The current form of the internet is not perfect. We have no control over our data, and serious concerns exist regarding security, content censorship, and decision-making. Data is centrally stored and regulated, and single points of failure make the network less reliable. This is the state of the World Wide Web, thirty years after its birth. Web3 addresses such loopholes and brings higher transparency, sovereignty and reliability.
Web3 is also appealing because it is decentralized. That means users no longer need to rely on companies like Google, Apple, or Facebook for internet-enabled services. Instead, they can own and manage the internet and decide its governance, growth, and sustainability.
Since web3 is free from the top-down oversight of central authorities, no third party has the right to decide who has access to what services or content and how they use it. Digital transactions can also be carried out among multiple parties without intermediaries. Further, web3 can resolve data privacy issues more efficiently than all previous iterations of the internet.
Web3 is a groundbreaking innovation that has the potential to address the inefficiencies in web1 and web2. And the industry that has experienced its greatest impact is finance. This article discusses web3 in finance and offers insight into its many aspects. As you read, you will learn about decentralized finance, its merits, key components, future, and more. But before digging that deep into web3 in finance, let us touch upon the basics and begin by understanding what a financial system is.
What is a financial system? How is the current centralized economic structure flawed?
A financial system is a collection of institutions such as banks, stock exchanges, and insurance companies that allows money to be exchanged. Financial systems exist at all levels: business, regional, national and international. Borrowers, lenders, investors, and other players in the finance market trade current cash to make funds available for personal consumption and productive investments.
Many rules and procedures are in place to decide which projects get funded, who finances them, and the terms of financial agreements. However, governments, banks, and other similar financial entities devise all such rules and regulations. This is a grave concern for end users because the decision-making process in such a financial setup is highly centralized, where customers have little or no say. Even the monetary policies that result are lop-sided and fail to address the real concerns of the general public.
Centralized finance demeans the idea of financial inclusion and fails the purpose of having a financial system for the masses. But do we have a better alternative? Decentralized finance (DeFi) is a far superior alternative regarding transparency, inclusion, and autonomy. In the following section, we will discuss the concept of DeFi or web3 in finance and how it can help overcome the limitations of a centralized financial services system.
TradFi, CeFi and DeFi: What are they, and how are they different?
Our current financial system operates under three models, namely traditional finance (TradFi), centralized finance (CeFi) and decentralized finance (DeFi). While TradFi deals in fiat currency, CeFi and DeFi involve cryptocurrency transactions. Let us understand each of these financial models for a holistic view.
TradFi or traditional finance is a term for the mainstream financial system, which includes retail banks, investment banks, commercial banks, other similar financial institutions, and fintech companies. Goldman Sachs, PayPal, and Morgan Stanley are some popular examples of TradFi institutions. Most of these brick-and-mortar institutions offer banking and other financial services.
While most players in the TradFi market are digitalizing their operations and services, they still have high levels of centralization and barriers to entry. Unlike web3 in finance, they must also adhere to strict Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements.
Decentralized finance (DeFi) is the true representation of web3 in finance and refers to the infrastructure, processes, and technologies used to democratize financial transactions. DeFi is a blockchain-powered financial ecosystem that saw a boom in 2020 when its market capitalization grew from $700 million locked into DeFi smart contracts at the start of the year to $15 billion in December. Here are the key benefits that DeFi or web3 in finance provides:
- Open: Anyone who has a wallet linked to a DeFi wallet can access its services. Users do not need to open accounts or engage in lengthy paperwork.
- Protects identity: You don’t need to disclose your real identity as DeFi platforms do not seek your details, such as your name or email address.
- Flexible: Moving assets from one account to another is a breeze because fund transfers can be undertaken permissionless.
- Fast: Rewards and interest rates usually get quickly updated, sometimes in as little as 15 seconds.
- Transparent: The transaction records are open to everyone, which grants an extremely high level of transparency, which is impossible in a centralized financial system.
Centralized finance or CeFi is an integral part of web3 in finance and offers crypto investment opportunities that combine the yield benefits of DeFi with the security and user-friendliness of TradFi. Centralized finance is a financial setup wherein users can obtain loans and earn interest on their cryptocurrency with the help of centralized exchanges. The third-party company you choose for CeFi services will have the custody of your private keys required to undertake payments and make coin orders. CeFi aims to ensure fair exchanges while optimizing the cost-efficiency and performance of transactional services. With CeFi, it is possible to earn interest on savings, obtain loans, spend using a cryptocurrency debit card, and do more.
