Transitioning from Centralization: DeFi Wallets Lead the Way

By Tinotenda Muradzikwa and Maximillian Jungreis Published on Jun. 29, 2023

Decentralized finance, commonly referred to as DeFi, is an emerging technology aimed at building a new financial system that is open to everyone and does not depend on traditional financial intermediaries, such as banks, lenders, etc. It gives power back to people, merchants, and businesses through the use of a DeFi wallet and allows them to conduct transactions directly amongst themselves using blockchain technology. So far, existing solutions have almost exclusively been developed based on the Ethereum blockchain.

The most frequently advertised upsides of DeFi are its openness, stemming from blockchain’s permissionless data, as well as its censorship resistance. One key feature that sets it apart from the traditional financial system is the lack of a conventional KYC process, or know your customer. For those unfamiliar with KYC, it's a standard practice in traditional finance in which financial institutions verify the identity of their clients and assess potential risks for money laundering or financing terrorism.

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While KYC is an essential safeguard for traditional financial institutions, it can also be time-consuming and costly for the institution and the customer. In contrast, DeFi operates on decentralized networks, meaning no central authority oversees the verification process. Instead, DeFi relies on smart contracts and other cryptographic technologies to facilitate transactions and enforce rules. As a result, DeFi can adhere to different KYC regulations than traditional finance, making it faster and more convenient for users.

In addition to the lack of a traditional KYC process, DeFi is also known for its low administration costs. Traditional financial institutions often have high overhead costs, such as the costs of maintaining physical branches and hiring employees to manage operations. DeFi, on the other hand, can operate more efficiently thanks to its decentralized structure and the use of automation through smart contracts.

As a result, DeFi can offer many financial services at a fraction of the cost of traditional financial institutions. Overall, the lack of a conventional KYC process and low administration costs make DeFi an attractive alternative to the traditional financial system for many users. While DeFi is still a relatively new and rapidly evolving sector, it is worth keeping an eye on as it can revolutionize how we access and use financial services.

How to invest in DeFi lending advancements

While DeFi has countless potential applications, the most common use cases are related to lending/borrowing, investing, and insurance. Some of the startups in the space include nobank, which offers a platform to invest in crypto, and Toggle, which provides decentralized identity verification solutions that help businesses prevent, detect and resolve customer-related issues.

DeFi lending primitives are still in their infancy. That being said, DeFi has been the most significant market cap activity within Web3, with a peak total value locked (TVL) of over $175bn at the height of the 2021 bull market. These protocols let their users lend and borrow cryptocurrencies on their platforms through smart contracts, where every transaction is recorded on the blockchain. However, these solutions differ from traditional lending in established financial markets, where borrowers lend more than they own in assets and expect to pay interest with cash flows earned using this borrowed money.

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Decentralized finance, DeFi, lending allows users to borrow or lend cryptocurrencies without needing a traditional financial institution. This is done through smart contracts and the issuance of new tokens representing the value of the loaned assets. One type of DeFi lending is margin loans, in which users supply collateral, such as ether, better known as ETH, to a smart contract in exchange for new tokens representing the value of the collateral plus interest. These tokens can later be redeemed for the original collateral plus interest.

While DeFi lending offers the benefit of users being able to keep custody of their assets and not having to share personal information, it is currently limited in potential use cases due to the high volatility of interest rates and is mainly used for speculation on rising cryptocurrency prices. Another type of DeFi loan is the flash loan, which does not require collateral but has faced criticism for its vulnerability to fraud. Be sure to check out the video below where we discuss notorious hacks and scams occurring in web3, and how users and businesses should protect themselves.

Future of the DeFi lending

Margin loans are a great start, but they will not be enough to achieve DeFi’s goal of radically reshaping the global financial system. To do so, protocols need to offer loans that do not serve only a tiny niche of the market but can be adopted worldwide. The loans must enable borrowers to borrow more than they already own in assets to restore the initial purpose of loans. If this is achieved, the DeFi lending market will not only be able to compete with existing financial players but also expand the global lending market by extending access to capital for borrowers, especially in countries with less developed financial systems. As a result, DeFi’s lower costs in terms of time and administrative requirements, as well as fees, play a vital role.

“The future of DeFi is critical because it represents a shift in the way we think about financial services. With DeFi, we have the opportunity to create a more inclusive, transparent, and accessible financial system that is not reliant on traditional institutions. The potential impact of DeFi on traditional banking and financial services cannot be understated, and we must continue to foster its development and adoption.”

— Maximillian Jungreis, Head of Crypto and Digital Assets at Plug and Play

However, several key issues must be addressed to achieve this commercial viability. Some of the critical roadblocks are identity verification, credit decisions, user experience, money supply, and interest rates.

