The use of technology in financial services is not new. Most transactions at banks or other financial services companies are accomplished with the help of technology nowadays. However, the role of technology is restricted to being a facilitator of such transactions. Companies still have to contend with navigating the legalese of jurisdictions, competing financial markets, and different standards to make a transaction possible. With its stack of common software protocols and public blockchains to build them on, DeFi places technology at the front and center of transactions in the financial services industry.
DeFi is commonly placed in the domain of blockchain and cryptocurrencies. But its scope is much wider. To understand the thought processes that led to the development of decentralized finance, it is important to understand the current state of the finance ecosystem.
Modern financial infrastructure is built on a “hub and spoke” model. Key economic centers of activity, such as New York and London, function as operational hubs for the financial services industry and influence economic activity at spokes – regional centers or financial powerhouses like Mumbai or Milan that may not be as important globally as hubs but, nevertheless, function as nerve centers for their respective economies.
Economic prosperity or hardship radiate outwards from hubs to spokes and towards the rest of the global economy. This model of interdependency is repeated in the functioning of global financial services corporations. They have headquarters in hubs and local branches, partnerships, or investments across the world. The sprawl of their operations means that the organization itself is subject to a phalanx of laws and regulations in each of its financial jurisdictions. Their reach has made such institutions systemically important to maintain the global economy’s balance and necessary to maintain or create new financial services infrastructure.
While this model worked well in the last century, the financial crisis and, subsequently, the Great Recession revealed the flaw in this architecture. The balance sheet problems for a couple of large financial institutions produced a domino effect of tumbling economies and, subsequently, the onset of the global recession.
Decentralized finance uses technology to disintermediate centralized models and enable the provisioning of financial services anywhere for anyone regardless of ethnicity, age, or cultural identity. DeFi services and apps are mostly built on public blockchains and they either replicate existing offerings built on the rails of common technology standards or they offer innovative services custom-designed for the DeFi ecosystem. At the same time, DeFi applications provide users more control over their money through personal wallets and trading services explicitly catering to individual users instead of institutions.