How Web3 Is Reinventing Traditional Finance

Our generation is blessed with a chance to observe how technology is shifting the economic paradigm toward something previously unavailable to our imagination. Blockchain technology, which initially just offered an alternative model of transactions processing, has evolved into a whole new economic framework with its unique set of principles and ways of doing things. Today this framework is known as Web3.

In this article, we will focus on what exactly Web3 brings to the industry of finance, what would be the impact and how to benefit from the new world order. It’s essential to develop a well-informed and nuanced understanding of disrupting concepts at their early stages before they turn too complicated.

Let’s dive in.

What is meant by traditional finance?

By “traditional finance,” we generally understand a broad array of financial services, activities, and solutions facilitated by trusted third parties. These trusted figures intermediate the relationship between customers and money. Let’s call them centralized finance (CeFi).

Today there is a tendency to oppose “traditional ” and “decentralized” finance as they are two different worlds. One is something from the dark times and outdated, while another comes as progressive and futuristic.

In fact, current traditional finance is already not so traditional in many aspects. With the rise of Fintech, it has drastically changed and become unprecedentedly innovative.

FinTech brought technological innovation to many financial activities, including banking, insurance, trading, asset management, etc. It leveraged cloud computing, application programming interfaces, big data, and artificial intelligence, making financial services instantly available on any device.

Along with old-fashioned classical finance businesses like banks, working only in specific hours and having questionable customer care, we started to have innovative online services, like neobanks, online trading, investment apps, etc.

They offered a convenient interface, a wider range of products, more accessibility to capital for younger and riskier clients, and 24/7 support. No more bureaucratic paper nightmare. All became easily possible from a mobile phone.

However, what has really remained traditional in CeFi is its infrastructural bottlenecks:

• Intermediated framework. Intermediaries are always present in any interaction between a customer and money. Historically, intermediaries have played defining roles within financial markets, serving as agents and brokers of trust, liquidity, settlement, and security. The range and value of intermediaries have grown over time to meet the needs of an increasingly complex financial system.

According to Wharton, since the 2008 Global Financial Crisis, there has been increased attention to inefficiencies, structural inequalities, and hidden risks of the intermediated financial system. Such controversies as the GameStop short squeeze, in which retail investors were blocked from trading during a period of volatility, also cast a spotlight on other shortcomings of legacy financial infrastructure: slow settlement cycles, inefficient price discovery, liquidity challenges, and the lack of assurance around underlying assets.

• Censored and permissioned approach. This characteristic arises out of the previous one. To access specific services, you have to meet certain qualification requirements of an intermediary (to have a relevant credit history or own some assets). In terms of business transactions, sometimes your bank can have too harsh a compliance policy, which means extreme suspicion towards any payment done by your company. In the end, your company's bank account might be blocked out of the blue because transactions seem "questionable" for whatever reasons. It requires time and a lot of effort to recover the account. While it's blocked, business is paralyzed. So as we see here, dependence on an intermediary discretion can be painful and costly.

  
  

• No respect for privacy. Users always have to disclose their identity and provide sensitive personal data to access services. Law requires a service provider to keep this data as strictly confidential and destroy it after a while. However, the reality is a bit different. How often did you get bombarded with ads from companies that you never clicked on? I did a lot. Because your private information that is deemed to be confidential, in fact, is blatantly shared and disclosed without your consent.

  
  

• Underserving clients with low income and risky credit profiles. Often, clients can be labeled "risky" because they are young and don't have a compelling credit score yet. The same applies to small and medium enterprises that were just recently launched or probably do not have enough funds to provide the required collateral. All too often, these types of users are literally discriminated cut off from access to capital.

This is just a short list of CeFi infrastructural drawbacks. Unfortunately, FinTech didn't manage to address them and probably didn't have much incentive for it.

Not an issue. We have Web3 technology as a solution. Its mission is to overcome all these old-school challenges and offer a better reality instead.

