each counterpart of the financial world — traditional banking and decentralized banking. This talk will focus on decentralized lending and borrowing, which is currently one of the most popular applications for DeFi in terms of volume/value locked. This specific application has, in a sense, sparked the hype around the larger concept of DeFi.

What is DeFi and traditional finance?

Decentralized finance, or “DeFi,” is a set of financial services and products built on top of blockchain technology that aim to provide users with the same services as traditional financial institutions, but without the need for a centralized third party. Users provide financial counterparts for each other without any middlemen being involved.

There are many financial products available through decentralized finance (DeFi), including lending and credit services, decentralized exchanges, stablecoins, insurance, payments, and custodial services. However, the popularity of DeFi is mainly due to the fact that it is the first application of its kind. DeFi protocols have the ability to learn from each other and evolve, which is one of the reasons decentralized finance is moving quickly, according to Jon Jordan, communications director of DappRadar. He told Cointelegraph:

” One of the benefits of DeFi is that it runs on an open permissionless blockchain, which allows dapps and tokens to be interoperable. One dapp can come up with a new feature and then other dapps can integrate that into their product without asking permission, for example, flash loans. The interoperability of different platforms has been the reason for the recent explosion in yield farming.

These services differ from traditional banks in a few ways, some of which may be seen as good or bad. Although these lending and credit services may appear to be similar to each other and to the centralized services they are based off of, the way each one works is often quite different from traditional services.

DeFi runs without a central authority?

There are different types of lending and credit platforms within the DeFi space. Most of these platforms make use of the Ethereum blockchain. The following projects all involve users borrowing and lending to each other without any central entity. Each project employs different strategies to make this possible. You don’t need to fill out Know Your Customer identification or paperwork. There is less bureaucracy and control than in a traditional lending system, but it still provides some security for the lender. Stani Kulechov, CEO of Aave, told Cointelegraph:

DeFi’s main advantages are that it is open to everyone (no KYC, credit score, etc.), the same rules apply to everyone, liquidity is global (you can access the market from anywhere and anytime as long as you have an internet connection), and it is non-custodial so you have full control over your money and can use it however you want.

Lenders can provide liquidity to Aave by depositing Ether or ERC-20 tokens into a pool contract. The funds deposited can be used to earn interest or as collateral to borrow an asset. By using this method, users are able to get a short-term credit line for stablecoins or other tokens without having to get rid of their assets.

Meanwhile, with MakerDAO, users can get the stablecoin Dai by putting up their ETH as collateral, though users must deposit more ETH than they want to withdraw, at a rate that can change. The ETH held in the system creates stability for Dai and prevents it from being affected by wild swings in the price of ETH.

Lastly, Compound uses a similar model as Aave, although it has a fairly unique reward mechanism. This mechanism has led to the creation of yield farming, where governance tokens are rewarded to lenders and borrowers on top of the given interest.

The interest rates for DeFi protocols can be quite high, sometimes reaching double digits, whereas banks usually offer less than a 1% return on deposited funds. Furthermore, traditional finance requires documentation and credit scores. However, traditional finance also allows for different types of collateralization, especially with different assets such as homes. Tokenization could allow houses, or parts of houses, to be plugged into a DeFi protocol in the future. However, this is still just a theory at this point.

Defining Institutional DeFi:

Firstly, and for the purpose of this series, I would define ‘Institutional DeFi’ as:

A. Crypto Native Businesses

Organizations that are already involved in cryptocurrency and are heavily invested in it are likely to be “underbanked” in a traditional sense. Due to how new they are to cryptocurrencies, they are unable to access typical banking and financial services such as lending and borrowing. Furthermore, navigating between a fiat currency and cryptocurrency world is difficult for them.

e.g. . DApp startups, companies that provide middleware services, crypto day traders, venture capitalists, and foundations are all potential investors.

B. Financial firms

Traditional investors who are interested in crypto should look into DeFi as an alternative asset class. This includes taking custody of the asset or investing in derivatives and ETFs.

e.g. Investors including professional traders, family offices, hedge funds, banks, and pension funds are all interested in commodities.

C. Fintech firms

This text discusses how making DeFi financial products easy to plugin to Fintech can help bring new Retail customers onboard through regulated on and off ramps. Fintech companies that can offer products with high yields, like those seen in DeFi, would not only become profitable, but would also be able to attract new users more easily.

e.g. Fintech startups like Square

D. General Commercial Underbanked

financing. Some people argue that there is a market for defi today for people in different parts of the world who don’t have access to banks or affordable debt financing.

e.g. sole traders, SMEs, entrepreneurs, gambling / adult industry

Sequencing Institutional DeFi Adoption:

The groups of people mentioned in the text are those who would be most likely to adopt DeFi, with crypto natives (those who are familiar with cryptocurrencies) and small-time traders being the most likely, followed by underbanked SMEs (small and medium-sized enterprises) and finally large financial institutions. This is expected to happen over the course of the next decade. The majority of institutions that are already using cryptocurrencies are not using DeFi, which could be seen as the low hanging fruit.

The more widespread adoption of cryptocurrencies will be driven by how familiar a given group of stakeholders is with crypto, or how much they need it because the existing financial system doesn’t work well for them, leading to either a high tolerance for risk or a feeling of desperation. It also depends on the DeFi industry’s ability to make transactions more accessible and efficient for institutions and their partners.

