Thought Paper

How Decentralized
Finance (DeFI) is
Changing the Face
Global Lending
Raktim S

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Inspiring Better Banking

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 Content

Introduction______________________________ 03

Decoding DeFi___________________________04

Benefits of DeFi__________________________ 06

The use cases of DeFi_____________________ 08

Final thoughts____________________________ 09

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 Introduction
Lending, borrowing, selling, and buying have gone on for centuries. These
are important aspects of finance, which are for the most part managed by
centralized systems, long-established and governed by authorized banks
and financial bodies. Traditionally, if a consumer wanted to take a car loan or
mortgage on a new home or buy stocks or invest in funds or avail any kind of
financial service, they would need to go through some form of middleman,
namely the governing financial bodies like banks, exchanges etc.

In case of lending, banks and exchanges earn some percentage of the

profit resulting from these transactions. Typically, to ensure security,
they apply gatekeeping measures (KYC checks) for those requiring these
financial services. As a result, the process becomes lengthy with many
people involved and can create friction points in the formal credit system.
Decentralized finance (DeFi), on the other hand, is aiming to cut out the
middleman, and making lending and other financial transactions possible
and more convenient between peers directly. At present, DeFi services
can be enabled for a number of crucial areas of finance from lending to
borrowing, funding, trading, derivatives, and insurance.

In this paper, we examine the emerging role of DeFi in reimagining peer-

to-peer (P2P) financial transactions, its potential in the future of lending,
benefits, and concerns.

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 Decoding DeFi
The central idea behind DeFi is to facilitate the management of money through P2P transactions Some Interesting facts
between individuals, merchants, and businesses without interventions by large financial institutions
related to DeFi
or corporations. It’s based on open-source technology without a controlling authority to deny access to
any financial product/services sought by users. It also facilitates market exchanges round the clock. The global DeFi market, which is predicted
to grow to USD231.19 billion by 2030, as per
DeFi is based on Blockchain technology, which enables financial applications and protocols with
Grand View Research. DeFi wallets totaled
programmable functionality. Transactions on the blockchain are carried out automatically by smart
4.3 million unique addresses in January 2022;
contracts. Smart contracts include terms of agreement and the deal struck between concerned parties.
although the same user may have multiple
These contracts set up a rules-based ecosystem where financial transactions such as lending, and
wallets/addresses, this indicates a healthy
investing can take place without needing third-parties like banks and brokerage houses.
future.
The transactions happen automatically when the conditions of the smart contract are met, as opposed
AAVE, MakerDAO, Compound, Alchemix
to traditional finance where many people and systems can be involved in processing, verification,
are examples of lending platforms that are
and logging of transactions. Transaction records are maintained on the immutable ledger and
competing in the DeFi space.
independently verified by thousands of computers around the globe.
The Number of cryptocurrency Automated
From a consumer perspective, with just an internet connection, individuals can conduct financial
Teller Machines (ATMs) as of November 2022
transactions with peers. They have software to note every financial transaction and get it validated in
was around 38,000.
distributed financial databases, which are accessible in various locations. These databases typically
gather data from all users and rely on a consensus mechanism for verification. On May 22, 2010, a man in Florida paid 10,000
bitcoins (BTC) for two pizzas. This is generally
As a result, more of the work historically handled by banks and other financial institutions can now
recognized as the first bitcoin transaction
be performed between peers, directly. Here the concerned parties agree to provide cryptocurrency in
for a commercial purpose.
exchange for goods/services without needing an intermediary or overseer.

