If you like crypto, how about decentralized finance?

19 September, 2019

It would be interesting to get inside Satoshi Nakamoto's head. One cannot help but wonder if the mysterious Bitcoin creator ever considered that his project would lead to the creation of what we now know as blockchain and cryptocurrency. Satoshi was either incomparably brilliant or someone who just stumbled onto something that turned out to be really big.

One of the natural outflows of Bitcoin was development of the Ethereum platform. Ethereum was not originally designed to be an alternative monetary system. It was designed to be a computing platform on which decentralized applications could be built. And that leads us to what is known as decentralized finance (DeFi).

If you like cryptocurrency, chances are you are going to like DeFi as well. DeFi is an emerging technology that marries blockchain with traditional financial services to give users the best of both worlds. The key to DeFi is decentralization. We will explain it all to you in the following passages.

Blockchain and decentralization

At the core of all cryptocurrencies is blockchain, a technology that allows for the digital tracking and distribution of assets in a completely decentralized environment. If you are not sure what decentralization is, rest assured that it is an easy concept to understand.

You have a traditional bank account, right? You might own your money, but you don't own the account. You also do not own the bank. Your account and the bank that owns it are controlled by a Board of Directors and shareholders. The Board of Directors are responsible for making each and every decision pertaining to the bank. In essence, control of the bank is centralized under the authority of the board.

Cryptocurrency is subject to different rules. You own your coins by virtue of the fact that you possess the keys that give you access to them. Your coins are represented as digits on a computerized ledger, which exists in multiple copies stored on computers around the world. No one owns that ledger. The network doesn't own it; the computers don't own it; the developers that build the code don't own it.

None of those entities exercises exclusive control over the ledger either. For any transaction to be considered official, all of the computer nodes must validate and verify it. Only when they all agree is the transaction considered official. This is the essence of decentralization.

Decentralized finance

We can now take what we know about a decentralized cryptocurrency ledger and apply it to banking. That's what DeFi does. DeFi is a blockchain enterprise that allows for banking services utilizing digital assets rather than fiat. However, fiat can be part of the equation.

For the purposes of illustration, we will talk about a company doing business under the name Dharma Labs (Dharma). When Dharma first launched, the initial iteration of its blockchain was utilized as a financial ecosystem to facilitate lending via cryptocurrency. They utilized a peer-to-peer model.

Investors willing to pool their cryptocurrencies on the platform could turn around and lend that money to others. Borrowers could borrow cryptocurrencies for whatever reason. They could use what they borrowed straight up or convert it to fiat. Everything worked much the same way as standard peer-to-peer lending with fiat.

By all accounts, everything went just fine. Dharma was making money and both lenders and borrowers were happy. But it didn't take long before customers began demanding more. It was all well and good that they could borrow, but they wanted access to other financial services as well.

So Dharma began the process of phasing out version 1 of its platform and preparing to launch version 2. That second version was recently launched as a beta project. Dharma's new software will not facilitate any more lending for the time being. They are phasing out all of their existing loans as these are paid off.

Instead, customers will be able to use Dharma as a savings vehicle. They will be able to purchase stablecoins and park them at DeFi where they will earn interest - just like a savings account at your bank. Better yet, they will be able to move funds in and out instantly.

Dharma eventually hopes to bring back lending along with a host of additional banking services. But for now, they are focusing on savings while they get the new platform from beta to full release.

What Satoshi only dreamed of

Decentralized finance does not seem like a big deal until you step back and really analyze it. Dig into the details and you will discover it really has a lot of potential. That potential lies in traditional banking services. Now, before you get excited, remember that traditional banking services are not bad in and of themselves.

As a stand-alone entity, a savings account is a good thing. Equally good are checking accounts, certificates of deposit, consumer loans, mortgages, and so forth. What makes traditional banking services so much trouble are the banks that offer them. Adding to the trouble is the control exerted by national governments and central banks.

Satoshi dreamed of Bitcoin becoming an alternative monetary system that might eventually replace fiat. In order to do that and maintain decentralization, Bitcoin would have to become a complete ecosystem for all things banking. It has not reached that lofty perch, nor is it likely to. Bitcoin's code just doesn't contain the mechanisms to support DeFi.

However, Ethereum's code does. In fact, DeFi is built on the Ethereum platform. Thanks to Ethereum's capabilities, DeFi stands a very real chance of giving conventional banking and cryptocurrency itself a real run for its money.

What it's capable of

Understanding the vast potential of DeFi is not that difficult when you use Dharma as your example. Just look at some of the things they want to do and you'll see exactly where Dharma is headed. When it is finally mature, Dharma is going to be capable of some incredible things. For example:

A fiat on-ramp

Dharma reaching its full potential will require a way to seamlessly integrate cryptocurrency and fiat. And no, this is not a contradiction. The reality is that fiat is never going away. Some countries may convert paper and minted coins to digital currencies, but they are never going to give up their currencies in favor of a decentralized global currency.

As such, some mechanism for onboarding with fiat is going to be necessary for DeFi to truly thrive. It turns out that Dharma is working on that. They hope to have multiple ways to interact with their platform using fiat.

What might that look like, practically? Let's say you want to open a Dharma savings account. Fine. You use fiat to purchase stablecoins you then deposit in your Dharma account. So far so good. But you only need to make that conversion as long as your fiat continues to exist as paper bills and minted coins. If your country ever converts its fiat to digital currency, you will be able to store fiat in your Dharma account.

Borrowing services

Dharma hopes to eventually have borrowing services in place too. It is not clear if they intend to return to the peer-to-peer model, but it's doubtful they will. Any success they enjoy with their saving platform should provide the resources they need to lend.

Should this plan succeed, we are essentially looking at Dharma making loans just like a bank. Borrowing would be a simple matter of applying for a loan and waiting to be approved. You would make your monthly repayments using any of the stablecoins the platform accepts.

How is this different from what a bank does? Remember the word 'decentralization'. Dharma is a decentralized blockchain environment. The company behind it does not control the platform in the same way a bank is controlled by its officers. That puts the power of the platform in the hands of its users rather than a small number of owners.

A bank without borders

Dharma's eventual goal is to have a platform that acts just like a bank without borders. Anyone with an internet connection and a device to get online will eventually be able to use the simple Dharma interface to access banking services. They will be able to make deposits and withdrawals, conduct wire transfers, pay bills, and even borrow.

All of this will be done outside the control of national governments and central banks. That is the beauty of it all. It is no wonder that so many in the cryptocurrency space are starting to sit up and take notice. DeFi in general, and Dharma in particular, stand a real chance of completely upending the cryptocurrency paradigm.

The key to making all of this work are stablecoins. Dharma has chosen the stablecoin model for holding assets because stablecoins are not subject to the price volatility pure cryptos are known for. If all of this is to work, a few more reliable stablecoins have to be developed. Not enough exist yet, which could be the monkey wrench in Dharma's plans.

Having said that, there is no need to dwell on that right now. The fact is that DeFi is a rapidly maturing concept that could eventually lead to realizing Satoshi Nakamoto's dream of new global monetary system.