What would banking look like in a decentralized financial system? You won’t have to wait long for an answer. The proliferation of blockchain and decentralized blockchain platforms has given rise to decentralized banking, which serves as an alternative to traditional banking. The term defi refers to finance activities that don’t involve conventional banking systems and methods. What is the role of banking in a cryptocurrency-powered world? What is the mechanism for deposit interest accrual? How does blockchain banking execute borrowing and lending operations? Let’s find out!
Lending, or Savers’ Interest Income
In traditional banking, financial institutions accept consumer’s fiat and store it for them. The institution gives interest as a motivation, and the organization invests its stored currency in providing loans and receiving greater returns on investments. Crypto banking copies this model and improves it.
The current way of crypto banking works like P2P lending. Borrowers and lenders collaborate closely throughout the application process, with the platform acting as a go-between. In defi, smart contracts and algorithms regulate money flow, resulting in a much less central role for the crypto-powered platform. These mechanisms allow lenders (crypto depositors, also known as “liquidity providers”) to enjoy lower operational expenses and increased interest income. Lenders don’t have to verify the viability of each loan request as they would on a peer-to-peer loan platform. Instead, lenders need to put their cryptocurrency up for lending (also known as “liquidity pools”) and trust smart contracts (and insurance) to keep their deposits safe. Algorithms automatically adjust interest rates based on supply and demand. Most crypto bankers, like traditional bank deposits, allow for immediate cash withdrawals without fees.
What exactly is interest income in crypto banking? In decentralized finance, you can choose a leading cryptocurrency or a stablecoin. Cryptocurrency is highly volatile, with huge fluctuations in price regularly. It can rise or fall 10%, 20%, 30%, or greater within hours. Some people don’t mind the fluctuations, but depositors scared of volatility can choose stablecoins (a cryptocurrency tied to the price of a fiat asset) to keep their interest balance tied to the price of the U.S. dollar.
The other aspect of defi is the borrowing of money. Borrowers in traditional banking spend time gathering collateral, demonstrating their creditworthiness by maintaining their credit ratings, gathering required documentation, and courting lenders. Crypto banking does away with most of these tasks. In defi, borrowing requires collateral (usually in Ethereum coins or tokens) equal to or greater than the desired amount. There are crypto-powered, centralized financial platforms that act like traditional financial institutions. Still, they’re able to offer more benefits (lower costs, no onerous requirements, loose payment schedules, etc.) than you would expect to find at non-blockchain banks.
The next evolution of defi borrowing is the development of unsecured loans. It would need to operate similar to traditional lending, involving down payments and collateral less than the desired amount of the loan. There isn’t an easy way to create trustless, unsecured loans in crypto banking—for obvious reasons. Traditional banking relies on credit scores (by companies with unknown, proprietary standards). Crypto banking would need a similar system; otherwise, fraud would run rampant and dismantle cryptocurrency lending. But how could a system be developed and operate differently (with more transparency) than the credit system used by today’s traditional banks? One solution is a biometric tracking token similar to KYC (know your customer) or acts as an extension of it. Called BOA (biometrically owned account), this system would create a key and address based on a digital biometric scan. And live on the Ethereum blockchain, eventually becoming interoperable across different blockchain platforms. In the crypto borrowing sector, progress is happening, but finding a way to offer unsecured loans will be the most significant development area.
Projects and Tokens to Watch
Defi is the newest area of expansion for cryptocurrency, as businesses and developers scramble to create viable alternatives to traditional finance:
- Compound: a token that can calculate and aggregate interest rates automatically using algorithms, useful for a wide variety of financial applications depending on the platform that adopts the token.
- Celsius Network: it’s a platform that accepts deposits of cryptocurrencies to use for lending and offers interest in the form of other coins, stablecoins, or its native token CEL. The organization claims to re-distribute 80% of received interest payments back to depositors.
- MakerDAO: the organization which created Dai, its stablecoin that ties the token price to $1 and backs it by cryptocurrency collateral. Dai enables developers to mint the stablecoin themselves by collateralizing it with Ethereum, BTC, wBTC, USDC, or BAT. When the loan is paid, the collateral is returned.
- InstaDapp: a wallet platform that provides integration between various defi protocols and tokens (Compound, MakerDao, Uniswap, etc.).
- Zero collateral: a platform that uses credit history or on-chain actions to determine a risk profile, loan origination, and setting the interest rate. Depositors can also act as lenders to earn interest.
- Uniswap and 0x: two popular decentralized exchange platforms that can swap ERC20 tokens using Ethereum coin.
- More tokens and protocols: a list of tokens and protocols that are shaping the burgeoning sector.
This list is only a tiny representation of the innovations shaping defi banking. You can research each of these topics further using the basic introduction received in this guide.
- Interest rates: compare interest rates by different platforms by using websites such as defirate.com and defipulse.com.
- Projects and platforms: you can browse defipulse.com and defiprime.com as starting points, using search terms such as “defi protocol” and “defi platforms.”
- Liquidity pools: find the best interest rate yields from decentralized protocols such as Balancer, Uniswap, Aave, Compound, etc. Some popular research sites include Uniswap.info and yieldfarming.info.
Defi started on Ethereum, but other blockchain platforms are leading the charge to develop alternatives. The problem stems from Ether’s increasing gas fees and slower transaction speeds. One solution to that is the development of Layer 2 protocols, known as “sidechains,” that have their network powered by an underlying blockchain (example: Polygon is blockchain-powered by Ethereum; therefore, it’s a Layer 2 sidechain of Ethereum). The main alternative blockchains to Ethereum are Avalance, Cardano, Solana, Polkadot, Stellar, Tezos, and Fantom.
Blockchain interoperability is the latest evolving trend in the cryptocurrency space. As Layer 2 protocols dominate attention, there’s a demand to have defi tokens and platforms become cross-compatible across multiple blockchains. For example, imagine depositing BAT tokens on Avalance for a borrower using Ethereum (which results in lower gas fees). A concept is known as “bridging.” It is being developed on the most popular blockchains to enable different blockchain platforms to communicate and become cross-compatible.