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 The building blocks of DeFi
Like any financial system, DeFi requires two fundamental components,
namely a platform on which to operate and a currency to facilitate financial
transactions. In centralized systems, financial institutions such as banks provide
the platform infrastructure while the currency can be any fiat currency. In order
to offer the full range of financial services, DeFi must offer viable alternatives to
these components.
Infrastructure
Using DLT (Distributed Ledger Technology) platforms, developers can generate
decentralized programs to carry out various financial services. This involves
developers defining the rules and conditions to be followed on how a specific
financial service needs to be processed through a smart contract, which are self-
regulating computer code running on the blockchain network. Smart contracts
are automatically executed each time these pre-defined conditions are met.
What’s noteworthy is that once these contracts are deployed, it’s not possible to
change them.
Key layers of a DeFi Stack:
1. Settlement layer: This forms the basis that shapes other DeFi transactions and
includes a public blockchain and its native digital currency or cryptocurrency.
Ethereum is an example of a settlement layer with ether as its native currency
that can be traded during crypto exchanges.
2. Protocol layer: these encompass the commonly agreed principles and rules to
be followed by all participants within the DeFi ecosystem. They are interoperable
and therefore, available for use by multiple entities in parallel to carry out
various tasks on the network. DeFi protocols bring in disintermediation by using
stablecoins as assets, blockchain ledgers for making settlements, and smart
contracts for automatic execution.
For example, Synthetix is a derivative trading protocol on Ethereum that
generates synthetic versions of real-world assets.
3. Application layer: These include customer-facing applications wherein the
associated protocols are simplified to facilitate financial services based on the
customer’s needs.

Currency 4. Aggregation layer: This comprises aggregators who integrate different
applications from the application layer that can be offered as a service to
DeFi requires a stable currency that makes it reliable and secure while helping
customers.
control crypto volatility. Stablecoins take care of this requirement. These are
cryptocurrencies whose value correlates to a fiat currency. For example, Dai is
a stablecoin whose value stays close to that of one United States Dollar (USD)
making it ideal for DeFi. In fact, the primary aim of stablecoins is to be the
stabilizing bridge between fiat and crypto currencies.

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 The benefits of DeFi
Operating within a public blockchain environment, DeFi enables a standardized
and well-oiled framework for financial transactions to happen while promoting
transparency, and accountability of transactions for all parties involved.

Here, data is hosted on a decentralized database that is highly secure through the use
of cryptography and erases the need for an institution, such as a bank or broker, to
verify transactions.

In the formal credit system, if a person asks for a bank loan, the bank needs to take
various documents as security against concerns of non-performing assets. In case of
DeFi, the practice is to over-collateralize – for example, a loan of USD100 will need a
collateral equivalent of USD150. But no documents are required.

It provides a f riction-f ree process where they can borrow at very low Interest rates
for various f inancial needs. This, in turn, opens pathways towards liquidity and
economic growth.

These advantages will also help customers who don’t want to break/redeem their
digital assets as they feel that it will appreciate in future. Also, during redemption of
those Digital Asset, they on need to pay tax. In some cases, they may have to pay Short
Term Capital Gain Taxes. Customer may want to hold on to these assets for long term.

Here, we discuss how DeFi unlocks these benefits through:

Blockchain technology provides decentralized finance, which increases financial

security and transparency, unlocks liquidity and growth possibilities, and supports an
integrated and standard economic system.

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 1. Programmability This kind of transparency around transaction data not only
Smart contracts allow the creation of new financial ensures all activities over the network are accessible to
instruments and digital assets and automate the everyone involved but also gives access to a wealth of data
execution of these contracts. With the help of smart sources that can be analyzed and leveraged in strategic
contracts, providers of DeFi can create new financial decision making.
instruments and associated digital assets and automate
Users also have access to the DeFi protocols and can use the
the execution of these contracts. Counterparty risks that
associated code for viewing, auditing, and building it further.
are concerns in traditional finance, can be addressed
with DeFi owing to settlements enabled through smart 4. Permissionless access with minimal investment
contracts running on blockchain. Users only require internet access to set up a crypto wallet
with minimum funds, and that’s all they need to access and
These contracts also go a long way in establishing fair
explore the multitude of applications available. As DeFi is
and feasible terms such as collateral required or payment
on the blockchain network and open source, anyone with
scheduling for all parties involved. As there is zero human
an internet connection can view, audit the source code,
intervention, it drastically lowers the risk of errors while
and see all the transactions. This kind of permissionless and
improving process efficiencies.
open access is what makes DeFi an exciting prospect and
2. Interoperability enabled by protocols and distinguishes it from traditional finance.
customization
5. Self-custody of assets
DeFi protocols have earned the nickname “money legos”
Those who are transacting in the DeFi marketplace get to
because these can be easily integrated with various third-
control their private information and are sole custodians of
party applications and customized interfaces. This facility
their assets. This kind of security is ensured with the help
makes for interoperability between all parties that are part
of digital wallets they establish in line with permissionless
of the DeFi ecosystem.
financial applications and protocols.
3. Transparency enabled by publicly accessible data
By definition, public blockchains have to share all
transaction details with its users for verification purposes.

