A payment is a transfer of value between two or more parties, typically in exchange for a good or service. Whether it’s friends sharing the cost of a meal via cash, card, or app; a pension fund purchasing shares on behalf of its savers; or a daughter or son remitting money to their parents in another country, payments permeate all aspects of our lives.
But how do payments work today? And why is DeFi the future of payments?
How do payments work today?
Let’s start by going back to basics.
Cash is the most simple form of payment. If two or more parties wish to transfer value, they can physically deliver the asset. In this example, Alice is delivering cash to Bob.
But cash isn’t very efficient. You have to carry it around, and that can get out of hand very quickly if large sums, especially across long distances, are involved.
Balances on ledgers
So a new method of payment was invented in renaissance Italy: adjusting balances on a series of ledgers. This innovation still underpins the electronic financial system we have today.
Let’s see how this works:
This form of payment solves the problem of having to physically deliver assets, which makes things far more efficient. But it also means that money is never actually sent. Only messages can be sent, and financial institutions act on those messages by updating their internal balances.
Taking a more holistic view, we can see that the global payments system is composed of thousands of ledgers managed by a multitude of banks and other financial institutions, that each send messages to each other.
But while this approach is more efficient than physically delivering cash, it does still have its own drawbacks:
- Silos of liquidity: A payment can only be settled if financial institutions each have an account with one another, or they both have an account at another financial institution, such as a central bank. Just look at how Bank B needed an account at Bank A for the payment above to work.
This means that payments can only ever traverse through pairs of relationships between financial institutions. This limits how quickly payments can be settled; how much can be paid; and with multiple intermediaries sometimes involved to find a “route” through those pairs of relationships, fees can quickly add up. Card payments for example typically cost merchants between 1-3% of the price of purchase.
- Trust: The parties involved also need to trust each other. Bank B can only debit its own account and credit Bob’s account if it trusts that its funds at Bank A are safe. There is nothing physically stopping Bank A from changing Bank B’s balance within its ledger, and so each entity needs to keep its own record of its accounts held with every other entity. Counterparty risk, the risk that another entity doesn’t meet its obligations, needs to be carefully managed.
- Error & Cost: Because payments are only really messages that result in an update to a balance on a centralized computer, this can result in error. Imagine if a message doesn’t get through or is corrupted - this could result in a double spend, or perhaps no spend at all! Financial institutions thus have a myriad of processes and controls to prevent, detect, and resolve issues. This adds significant cost which is passed down to the end customer.
How do payments work in DeFi?
The first thing to know about DeFi is that it is all about public decentralized ledgers. Instead of each institution having its own set of ledgers, and these ledgers having to be updated following a series of messages, everyone, including individuals, companies, and financial institutions, each has their own account (or more!) on the same ledger.
This opens up a world of possibilities. If everyone is on the same ledger, then to pay another person, you don’t have to go via an intermediary, you just instruct the ledger to be updated.
How DeFi payments are better
Decentralized public ledgers address the problems described above in the following ways:
- Silos of liquidity: The silos of liquidity in the existing financial system that limit how quickly a payment can be executed, how much can be paid, and with intermediaries taking fees, is gone, as all liquidity is in on a single ledger, and any payment no matter how large or complex can be settled instantaneously without any intermediaries.
- Trust: The need to trust another party is gone, as every individual, company, or financial institution is in control of its own funds on the one ledger. There is no longer any counterparty risk.
- Error & Cost: Transactions are immutable, and are only executed if they are cryptographically valid. This means that issues involving balances not reconciling across different ledgers is no longer a thing as there is now only a single ledger - a single source of truth. You no longer need a series of costly institutions to manage a series of centralized ledgers any more - you only need the computers that form the decentralized network.
A payments system in DeFi can thus be at least an order of magnitude faster, cheaper, and more efficient than the existing paradigm. Paying $1 or paying $1 billion can be done instantaneously, with almost zero fees. And you no longer need to wait for intermediaries to pass messages between themselves, orchestrating a complex shuffling of liquidity between ledgers.
With global payments revenues estimated at $2 trillion dollars a year we think a large portion of this can be passed back to end users in the form of less fees, better service, and faster access to working capital. The opportunity is ripe for those that build DeFi.
Radix is making DeFi development intuitive and secure with the world’s first asset-oriented smart contract programming language, Scrypto. You can get early access to Scrypto, and be a true trailblazer for DeFi, as part of our Alexandria release launching December 15.
Until then, check out our blog Scrypto is Coming to get yourself ready.