Diving deeper into DeFi, the financial layer of the decentralized web3 ecosystem
Decentralized finance or DeFi is an umbrella term for financial products and services running on a decentralized network of computers.
The architecture of decentralized finance is designed to eliminate the involvement of intermediaries, which makes the entire system highly transparent. The following qualities characterize web3 in finance:
- Open-source software
- Permissionless operations
- Decentralized management and governance.
The decentralized system of finance functions without the intervention of a central authority. It is, therefore, accessible to everyone. With a DeFi platform, users can:
- Have full control over their assets
- Undertake peer-to-peer exchanges and transaction
- Not just use but also create decentralized applications (dApps)
Decentralized finance or web3 in finance removes the involvement of financial intermediaries such as banks and brokerages and equips users with the following capabilities:
- Lending and borrowing funds
- Trading cryptocurrencies
- Earning interest on savings
- Buying insurance
- Trading derivatives
What propelled the need for a decentralized financial setup?
Before 2008, the global financial system was entirely centralized. However, the aftermath of the financial crisis of 2008 saw the decentralized finance movement gain momentum. Although some of the foundational ideas related to web3 in finance emerged before this time, and attempts were made to create a decentralized digital currency, the 2008 financial crisis sparked the movement of decentralized finance in web3.
Innovators started to work heads down to address their growing dissatisfaction with the traditional financial industry. And finally, in October 2008, Satoshi Nakamoto, more commonly known as Satoshi by the crypto community, published their Bitcoin whitepaper, which suggested the creation of a digital currency. This idea laid the groundwork for the creation of the entire cryptocurrency and blockchain industry, which eventually led to the birth of DeFi or web3 in finance.
However, the problem with cryptocurrencies is that they only address the basic financial requirements of users: the storage and transfer of funds. These are undoubtedly important but represent only the most basic functions of money. Thus, for a truly decentralized financial ecosystem to exist, users needed to be able to do more with their cryptos. In response to this need, a wide range of decentralized finance services was created based on users’ requirements and demands. Now, one could invest, borrow, lend, and earn interest on their cryptocurrency holdings in a peer-to-peer manner without the top-down oversight of a central authority.
The financial tools available under the DeFi model are mostly in the form of decentralized applications, commonly called dApps. Smart contracts power all such solutions, allowing people more control over their finances. They also lower the entry barriers to financial markets. DeFi also eliminates the risks associated with single points of failure. Thus, 2008’s economic meltdown came as a boon for a wide cross-section of the global population eagerly waiting for a trustless way to perform financial activities.
The critical components of DeFi
The implications of web3 in finance are profound. As mentioned above, DeFi is the financial layer of the web3 ecosystem and hence, bears great significance. But DeFi is not a discrete entity; it is a collection of different components responsible for diverse capabilities. Here are some of the most essential elements of decentralized finance in web3.
Lending and borrowing
To use traditional financial services, users must have a bank account. This is a luxury that billions of people worldwide do not currently have. Obstacles in the way of borrowing include having a good credit score and sufficient collateral to prove to banks that you are creditworthy and capable of repaying the loan. Web3 in finance lifts any such barrier to lending and borrowing by allowing everyone to secure their digital assets to be used for obtaining loans. You can also get a return on your assets by participating in lending pools. Further, web3 in finance allows you to engage in financial activities like borrowing and lending without a bank account. You also do not need your creditworthiness checked.
Cryptocurrency prices are highly volatile. To address this issue of volatility, stablecoins were created. Stablecoins are pegged to stable assets such as the USD and hence, do not undergo rapid price fluctuations. Tether or USDT was one of the first stablecoins to be created, which was centralized. The drawback with a centralized stablecoin is that its users need to trust that the USD reserves against it are fully collateralized and that they exist.
The straightforward solution to this problem in the realm of web3 in finance is decentralized stablecoins created through over-collateralization. They run on blockchains and are governed by DAOs (Decentralized Autonomous Organizations). Thus, their reserves can be publicly audited.
Decentralized exchanges (DEXs)
Crypto exchanges facilitate the exchange of one cryptocurrency for another. Some of the most popular crypto exchanges out there include Coinbase and Binance. But the problem with these crypto exchanges is that they are centralized and serve as not just intermediaries but also custodians of the traded assets.