Web3 injection in finance

Web3 is an umbrella term for the solutions leveraging blockchain technology and facilitating decentralized alternatives to traditional service providers and market structures.

We will avoid comparing it with Web1 and Web2, as you can find it on every Internet corner. To understand what Web3 basically is, check out the article “Web3 and DeFi: Collaborators OR Competitors?”

In finance, Web3 takes innovation way further than Fintech. Along with offering new financial services and income opportunities, it’s aimed to reform the whole underlying finance infrastructure at its core. Web3 strives to eliminate all those “good old traditions” of CeFi, as we discussed above, and shift the industry paradigm towards unrestricted access and democratization, privacy, low transactional cost, and independence from any third-party discretion. This new way forward in finance is referred to as DeFi (decentralized finance).

While traditional finance relies on intermediaries to manage and process financial services, DeFi operates in a decentralized environment—public, permissionless blockchains. Services are generally encoded in open-source software protocols and smart contracts.

Here are the main innovative components that DeFi brings to finance:

• Blockchains. Distributed ledgers serve as settlement layers for transactions. Currently, most DeFi services operate on the Ethereum network due to its capabilities and developer adoption. However, as DeFi activity is growing, it is gaining traction on other blockchains and cross-chain ecosystems.

  
  

• Digital Assets. Tokens represent value that can be traded or transferred within a blockchain network. Bitcoin and other cryptocurrencies were the first blockchain-based digital assets. Others have a range of intended functions beyond payments.

  
  

• Smart contracts. A smart contract is computer code that allows for transactions to be automatically executed when certain predetermined conditions are met. They are the key facilitators of blockchain protocols’ work. Smart contracts are programs that automatically self-execute upon certain conditions being met. They are tamper-resistant, which means excluding the risk of any third-party interference or modification of their terms. In DeFi, smart contracts are used as a means of transactional intermediation, therefore replacing conventional trusted middlemen (like banks, brokers, etc.). They also drive such essential elements of any Web3 ecosystem, like DAOs and distributed data storage.

  
  

• DAOs. A DAO, or “Decentralized Autonomous Organization,” is a community-led online entity with no central authority. Unlike traditional companies, DAOs eliminate the hierarchy of corporate management bodies and offer a decentralized governance model. Voting, decision making, distribution of dividends, execution of the agreed-upon decisions, and other business-related matters are regulated by the rules laid down in blockchain-based smart contracts and performed by them automatically. This is done to exclude any risk of human error or manipulation of votes.

  
  

• Distributed data storage. The vision is to ensure that users’ information is stored sliced to multiple independent network nodes instead of one server that is not under users’ control. This distributed approach seeks to procure high-quality data protection and enable users to manage their data, encrypt and keep it private, authorize access to data, and backup the storage.

  
  

• Wallets. Software interfaces for users to manage assets stored on a blockchain. With a non-custodial wallet, the user has exclusive control of funds through their private keys. With custodial wallets, private keys are managed by a service provider.

  
  

• Decentralized Applications (Dapps): Software applications built out of smart contracts, often integrated with user-facing interfaces using traditional web technology.

  
  

• Oracles. Data feeds that allow information from sources off the blockchain, such as the current price of a stock or a fiat currency, to be integrated into DeFi services.

  
  

• Cross-chain interoperability solutions (bridges, swaps, wrapped tokens, hashed-time locks, etc.) that make it possible to transfer value from one blockchain to another without losing on security and data reliability.

What is this new financial paradigm supposed to mean for a user?

• Low entry barriers to access the capital: no KYC/AML, credit score assessment, and risk profile. All you need is just an understanding of the products you are interested in and how to harness the infrastructure. One more thing: as DeFi stands for users' complete control over their assets, you have to develop increased responsibility for the management of your private keys. There is no support team to have your back once you forget passwords or seed phrases.
• The new way of transacting: peer-to-peer (i.e., no intermediary in the process), private, cheap, and free from cross-border barriers.
• The new array of products and strategies for income generation.
• Flexibility and protection if a financial crisis or any other "black swan" happens.
• The cherry on top - Incentives. There is an excellent practice in DeFi and the whole crypto industry to incentivize users for their active role in a network's community and development. Users are rewarded for participation in networks' governance, transactional validation, protocol development, and promotional evangelism. Each network has its own unique incentive design to keep its community members loyal and engaged long-term.
  

