By Emil Bjerg, journalist and editor
With most of the attention going to AI in the past years, it can be easy to forget that we’re in the midst of nothing less than a revolution with Web3. Through current use cases, in this article we guide you to how Web3 can impact the future of finance.
After being declared dead multiple times, cryptocurrencies have made another comeback over the last year. Bitcoin is more valuable than ever, and other coins like Ethereum and Solana have also seen a spike in value lately.
Even giants are joining the party: JPMorgan Chase, a long-time crypto skeptic, just launched its own JPM Coin on a private blockchain for smoother institutional transactions. This move highlights the growing mainstream acceptance of Web3 and cryptocurrencies.
The development says a lot about the momentum that cryptocurrency has been building in finance, but Web3 is more than cryptocurrencies.
So what is Web3?
As Forbes writes “Web3 or web 3.0 is basically the next iteration of the Internet.”
Web3 is a progression from the first iteration of the web and web2, the internet we’ve known in the latter decades with social media and user interaction.
Forbes continues: “Web3 represents the next big evolutionary leap forward of the Internet – a leap that’s driven by blockchain, NFTs, and cryptocurrency. But perhaps the biggest defining feature of web3 is decentralization”.
Decentralization’s role in the future of finance
We’re about to get much more familiar with the term DeFi – decentralized finance.
Today, banks and other institutions often act as gatekeepers, deciding who gets loans and at what rates. DeFi powered by Web3 technologies can bypass them – allowing anyone with an internet connection to participate in lending and borrowing through tools like blockchain technology. This potentially makes financial services more accessible to everyone, not just those approved by traditional institutions.
Skipping the middle man via decentralization can also be applied to exchange or insurance. Web3 fans believe that this will give some power back to the consumer, both by expanding financial opportunities and by giving users more control over their financial data.
We’ll come back to how Web3 secures these types of transactions, but first, let’s have a look at how a lot of us could be lending and investing in the near future.
Decentralized lending in action
To give an example of how DeFi is already being applied, let’s take a look at Aave, a DeFi lending platform built on the Ethereum blockchain. Aave allows users to deposit cryptocurrencies like Ethereum (ETH) or USD Coin (USDC) into so-called liquidity pools. These pools essentially function as communal pots of money that other users can borrow from.
Here’s an example on how it works for borrowers:
Sarah, an entrepreneur looking to expand her business, needs a loan of $10,000. Instead of approaching a traditional bank, she borrows via Aave. Aave displays various interest rates offered by lenders based on factors like loan amount and loan duration. Sarah chooses a rate and specifies the amount she needs.
The funds are sourced from Aave’s liquidity pools contributed by other users like investors or crypto enthusiasts seeking to earn interest on their holdings. Smart contracts, self-executing code on the blockchain, automatically handle the loan transaction. Once Sarah repays the loan with interest, the funds are returned to the liquidity pool, and the cycle continues.
Decentralized lending currently comes with some risks – which we’ll return to by the end of the article – as well as some clear benefits. By lending on a decentralized platform, Sarah has been able to loan without a bank as an intermediary. Because of the lack of intermediaries, DeFi platforms often offer lower interest rates. Loan applications and approvals can potentially happen much quicker on DeFi platforms as well. As a final benefit, DeFi platforms are generally accessible to anyone with an internet connection and a crypto wallet.
DeFi is also being applied in exchange.
Decentralized Exchanges (DEXs): Trading Crypto Without Middlemen
Decentralized Exchanges (DEXs) are another innovation of DeFi, this one with potential to disrupt the traditional model of stock- and cryptocurrency exchanges. Unlike centralized exchanges where users deposit their holdings, DEXs operate on a peer-to-peer basis.
To illustrate how that works, let’s have a look at Uniswap, one of the biggest decentralized exchanges:
David, a cryptocurrency enthusiast, wants to trade his Bitcoin (BTC) for Ethereum (ETH). Unlike a centralized exchange, David doesn’t deposit his BTC with Uniswap. Instead, Uniswap works like a liquidity pool filled with crypto from other users looking to earn money by letting people trade. David simply taps into this pool to swap his Bitcoin for Ethereum, all without anyone holding onto his coins. These liquidity pools hold various cryptocurrencies deposited by users who wish to earn income on their holdings through trading fees.
