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Senators and regulators explain why the $60 billion collapse of a major cryptocurrency is not the industry's Bear Stearns moment
The emergence of decentralized finance (DeFi) or open finance innovation was a watershed point in financial history. It grew to popularity in the summer of 2020 with the development of tokens like as Compound and Sushiswap, which promised lucrative payouts to crypto traders.
According to DeFi Pulse, the total value locked in DeFi protocols is more over $78 billion, representing a tenfold increase since May 2020. This is the current value of all deposits held in the form of cryptocurrencies for lending, staking, liquidity pooling, and other purposes.
According to Dune Analytics, approximately 4 million unique addresses (proxy for users) are utilizing DeFi apps, representing a 40x increase in the previous two years.
In 2021, Ethereum, the fundamental blockchain enabling DeFi apps and the second biggest cryptocurrency by market capitalization ($345 billion), will have settled over $11.6 trillion in transaction volumes, surpassing Visa (the second largest payment processing firm). This is a new alternative financial infrastructure that is posing a threat to traditional finance.
Why is DeFi growing so quickly, and why does it matter?
The 2008 financial crisis demonstrated how vulnerable our existing financial system is and how heavily reliant it is on banks and financial institutions that operate as middlemen in delivering any financial service.
Financial infrastructure has not altered structurally since the industrial revolution, and it is analogous to software in the pre-internet age. Due to high entry hurdles, opaque and inefficient processes, and high transaction costs, core finance has seen scant innovation.
Over 190 million individuals in India do not have bank accounts; retailers must pay 2-3 percent on every card or online transaction; small enterprises struggle to obtain credit from banks; and international wire transfers are costly. Despite the fact that trades in capital markets are completed electronically, the settlement period is T+2 days.
While several fintech businesses have arisen in the recent decade, they have all been built on top of pre-existing financial infrastructure. Financial product and service development has traditionally been a top-down process driven by a few big financial organizations such as asset management businesses, commercial banks, and insurance companies.
DeFi is a bottom-up invention that substitutes human trust with mathematical trust, paperwork with smart contracts, legal enforcement with cryptographic enforcement, and third-party audit with open source code and a public ledger.
It allows developers to construct new financial products including decentralized banking, decentralized money markets, and decentralized asset management businesses.
DeFi wants to be 10x better, quicker, and cheaper than current financial services.
Decentralised finance will do to centralised finance what the internet did to information.
Consider how quickly information is spread throughout the world now thanks to social media. What if money is transmitted at the same rate as deals are conducted and settled?
Bitcoin called into question our preconceived notions about money. For the first time in history, we may send and receive money from anybody, anywhere in the world, without the need for a centralized middleman. The introduction of Ethereum as a smart contract development platform in 2015 was the "AWS (Amazon Web Services) moment in crypto," allowing developers to construct more complicated financial apps like DeFi on top of it.
Comparison of a decentralized financial stack with a centralized finance stack
Loans, gold, equities, and fiat are all assets in centralized finance. In the form of cryptocurrencies, DeFi has new-age assets such as Stablecoins (1:1 fixed to the US dollar), NFTs, and protocol native tokens such as Ethereum, Compound, and Aave.
Payments - When a customer makes an online payment to a merchant in centralized finance, several intermediaries are involved, including the issuing bank, the acquiring bank, payment processors such as Visa/Mastercard, and the payment gateway, for authenticating and executing the transaction.
The transaction cost rises as a result. The identical transaction will be conducted and confirmed in the DeFi world via blockchains such as Ethereum, which comprise the base layer of the DeFi stack and serve as a single source of truth for all transactions inside the network.
When a transaction is broadcasted on the network, it is processed, cleared, and settled without the need for any middlemen.
Stablecoins are ERC 20 (Ethereum tokens) meant to remain at a set value ($1) even when the price of Ethereum varies, hence addressing the issue of cryptocurrency price volatility. They are developing as speedier and less expensive options for making domestic and cross-border payments throughout the world.
The market cap of the top five stablecoins (USDT, USDC, Binance USD, Terra USD, and Dai) is $170 billion.
Yield seeking (Lending, Borrowing) - In the DeFi world, anybody may obtain crypto loans outside of the regular banking system without KYC or a credit score, or borrow using crypto collateral.
It is a peer-to-peer lending/borrowing market that operates without the intervention of centralized banking and is powered by smart contracts. Once written on the blockchain, smart contract logic is unchangeable.
MakerDAO, Aave, and Compound are three of the top five DeFi lending/borrowing systems. Compound has provided loans totaling more than $4 billion.
Trading (Exchanges and Liquidity) - In centralized finance, being a market maker necessitates enormous amounts of money and is consequently concentrated in the hands of a few major organizations. DeFi is creating a level playing field for anybody with a little amount of cash to become a liquidity provider to a trading pool and earn a dividend using an automated market maker protocol like Uniswap.
As with any promising new technology, there are hazards such as unsustainable high returns, leverage trading, smart contract flaws, and cryptocurrency price volatility.
We are still in the early stages of DeFi, which is rapidly evolving. From basic blockchain protocols to decentralized apps to front-end UI, there is innovation at every layer. Indian founders are tackling difficult challenges in DeFi, such as Layer 2 scaling solutions like Polygon and Biconomy, and Gemba Capital is aggressively looking to invest in this market.
DeFi represents a significant chance to disrupt any financial contract, including derivatives ($1 quadrillion), the stock market ($90 trillion), and insurance ($6 trillion). And this is only the start.
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