Summing up DeFi vs. Traditional Finance

Is DeFi really that decentralized?

In theory, DeFi is meant to be fully decentralized.  However, the reality is a bit more complex and nuanced.

Some types of market participants, like institutions, are often not allowed to work with non-regulated counterparties.

On the one hand, institutions are fancy to earn on crypto, but on another must comply with their licenses and applicable regulatory requirements.

For that kind of participant, the crypto industry has developed "semi-DeFi" solutions involving KYC/AML checks, financial monitoring, and other practices from traditional finance. These specific solutions are called "centralized decentralized finance," or CeDeFi.

A good example here is Aave. Originally Aave was the entirely decentralized lending/borrowing protocol where users could deposit and borrow different crypto assets. Recently Aave has also offered to the market Aave Arc - a protocol where all users need to get whitelisted (i.e., get permission to access).

Aave Arc is, therefore, a separate market from the current permissionless Aave. It's purposed to incentivize institutional involvement in a regulatory-compliant way.

𝐒𝐨 𝐚𝐝𝐝𝐫𝐞𝐬𝐬𝐢𝐧𝐠 𝐭𝐨 𝐰𝐡𝐚𝐭 𝐞𝐱𝐭𝐞𝐧𝐭 𝐃𝐞𝐅𝐢 𝐢𝐬 𝐝𝐞𝐜𝐞𝐧𝐭𝐫𝐚𝐥𝐢𝐳𝐞𝐝, 𝐭𝐡𝐞 𝐟𝐚𝐢𝐫 𝐚𝐧𝐬𝐰𝐞𝐫 𝐰𝐨𝐮𝐥𝐝 𝐛𝐞 "𝐢𝐭 𝐝𝐞𝐩𝐞𝐧𝐝𝐬." 𝐓𝐡𝐞𝐫𝐞 𝐚𝐫𝐞 𝐬𝐨𝐦𝐞 𝐜𝐨𝐧𝐭𝐞𝐱𝐭𝐬 𝐰𝐡𝐞𝐫𝐞 𝐃𝐞𝐅𝐢 𝐡𝐚𝐬 𝐭𝐨 𝐭𝐚𝐤𝐞 𝐩𝐞𝐫𝐦𝐢𝐬𝐬𝐢𝐨𝐧𝐞𝐝 𝐚𝐧𝐝 "𝐰𝐡𝐢𝐭𝐞-𝐠𝐥𝐨𝐯𝐞𝐬" 𝐟𝐨𝐫𝐦𝐬 𝐭𝐨 𝐩𝐫𝐨𝐯𝐢𝐝𝐞 𝐚𝐜𝐜𝐞𝐬𝐬 𝐟𝐨𝐫 𝐦𝐨𝐫𝐞 𝐜𝐚𝐭𝐞𝐠𝐨𝐫𝐢𝐞𝐬 𝐨𝐟 𝐮𝐬𝐞𝐫𝐬.

Besides that, many DeFi projects have a "backdoor" in their terms&conditions, reserving their right to unilaterally inject KYC/AML checks if the applicable law requires it.

So as we see, there is plenty of room for centralization of what has been initially designed as decentralized.

Most developed DeFi examples

DeFi embodies a variety of activities meeting the criteria of trust-minimized, non-custodial, open, composable, and programmable financial services.

Let's look at the most developed segments in the table below.

• Stablecoins. Basically, stables are purposed to maintain a constant value of a token relative to some asset, most commonly the U.S. dollar or other major fiat currency. In other words, stablecoins help hedge against crypto price volatility. An example of a decentralized (non-custodial) stable coin is Dai by MakerDao.

