DeFi (decentralized finance) is a concept in which a peer-to-peer network provides the hardware necessary to run all the processes of a complex financial system.
The key thing to understand about the DeFi is that it’s, by default, cutting all the middlemen out of the equation.
This way, it will eliminate the need for escrow (with the help of smart contracts), minimize the need for credit unions (through peer-to-peer lending), and enable transactions without the need for a financial institution (with real-world infrastructure).
For anyone reading between the lines, this could mean just one thing – the banks might become obsolete. Now, in the past, a lot of people were skeptical – not of the intention of DeFi (this was always transparent) but of their ability to do so.
Well, today, no one’s doubting this anymore. The success of crypto (both as an investment asset and a substitute for fiat cash) serves as a testament to this. So, how will DeFi affect the banking system (which will not go down without a fight)? Let’s find out!
#1: Higher adoption of DeFi and lower frequency of use for banks
One thing that goes in the favor of the banking system is that, unlike DeFi, everyone has been at the bank, everyone has done business at the bank, and everyone knows how the bank works.
With DeFi, there’s this huge bottleneck of people hearing about it but not knowing how it works first-hand.
Well, in 2017 BTC exploded in value and so many people heard about it for the first time. Suddenly, everyone and their grandmother wanted to buy Bitcoin and it quickly turned from “that geek thing” into a household name, a flagship of the industry.
This process has been repeated several times, and it’s not slowing down anytime soon. In fact, there’s a huge list of coins that are predicted to explode in 2024. With each success story, more attention is sent this way, more people buy crypto, and more people acquire this first-hand experience.
So, what happens when they finally do try it out? They use them, see that they’re real (yes, a real concern that some people have with crypto) and that they are as useful as real money and investment assets.
Then, they figure out that they can get paid in crypto on their freelance gig, so they do just that. Before you know it, their reliance on the bank is down, and their trust in crypto rises.
#2: Making up for shortcomings of the traditional banking system
Sure, people are not very fond of banks. In fact, when an average person mentions the word bank or banker, the connotation is usually not a positive one.
Nonetheless, this sort of aversion, even one well-founded, is not enough to make a lot of people shy away from the banking system. It’s a system that they’ve used for most of their lives and a system that exists for centuries and millennia.
It’s a trustworthy institution, even though some of its practices may be seen as morally dubious by the general populace. The thing is that the reason why people might switch to DeFi principles and financial assets is because they effectively make up for the shortcomings of the traditional banking system:
- The fees are lower (since there are no intermediaries)
- It requires less paperwork (silent KYC methods instead of formal checks)
- Effortless transactions regardless of the location (all benefits of digital money)
One of the things that banks could do to keep their clients would be to start addressing some of these issues and fixing these problems. However, massive institutions are rigid, and they’re virtually designed to be resilient to change. This is one trait that might come to haunt them.
With more and more businesses working with businesses all over the globe, the fact that international transfers are simpler this way makes a huge difference.
#3: Solving problems through technology
The key thing you need to understand is that banks weren’t always this unnecessarily complex bureaucratic hell that they are today.
Each of their processes played an important purpose. The problem is that there are far more sophisticated tools today that could resolve these issues more effectively (and less costly), yet, they still cling on.
One example of this is the concept of escrow account. Here, the money is deposited to be released when certain conditions are met. Now, this depends on a series of factors but the system can be drastically improved by blockchain-powered smart contracts. This way, the contract is always executed, and there’s no uncertainty around the way it functions.
Another great example is peer-to-peer lending platforms. These are so effective because they give you a chance to pick people you want to lend your money to (as a lender).
As a borrower, you get a chance to secure a loan even with no credit history (or poor credit history). Again, the risks are transparent; there’s a lot less paperwork and a lot less red tape.
#4: Regulatory challenges and compliances
The next thing you need to understand is that the challenge that DeFi is facing might have been its biggest selling point early on. We’re, of course, talking about the fact that it’s either lightly regulated or that it’s not regulated at all.
Banks have greater oversight and insist on greater transparency, so, in the past, a lot of malicious online actors used them for criminal dealings. The biggest concern that governments have over crypto and DeFi, in general, is the risk of it being used for money laundering.
However, the regulation is almost already here. There are more and more rules, more and more oversight and regulation like AMA, and methods like KYC can help out with this quite a bit. All of this can be done in a simpler and cheaper way than what banks are currently doing.
#5: Reputation and public perception are shifting
In one of the previous segments, we’ve mentioned the fact that banks don’t exactly have a stellar reputation among the general population.
They’re often accused of being freeloaders, exhibiting exploitative and loanshark-like behavior toward their users and borrowers, as well as of being insiders in some sinister games that the elites play against all who are lower than them on the social ladder.
The truth is that whenever there’s a financial crisis, major banks get bailed out with the tax money paid by small businesses that the government will show no such leniency toward. They’ve been caught red-handed trading insider information, and seldom does anyone ever answer for it in front of the law.
While people don’t exactly know how DeFi works, they understand that, due to the democratic nation of the network, deliberately rigging the system is nearly impossible. This alone is more than enough for one to see DeFi as a great equalizer in this game.
Modern banks will have to try hard to stay competitive
Sure, modern banks are not just going to roll over and die. They still have a lot of fight left in them and a lot to lose if they just give in.
For one, they’re deeply embedded in the highest levels of the government and have an incredibly strong lobby. Still, if they don’t innovate in order to catch up with the technical advantages of DeFi even that might not end up being enough.