DeFi wallet and identity verification

One of the key benefits of blockchain technology is also one of the biggest hurdles to the widespread adoption of DeFi lending products — pseudonymity. In traditional finance, if someone defaults on their loans, they can access real-life assets or blacklist these borrowers until they have repaid their debts. In DeFi, however, the only information shared is a wallet address. Users can easily create a new wallet address and borrow from the same lender using this new information.

To solve this issue, DeFi will likely need to revert to the tools of an industry it is looking to replace: KYC. KYC would link the wallet address to a real identity that can’t be duplicated. If that address defaulted, the identity could be blacklisted in a database accessible to any crypto-loan provider. The requirement for any unsecured borrower to match their wallet address to an identity would prevent that borrower from just creating a new address and taking out a new loan. Several companies are currently working on potential solutions to DeFi’s KYC problem; Blockpass, Jolocom, Bloom, and Colendi (which also aims to build a digital credit score).

Credit decision factors

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Uncollateralized loans will require the lender to make a credit decision. However, due to the anonymity, they cannot rely on traditional credit decision processes. Aside from Colendi’s digital credit score, lenders must consider digital information about a wallet. Some examples could be the age of the address (the older the address, the longer the verifiable track record of income), surplus income (ratio of amounts transferred to the wallet relative to expenses transferred away from it), and network connections (more addresses transferring income to the wallet implies a more robust income stream).

User experience

Compared to traditional finance, some significant differences in the customer journey of borrowers and lenders will have to be addressed. For example, how can you pay for things once you have taken out a DeFi loan?

After signing up using one of the KYC solutions a lending protocol uses and borrowing tokens, users need to convert these tokens into fiat currencies. Currently, there are two options to do so. First, users can use the typical crypto exchanges, such as Coinbase, Kraken, Bitstamp, and others, and second, through projects like Sempo, which creates a synthetic local currency that can be used at onboarded stores (currently trialed on some Pacific Islands). This option really focuses on the inclusion goal of DeFi.

The problem with both options is that both are widespread and have high friction in the customer experience. Option 1 requires users to already have a bank account to use the crypto exchanges, which excludes many potential customers from developing countries. A possible solution to this could be LocalCryptos. On LocalCryptos, users can exchange tokens for cash in person, however, this in-person meeting can be a big hassle for customers and needs to be done every time a user borrows and pays back their loan.

Issues with DeFi lending

With the increasing commercialization of DeFi loans, the supply side of lending also needs to grow. Lenders can either raise cash in common terms and convert it to tokens or raise funding on-chain. This would be the beginning of the crypto-bond market, with bonds at first secured by crypto-assets (e.g., Ether and stable coins). Besides crypto loans, other options may include content rights; for example, a writer running an online publication with a subscriber base (paying in stablecoin) could borrow against future subscription fees by redirecting those fees to an escrow smart contract that repays bond investors.

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A significant problem standing in the way of the widespread adoption of DeFi loans is also its current way of determining interest rates. As mentioned above, and while the specifics depend on the lending protocol, the general idea is that interest rates are determined by supply and demand. This makes such a loan highly unattractive to borrowers pursuing long-term loans for investments, such as buying a house. This problem still needs to be solved.

How CBDCs factor into the best DeFi wallet solutions

Central Bank Digital Currencies, or CBDCs, are digital versions of fiat currencies, like the US dollar or the Euro, issued and backed by central banks. They differ from cryptocurrencies like Bitcoin or Ethereum, which are not backed by any government or central authority. CBDCs can be used in the same way that physical cash is used, but they can also be easily transferred and stored electronically. They offer the convenience of digital payments with the security and stability of a government-backed currency.

One potential use of CBDCs is in DeFi through applications that allow people to access financial services directly without intermediaries like banks or credit card companies. CBDCs could be used as a form of collateral or as a means of exchange within DeFi applications. For example, a person can take out a loan using CBDCs as collateral or use CBDCs to buy and sell assets on a decentralized exchange.

Overall, CBDCs offer an interesting new possibility for the future of money and financial services, and their potential use in DeFi is an exciting area to watch.

Is DeFi lending the best option?

DeFi lending is still in its infancy, and several key issues must be addressed before this niche becomes commercially viable. There are already startups working on addressing these, however, as of yet, it seems like there is still a long way to go.

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Moreover, once these challenges are addressed, these new solutions will face the same questions and challenges traditional lending propositions are facing now: What’s their go-to-market strategy? User acquisition costs? What’s the pain point? Why this company? Why would a customer switch? The current, seemingly religious following of decentralized finance will have to face the cold reality of having to play by the rules of an industry they are looking to replace. One of the main concerns remains its user-friendliness with the majority of DeFi projects still far from being user-friendly.