Smart Contracts in Decentralized Finance

May 2021 | Decentralized Finance

smart-contracts-in-decentralized-finance

Smart contracts and DeFi (decentralized finance) are set to change the future. Decentralized finance works on blockchain technology, which makes it possible to set up mobile applications that enable smart contracts for any monetary-related activity. Currently, the value of assets transactions through DeFi is over $68 billion, a 31 000% increase from March 2020, when it was $2.2 billion. As per industry experts, the ease of banking through decentralized finance may possibly lead to the end of traditional banking in certain sectors, especially borrowing and lending.

Decentralized Finance and Smart Contracts

In the traditional finance and banking system (centralized finance), usually, a bank or a financial institution (FI) acts as an intermediary. The bank or FI decides the interest rate and outlines the terms and conditions of the loan. If acceptable to the borrower, they sign the agreement and avail the loan. While, in the case of an investor, the bank or FI assures an interest income on the amount saved or invested in the bank or FI. The interest rate for an investor is lower than the interest rate at which a loan is given to the borrower. The difference in the interest rates makes up for the bank or FI’s income share.

In decentralized finance, there are mobile applications (Dapps) that enable borrowers to directly connect with investors/lenders. They can enter into an agreement at an interest rate that works for both parties. This arrangement assures a low-interest rate loan to the borrower and a higher return on the invested amount to the lender. A smart contract helps seal this deal. Decentralized finance makes the loan affordable, reduces associated expenses such as loan application fees, and encourages deposits.

A smart contract is basically a self-executing contract with the terms of the agreement between two or more parties, in this case, the lender and the borrower, directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. The code controls the execution of the agreement. Every associated transaction is trackable and irreversible.

Uses of Smart Contract in Decentralized Finance (DeFi)

Smart contracts have proven to be useful in the following sectors:

Financial Borrowing and Lending

As mentioned above, smart contracts have proven to be extremely useful in the borrowing and lending space. Decentralized financial (DeFi) platforms allow borrowers and lenders to directly connect with each other and enter into financial agreements which are fruitful for both.

Borrowers, who often did not qualify for loans under the traditional finance system or needed to provide some collateral, can also access funds from investors on defi applications. Smart contracts lock-in details of the interest rate, timeframe, and other required details of the transaction. Additionally, maintaining ledger of the payments made initially and during the payment period.

Peer-to-peer Transactions and Payments

Peer-to-peer payments allow an exchange of funds between two or more parties. Usually, carried out through traditional bank accounts transfers, or mobile applications. This proves useful when it comes to smaller transaction amounts. When it comes to higher value transactions, especially in cross-border payments, people are moving to crypto for peer-to-peer payments. Thus, avoiding the high transaction costs and significant time consumed while remitting through traditional channels.

Smart contracts allow seamless processing of these payments without involving intermediaries and enable maintenance of an online ledger of the transactions with the help of blockchain technology.

Protecting Digital Identity

Usually, to verify our identity online for KYC purposes, we provide copies of our physical identity cards, such as a passport or driving license. These records are maintained on databases accessible to third parties. Once provided, the individual has little to no control over its usage at least when it comes to extracting information from the source, such as name, age, location, or other relevant information.

Smart contracts allow peer-to-peer interactions without involving third parties. Thus, any identity information stored on decentralized applications is accessible only when the respective individual provides access to the data.

Digital Marketplaces Agreements

The current digital world allows individuals to work remotely. Businesses can reach out to service providers, freelancers, and other professionals through online platforms for specific projects. Similarly, there are several other digital marketplaces that link buyers and sellers. Recently there has been the addition of decentralized applications which enable buyers and sellers, or professionals to connect with each other. The use of smart contracts enables these parties to enter into a business agreement without relying on any intermediary or broker platforms, which usually charge a commission from both parties.

Tokenization

With the value of certain cryptocurrencies skyrocketing, individuals may not be keen on buying an entire coin. For example, the current value of Bitcoin is US$ 55,955.20. A common person may avoid putting all of their investable money into buying Bitcoin. However, one can buy a fraction of the Bitcoin, and become the owner of a portion of the Bitcoin. Thus, each Bitcoin could have several owners. Maintenance of the ownership is only possible through a smart contract. Smart contracts help outline the exact percentage ownership of each person, ensuring security as it is not easy to tamper with them. They also help maintain a record of any change in ownership due to buying or selling activities.

Initial Coin Offerings (ICOs) are proving to be useful in raising funds for new businesses. A start-up looking to raise funds to provide a new service or create an application can launch an ICO to attract funds. Interested individuals/investors can become a part of it by buying the issued token. These tokens may either have utility in the product being launched by the start-up or simply represent the individual’s ownership stake in the start-up.
This entire transaction between an investor and the start-up is coded through a smart contract.

It should be noted that the use of smart contracts is not limited to only these fields.

Future of Smart Contracts

Currently, smart contracts are still dependent on humans for initial coding. This could result in incorrect structuring of the contract due to inaccurate coding. Also, like other digital platforms, smart contracts are not 100 percent safe. There is a possibility of hacking in case of insufficient security.

Furthermore, many governments are still not pro-cryptocurrencies and decentralization. Thus, proving to be a hindrance in the smooth global execution of smart contracts, and acceptance of cryptocurrencies.

Decentralized service providers have started carrying out smart contract audits to prevent identity threats and ensure accuracy. However, this defeats the purpose of decentralization, which is to streamline transactions and agreements between parties without the involvement of a third party.

Smart contract usage could increase due to the various advantages upon addressal of the above concerns.

Penser is a specialist fintech and payments consulting firm with experience working for clients in the digital payments, card payments, and mobile payments sectors. We offer digital transformationdue diligence, and strategic planning services. Contact us to find out how we can help boost your business.