Smart contracts act like automated matchmakers. They find someone else who wants to trade Ethereum for Bitcoin in the pool, aiming to make the exchange smooth and secure. The whole process is recorded on blockchain for everyone to see, keeping things safe and transparent.
As with lending, there are several advantages to trading DeFi-style. All trades on a DEX are publicly viewable on the blockchain, fostering trust and reducing the potential for manipulation. Anyone with a crypto wallet can participate in trading on a DEX, potentially opening up opportunities for those in regions with limited access to traditional financial markets.
DeFi has several other use cases. One is decentralized Insurance; peer-to-peer insurance solutions that cuts out middlemen. Another is fractional ownership: Owning a piece of expensive assets, like real estate or artwork, without needing a fortune.
But what are the safety mechanisms enabling DeFi?
Smart contracts as a decentralisation enabler
As IBM writes “Smart contracts are digital contracts stored on a blockchain that are automatically executed when predetermined terms and conditions are met.”
Or in the words of Ethereum, a main actor in developing smart contracts, they “are computer programs stored on the blockchain that follow “if this then that” logic, and are guaranteed to execute according to the rules defined by its code, which cannot be changed once created.”
Traditional agreements often rely on intermediaries like banks or lawyers to verify identities, enforce terms, and mediate disputes. Smart contracts bypass these intermediaries by automating these processes. The code itself dictates the terms, and execution happens automatically when pre-determined conditions are met. This reduces reliance on centralized authorities and empowers individuals to interact with each other directly.
All transactions and data related to a smart contract are recorded on the blockchain, a public and distributed ledger. This transparency fosters trust among participants involved in the agreement. Everyone can verify the terms and track the execution of the contract, reducing the risk of manipulation or fraud.
As mentioned, there are also challenges with DeFi and smart contracts that are worth considering. It’s especially important to be aware of security concerns, an Achilles heel for all finance, also for DeFi.
Challenges with DeFi
Decentralization comes with its own set of security risks. Smart contracts can be vulnerable to hacks and exploits, and the anonymity associated with some Web3 applications can attract malicious actors. Although rigorously tested, there are potential risk of bugs or exploits in smart contracts. Therefore, continuous improvement of security protocols and user education are crucial to the popularization of DeFi.
Another challenge lies in the schisma between decentralization and regulation. DeFi thrives on being exactly decentralized, with no central authority controlling it. However, this very strength poses a challenge when it comes to regulation. Governments and financial institutions are looking for ways to ensure consumer protection and stability in the financial system, which can clash with DeFi’s core principles. Finding the right balance between fostering innovation and implementing safeguards is an ongoing discussion that will likely shape the future of DeFi.
Another challenge is the high energy consumption of some blockchains, particularly those using Proof-of-Work validation methods. Currently, sustainable blockchain protocols like Proof-of-Stake are being developed to address this issue.
DeFi: The future of finance?
Web3 holds immense potential to transform both finance and societies. As Forbes writes taking away control from intermediaries and authorities and placing it in the hands of users represents a major power shift – from Big Tech, banks, and stock exchanges to consumers.
While a substantial technological shift is happening, there’s quite some way before the average consumer becomes a part of the Web3 transformation in finance. Rather than a sudden transformation into decentralized Web3 finance structures, in the coming years we can expect the technological breakthroughs to slowly translate into consumer behavior. Something akin to what we’ve seen with the gradual, popular acceptance of cryptocurrency over the last 10 years.
While DeFi has the potential to disrupt traditional FIs, it’s unlikely to completely replace them. More likely, we may see a hybrid future where DeFi and traditional finance coexist and even integrate with each other. Traditional FIs could adopt aspects of DeFi, such as blockchain technology for faster settlements or offering DeFi products to their customers. If a gradual shift towards DeFi continues, we’re likely to see some tech companies, banks and exchanges as well as policymakers be critical of it while others will identify new business potentials. Ultimately, both more traditional finance systems and DeFi are likely to continue to evolve to better serve the needs of users in a financial landscape that’s simultaneously more complex and more accessible.
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