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 Use cases of DeFi
1. Creating B2B DeFi marketplaces
Companies in the B2B DeFi marketplace are offering to help prospective
customers in the US who want to borrow funds to buy a car. In these cases,
customer put in their cryptocurrency as collateral and get DeFi loans. These
customers (borrowers) are put in touch with prospective lenders who provide
stablecoins in exchange. This stablecoin is exchanged to USD and given to the
car dealer on behalf of the customer.
Later, the money is repaid at low rates of interest by the borrower to the lender.
2. Managing assets
DeFi platforms often provide tools that help users self-manage their assets
while carrying out activities like buying, selling, or transferring digital assets
such as purchasing, selling, and transferring digital assets. In the process, they
also get to earn interest based on the digital assets they own on the platform.
Plus, they get to keep their sensitive data completely private and password
keys under their control as they don’t have to share it with any intermediary.
DeFi lending protocols can help users purchase real-estate by using digital
assets they own.
3. Tokenization in place of real-world collateral
Tokenization is a mechanism that is undertaken to facilitate secure and
immediate transfers in DeFi transactions. Here, digital assets known
as tokens are created and subsequently issued and managed over the
blockchain. As more real-world assets and financial instruments can now be
brought into the blockchain environment, this paves the way for tokenized
collateral to be used to secure loans quickly from some qualified lender
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within the ecosystem. If the value of the collateral goes down or the borrower
is unable to make payment, liquidation happens immediately, which is an
advantage for the lender.
For example, USDC.homes provides crypto mortgages to those looking to buy
a home in the US. Qualified lenders, on their part, have the novel option of
participating in this ecosystem.
4. Synthetic assets in place of traditional derivatives
These are blockchain-based cryptocurrency derivatives that simulate traditional
derivatives by mimicking the value of the underlying real-world asset. They are
converted to collateral by tokens that are encoded into Ethereum-based smart
contracts with pre-set terms of agreement and incentives.
5. Employing decentralized exchanges (DEX)
DEX is a P2P marketplace for cryptocurrency buyers and sellers. True to
the promise of DeFi, DEX apps serve as cryptocurrency exchanges that
operate without a custodian or central authority. Here, users can conduct
financial transactions directly with their peers while preserving control
over their private access keys during the transaction. Moreover, blockchain
data is immutable and creates a trustless financial system that runs on
code completely. Decentralized exchanges exemplify such a system and is
becoming popular because of its focus on disintermediation.
DEXs use Automated Market Makers technology to provide asset-specific
liquidity pools that can replace the more traditional order books that were
the norm in centralized exchanges. This will be useful for treasury related
operations like usage of AMM for interest rate swaps etc.
 Final thoughts
While the DeFi network is an emerging technology with the potential
to be disruptive for organizations and individuals in the f inance
industry, its evolution reflects the transformation that is happening in
every sector of society.

DeFi is based on the peer-to-peer concept that builds a trustless system

where intermediaries are not required. By relying on this philosophy and
self-executing smart contracts on the blockchain, it aims to democratize
finance and particularly lending.

Even though DeFi has come under great scrutiny by skeptics and
naysayers in the industry, it’s an evolving area that can disrupt and shape
the future of finance. For sure, there are concerns and risks around smart
contract failures and still-evolving regulation around decentralized
governance systems that must be addressed.

However, those involved in traditional banking and financial services cannot

afford to ignore its growing popularity among certain demographics,
predominantly millennials. DeFi is already managing to resonate
significantly with these sections of society and attract their business, which
is bound to influence the way we work with money in future.

While it remains to be seen whether DeFi can evolve into a true alternative
for traditional finance, it’s definitely impacting finance between peers, and
gradually working its way into mainstream financial services. Traditional
bankers and financial service providers must take note and act now to stay
relevant as the face of finance evolves.

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