  
  

• Decentralized exchanges (DEXs) - seek to avoid taking custody of user assets. They can be accessed programmatically with non-custodial wallets. Transactions are automatically processed by smart contracts on a peer-to-peer basis or against a pool of capital. While DEXs can operate order books, the most prominent form of a DEX, automated market makers (AMMs), does away with the traditional order book entirely. Any holder of digital assets can lock up funds as liquidity for potential trades, earning a yield paid by traders. The price of any trade is determined algorithmically based on the ratio of available liquidity in the assets being traded. A trader is therefore dealing against liquidity pools supplied by market makers rather than an order book of potential counterparties subject to a bid/ask spread (Uniswap, SushiSwap)

  
  

• Lending protocols directly connect lenders with borrowers, enabling them to remain in full custody of their assets. Lending interactions are facilitated by smart contracts and recorded on particular blockchain protocols. A user doesn't need to provide any personal information or evidence of a good credit history to get access. Aave and Compound are two main protocols available in DeFi. They pool together the assets supplied by a lender into "money markets." In exchange, the lender obtains the protocol's native tokens (cTokens, aTokens) that represent the supply tokens value + interest. These native tokens can be later redeemed by the lender for their underlying tokens.

  
  

• Decentralized Derivatives (or derivative contracts) - tokens that derive their value from an underlying asset's performance, the outcome of an event, or the development of any other observable variable. Unlike conventional derivatives, decentralized ones do not require a broker. Instead, the contract terms can be programmed into smart contracts, eliminating the need for a third party. Settlement automatically takes place on-chain when the terms of the contract are fulfilled. Example: Synthetix.

  
  

• Insurance. The primary focus of DeFi insurance services are the DeFi-specific risks posed by smart contract failures, successful hacks of DeFi protocols, game-theoretical risks of incentive systems, and similar failures. DeFi insurance pools are collateralized with digital assets that provide capital associated with the individual protocol, in return for tokens granting a share of premiums. In the event of a hack or other failure, those funds reimburse premium-paying users. Claims assessors vote on whether claims are paid out, while claim payments are typically enforced by token-driven economic incentives. Surplus and investment returns generally accrue to capital providers or governance token holders. Example: NexusMutual

  
  

• Asset management. DeFi asset management protocols combine the underlying crypto investments through smart contracts into "vaults" or "pools", which function as a diversified portfolio of digital assets.  An example here is SetProtocol - a decentralized portfolio management protocol enabling users to create a token that represents a fully collateralized portfolio of other digital assets, including Bitcoin, Ethereum, and stablecoins. The underlying collateral that backs each Set is held inside of a vault smart contract. Sets automatically rebalance with predefined logic when certain conditions are met, such as a rebalance interval or a minimum percent deviation from target, eliminating the need to trust a human counterparty and reducing trading fees, similar to Robo-advisors in traditional finance.

• Aggregating solutions. These solutions mediate activity across various DeFi services. Examples here:

(i) Yield farming services such as Yearn Finance, which optimize liquidity and collateral provision returns.

(ii) Integrated interfaces (Zapper and Zerion) for order routing, yield optimization, and other DeFi activities across different protocols, which reduce complexity for users.

(iii) Multifunctional comprehensive trading solutions with cross-chain aggregated liquidity like Yellow Network. Essentially, Yellow Network is a single gateway trading environment, interconnecting multiple stand-alone exchanges in one automated non-custodial trading hub, providing a user with the aggregated liquidity and price feed, and seamless high-speed cross-chain transactions at minimal fees.

Final thoughts

Web3 technology is a game-changer for the finance industry. It has enabled us to look at finance from a fresh angle and create a flexible and accessible alternative that serves a wider variety of customers. While at the moment it’s hard to predict whether DeFi would totally replace traditional finance, it’s already clear: the world will continue moving towards a better economy and a more fair distribution of wealth.

By Julie Plavnik for Yellow Network

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