The decentralized finance (DeFi) sector is currently too small for most institutions to invest in, due to a lack of understanding and lack of compatible IT systems. Even if these institutions were able to invest, the markets are likely too thin to deploy meaningful amounts of capital. In other words, even though DeFi adoption is currently only 5% of the crypto industry, there is a lot of money to be made by fixing its problems. This is because DeFi is a very innovative and fast-moving area of finance. Importantly, you simply can not underestimate the superpower of DeFi’s composability which means no one entity alone needs to solve all these problems but each can be tackled by a specialist protocol which quickly combine into a stack that together to create a powerful form of open finance.

There are several things that could trigger innovation in DeFi and start what the author calls “DeFi 2.0”.

KYC, AML, privacy and accessibility

Since users of DeFi can interact with financial services without needing to provide KYC and identification documents, the industry has a lot of potential for growth in emerging economies. 1.7 billion adults around the world do not have a bank account, according to Global Findex. DeFi would benefit underdeveloped countries the most, but the unbanked population spans to developed countries as well.

Kulechov explained that anyone with an internet connection can access DeFi, which allows people who may not have access to banking resources to lend and borrow. While DeFi’s open-doors policy has its advantages, it also means that illicit money can circulate through the platforms without any Anti-Money Laundering measures. This means that regulating DeFi may soon become one of the biggest challenges.

DeFi platforms are accessible to anyone who wishes to join, although a certain level of technical understanding is required. Opening up a bank account requires no equipment or prior knowledge, but many people cannot do so because of the paperwork or inability to qualify for a product such as a loan. There are some cases where people can’t even get to a physical location to open an account.

Security and centralization

When comparing the security of DeFi platforms to that of legacy finance, how do the two compare? There is much to consider when addressing this question. Banks are vulnerable to hacking, but most hacks only result in the leak of private financial information. Transactions can be canceled and reversed, so the damage is usually limited to the financial loss experienced by the individuals affected. In DeFi, all transaction information is public and recorded on the blockchain. This is generally not a problem because the information is pseudonymous.

There is a tradeoff between security and decentralization when it comes to DeFi. Aave and MakerDAO are not centralized, so they are more difficult to hack. 51% attacks are when someone controls more than half of the Ethereum network, which would allow them to hack these protocols.

The blockchain is not the only thing to look out for when using these protocols. If there is an issue with an account, there is no one to freeze or reverse transactions. Protocols can be exploited if not properly audited. This has been the case with The Dao project, which was recently hacked, losing over $500,000, as well as with Balancer. In both cases, the hacker has since returned the funds.

Scalability, usability and liquidity

Even though the projects are running, there are still some issues with usability. An example of this would be most platforms not being translated into multiple languages, making them difficult to access for some people. Another example would be the technical knowledge required to use some platforms; some people do not have the required skills. DeFi protocols require an Ethereum wallet and some tokens. These can usually be acquired through banking. Although it is possible in theory, DeFi is not currently accessible in practice. Kulechov added:

” One of the challenges facing DeFi is educating people about it. Onboarding people to DeFi can be difficult, but there are lots of new educational resources becoming available, which is great. It is important to educate people not only on how to use decentralized applications, but also on security and risk.

There is no doubt that traditional finance is more liquid than new finance. DeFi is a new concept that is not very popular with people who are not involved in the cryptocurrency world. This means that there is very little money available to fund these projects. Compound has surpassed a major milestone with more than $1 billion borrowed in funds, and has $1.6 billion locked in currently. Aave has more than $200 million in locked funds. Don’t forget that traditional finance is still much larger than the DeFi industry. Not having enough cash on hand can make it difficult for people to get a loan or earn interest on an asset.

The current issues with congestion and scalability on Ethereum may soon make DeFi unusable. Fees can be high and transactions can take a long time to process if there is congestion on the network. Ethereum 2.0 will still take years to fully develop and implement, even though there are layer-two solutions available now. 4. The lack of scalability can lead to future issues for DeFi projects and users. Dmitry Baimuratov, technical content lead of the OMG Network — a layer-two scalability project for Ethereum — told Cointelegraph:

Many in the space believe that DeFi will play a big role in the future of the crypto industry.” DeFi has become the primary ecosystem player over the last year. This is because many people believe that DeFi will have a large impact on the future of the cryptocurrency industry. There is increasing interest from traditional financial institutions and funds in cryptocurrency. It is even more important to have scaling solutions that can deliver the required user experience for DeFi customers while Ethereum 2.0 is still under development.

Yes, maybe or no?

The advantages and disadvantages of both systems are shown above. There are some issues with DeFi that can be solved, such as liquidity and scalability. However, there are also some issues that can only be fixed with the help of a central entity, such as the lack of KYC and dispute settlement processes.

If this is true, can DeFi eventually replace the traditional financial model? Oneconcept may eventually replacethe other, but it is more likely that the two will exist together and serve different needs for different groups of people. Kulechov told Cointelegraph that making DeFi compatible with traditional finance systems would be a major milestone. He said that new innovations, like credit delegation, would make DeFi a source of liquidity for all of finance.