This doesn’t align with the idea of web3 in finance, as users have very limited control over their assets which could put them at risk if the platform is hacked or other issues arise. Decentralized exchanges, or DEXs, stand to resolve this problem by facilitating the exchange of cryptocurrencies without users having to give up the custody of their assets.
Derivatives refer to contracts with values derived from underlying assets. It is not surprising that derivatives are fast becoming popular in the world of web3 in finance, given the established popularity of derivative contracts within the traditional financial system. Besides, it is a fact that any growing financial market with risks and opportunities for speculation tends to create scopes for derivatives. It is also worth noting that the rate of innovation in the derivative market is correlated with the pace of the underlying market’s development. CeFi markets and the derivatives they create are tightly regulated and have taken years to develop.
Decentralized derivatives, however, can be created in an open and permissionless manner and without restrictions. Interestingly, derivatives in the world of web3 in finance are used the same way as traditional derivatives. Some of the most important DeFi derivative protocols include Synthetix, Hegic, UMA, Opyn, BarnBridge, dYdX and Perpetual. Although DeFi derivatives are still nascent, they are growing at a rate comparable to other crypto assets.
Web3 in finance has empowered the general public to be their asset managers, enabling them to make investment decisions that best suit them. Fund management involves overseeing your assets, including cash flow management, to ensure a return on your investment.
The two basic types of DeFi fund management are passive and active fund management. Active management of funds involves a team of investment decision makers who aim to outperform the market compared to a specific benchmark or index such as the Standard & Poor’s 500 Index. Passive portfolio management involves mimicking a certain index’s investment holdings to achieve similar results. It is worth noting that the level of transparency that web3 in finance offers makes it easy for users to see how their funds are managed.
One of the most important roles that cryptos play is facilitating the transfer of value between two parties in a trustless and decentralized way. With the emergence of web3 in finance, innovative payment methods are being devised. It is worth noting that most peer-to-peer payments take place via decentralized applications or dApps, which facilitate higher accessibility, security and ease of use.
Since web3 in finance offers a completely encrypted and permissionless payment infrastructure, it facilitates near-instantaneous transactions without involving any intermediary such as a bank. This, in turn, eliminates the need for end users to pay these intermediaries through processing fees. Using DeFi for your payments considerably reduces risks, costs, hassle and time to cash.
DeFi also allows organizations to make secure, scalable, and automatic payments, often with their current ERP infrastructure. This means a highly streamlined workflow and a low learning curve.
Insurance is a policy or arrangement whereby a company guarantees compensation for certain losses, damages and even death in exchange for a premium payment. DeFi users can opt for insurance services to protect their investment assets against various risks, such as smart contract hacks, multi-sig wallet issues, and attacks on DeFi protocols.
In traditional financial markets, a policyholder must prove that a loss has occurred and the claim for the loss is valid. Insurance companies verify the claims they receive and determine the payout based on their verification. However, in DeFi, parametric insurance is the norm. Instead of relying on policyholders’ claims, parametric insurance pays out when the parameters outlined in the policy are met. And the instrument that facilitates parametric insurance in the world of DeFi is called a smart contract. The smart contract describes everything from the payout amount and other insurance terms. Since smart contracts are self-executing, there is no need to file claims. Besides, the entire process can be completed quickly and more efficiently. Smart contract-based insurance also eliminates the scope for making false claims by policyholders. Thus, with web3 in finance, the sector receives a complete overhaul and benefits insurance companies and policyholders.
We can’t talk about web3 in finance without mentioning DAOs or Decentralized Autonomous Organizations. DAOs were created to democratize decision-making in decentralized organizations and facilitate governance in the world of cryptos. DAOs help spread power throughout an organization, aligning members’ interests and ensuring no group or individual can pursue selfish goals. DAOs are key to all community-based initiatives, including DeFi projects. Governance in DeFi is similar to the idea of business management and is leveraged by DeFi protocols to manage their projects. Governance tokens grant users voting power and a say in the protocol’s roadmap. Multiple toolkits and decentralized apps have also been created to support effective governance and enhance existing systems.
8 limitations of centralized financial institutions that DeFi stands to overcome
We have lived for centuries in a world of centrally controlled finance, where central banks control the money supply, intermediaries facilitate financial trading, and lending and mainly borrowing take place through traditional banks. However, decentralized finance has made significant progress in the pastime with the advent of web3 in finance. This model allows peer-to-peer transactions via a distributed ledger, not controlled by any central organization. DeFi has the potential to solve these 8 major problems of centralized finance. How? Read on to find out.
Web3 in finance eliminates the need for a centralized financial setup, allowing anyone to access financial services regardless of location and identity. DeFi services are mostly made accessible through dApps, giving users greater control over their money by issuing personal crypto wallets. DeFi platforms also facilitate trading and other services tailored to users’ needs and requirements.
Billions of people across the globe have no access to a bank account, which makes it extremely difficult for them to undertake financial activities. It is almost impossible for them to make financial transactions without risking their funds. Even trading at a large scale is only a figment of imagination for them. Lack of access to a structured financial system is one of the biggest reasons people rely on payday loans to address liquidity shortfalls. So, is having a bank account the solution? Well, even being banked does not guarantee ready access to funds. A bank might not be willing to lend the small amount that a new company needs. Web3 in finance makes things much easier. DeFi is accessible to all, with no intermediary to meddle in the financial affairs of users.
There are many loopholes in the centralized financial system. Credit card interchange rates and remittance fees are too high, and the time required for payment settlement is also long. Other inefficiencies include microtransaction issues, high brokerage fees, security vulnerabilities and delayed fund transfers. And since centralized financial institutions like banks also need to cover their brick-and-mortar costs, they keep the loan rates high and deposit interest rates low. All this makes the centralized financial system highly inefficient compared to web3 in finance. DeFi bridges such glaring inefficiencies in the centralized financial setup and makes web3 finance and banking the most preferred option for many.
Lack of interoperability
The traditional financial system is siloed and characterized by a lack of interactivity and interoperability. Besides, the switching costs are also high. Even the process of moving money between institutions is complex and lengthy. For instance, a wire transfer settlement can take up to three days. Web3 in finance, on the other hand, opens up possibilities of interoperability within the DeFi ecosystem. Interoperability between payment systems reduces the work, time, and monetary expenses on the user’s part.
The current financial system lacks transparency. The financial information available to bank customers is inadequate for them to make informed financial decisions. They also have difficulty determining if the rate on loans they are being offered is competitive. The consumer insurance industry has made progress in fintech services that can find the “lowest” rate, but the loan market is still fragmented. Besides, even the lowest price reflects legacy financial institutions’ brick-and-mortar costs and high back office expenses. Resultantly, everyone- from lenders to borrowers, suffers from the system’s inefficiencies.
The best thing about web3 in finance is the absence of middlemen. DeFi eliminates the need for intermediaries within the financial system by using a technology known as smart contracts. Smart contracts do not just regulate the custody of funds but also their distribution. By eliminating the need for human actors to facilitate transactions, DeFi reduces the scope for errors, delays, and bias.
Single points of failure
DeFi projects avoid risks by eliminating single points of failure by simply dispersing their operations. All financial records are stored on the blockchain, and since blockchains are distributed ledgers, the network continues to work even if a node goes out of order. Even the governance of DeFi protocols is carried out in a decentralized manner with the help of DAOs. This makes DeFi operations highly efficient, allowing the network to keep running.
The elimination of intermediaries and the distribution of records decrease the chances of corruption. Besides, distributed ledgers cannot be altered, which makes them more secure than centralized financial record systems. No bankers or brokers want to profit or gain an undue advantage. What more? Decentralized governance allows users to decide what is best for them and their community. This prevents money-minded people and groups from influencing their organization’s decision-making for personal benefit.
Web3 in finance: The way ahead
From the discussion above, it is easy to infer that DeFi is the perfect example of implementing web3 in finance. DeFi shows how cutting-edge technology can bring unprecedented efficiency to the financial sector. But is DeFi going to hit the mainstream soon? Although constant innovation is being undertaken in the web3 space, it is still a long before the internet goes completely decentralized. That means we will have to wait to see DeFi become the norm in finance. Nonetheless, web3 has made its presence felt across industries, especially in finance. And even market predictions paint a lovely picture of DeFi’s future. Undoubtedly, DeFi or web3 in finance is here to stay. In the times, decentralized finance will open up new markets and create new business models to benefit players in the financial system. And since web3 in finance is characterized by qualities such as decentralization, transparency, autonomy, and security, customers and financial service providers will not want to look back once they dip their toes in DeFi waters.
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