Decentralized Finance with its unique offering offers a range of benefits by hinging operations on the novel blockchain tech.
Decentralized Finance (DeFi) is flipping the script for the financial industry with the numbers around it suggesting that it could be at par with traditional finance in the future. Since coming into the scene, DeFi has grown at an astronomical pace with millions of users adopting the technology to revolutionize financial services.
DeFi makes use of blockchain technology to decentralize traditional financial services like lending, borrowing, and settling transactions. Using blockchains as the underlying technology, DeFi eliminates the need for a third party (banks) as transactions are carried out within a peer-to-peer network.
Given the functionalities, DeFi has been deployed in several sectors and shows no signs of slowing down. The total value locked (TVL) of DeFi assets has risen from less than $1 billion in 2019 to well over $150 billion today with analysts predicting that the industry could reach $800 billion in the near future.
This article takes a deep dive into “what is DeFi” and will take a cursory look at the risk and downsides associated with it.
What is DeFi?
Decentralized Finance is an innovative financial system that uses distributed ledger technologies to offer the services of traditional banking institutions like lending, borrowing, and transacting. DeFi is distinguished from traditional finance (TradFi) because it eliminates the need for a third party or an intermediary which typically exercises control in TradFi.
DeFi accomplishes this through the use of blockchains and distributed ledger technologies that are trustless and permissionless. This means that anybody in any part of the world can make use of the services as long as they have access to an internet connection. Without seeking the consent of a third party, a user can lend funds, borrow, or trade in a peer-to-peer environment as all transactions are stored on the blockchain and are transparent.
The end goal of DeFi is for individuals greater control over their assets and has the benefits of being faster and reaching greater numbers of the unbanked that TradFi has failed to reach over the years.
How Does DeFi Work?
In order to understand how DeFi works, it is important to have a firm grasp of blockchain technology. Blockchains are essentially a public record or ledger of transactions that are verified by other users using Proof-of-Stake or Proof-of-Work consensus mechanisms. Transactions are recorded in blocks and after confirmation, the block is closed and shares a connection to the previous and new blocks so that there is no way to change the details or information in a block.
DeFi depends on this technology to remove the need for a third party like banks and brokers that perform the traditional financial services. The transparency and secure nature of blockchains make it possible for DeFi to operate without centralized intermediaries.
DeFi makes use of other blockchain-related technologies to thrive. For example, cryptocurrencies and other digital assets play a major role in DeFi as they perform the role of currency like legacy financial systems. Digital wallets play the role of banks and their non-custodial nature allows the user total control of the assets in the wallet.
Smart contracts are another important aspect of DeFi. Smart contracts are self-executing contracts that run when predetermined conditions are met. These contracts are like terms and conditions and keep the DeFi protocols running without the need for a third party to monitor the processes.
What are the Benefits of DeFi?
DeFi offers several benefits to users that explain its soaring adoption. The benefits of DeFi are enumerated below.
1. Transparent Transactions
Blockchain tech allows individuals to see details of DeFi transactions with ease. This allows transactions to be tracked to ensure accountability and serves as an added layer of security. The fact that data on the blockchain is tamper-proof makes it preferred among users.
2. Non-Custodial Nature
The use of non-custodial wallets in DeFi gives users total control over their assets. This has the effect of ensuring that the assets of users cannot be seized and third parties do not have to charge extra fees for providing financial services.
3. Lightning-Fast Transactions
DeFi transactions are settled in real-time with little to no delays and interest rates are updated on a minute-to-minute basis to give users the full offerings. This is because blockchains on which DeFi protocols are built are designed to be fast with some capable of handling over 10,000 transactions per second.
The design of DeFi makes it possible for anybody with a digital wallet and an internet connection to access DeFi services. This has the effect of reaching the unbanked that legacy financial institutions have been unable to reach. DeFi makes it possible for individuals to trade, borrow and loan without seeking the permission of a banking institution.
5. Open-Source Protocols
The protocols of a large majority of DeFi applications are open source which means the codebase can be accessed by the general public. Developers and bug bounty hunters can go through the code to spot vulnerabilities before they can be exploited by hackers.
By being open-source, developers can build upon the platforms or create new products around the projects without seeking the permission of the team. This ensures that the nascent ecosystem remains innovative and does not shut itself to development like legacy financial institutions.
What are the Risks and Downsides of DeFi?
For all its benefits, DeFi still has its shortcomings that investors should be wary of. Here’s a list of some of the pitfalls that threaten the viability of decentralized finance.
- Security Breaches
In the first quarter of 2022, DeFi protocols fell victim to hackers that made away with assets running into millions of dollars. While traditional finance may have its own fair share of hacks, DeFi protocols have multiple entry points which hackers can exploit. These loopholes may be a result of software coding errors and other security vulnerabilities that allow bad actors to access funds from projects.
- Regulatory Threats
Since DeFi is an emerging field, DeFi protocols often operate in “a gray area” as government legislation is often insufficient. Regulatory agencies are trying to rein in the ecosystem without a blueprint, leaving experts unsure of how the pendulum will swing.
For example, the US Securities and Exchange Commission waved the threats of sanctions against Coinbase over its proposed lending offer to users while BlockFi was slammed with a fine of $100 million over lending products. Regulations could create a better environment for cryptocurrencies to thrive or they could swing the other way to stifle innovation in the space.
- Lack of Consumer Protection
This is a fallout of the lack of regulations governing DeFi. DeFi projects do not have the typical state-run reimbursement schemes that Traditional financial institutions have and in the case of a hack, DeFi projects are unable to compensate users for losses suffered. While some projects may return lost funds to users, other projects simply close their doors to the public.
- Guarding Private Keys
The non-custodial nature of DeFi is like a double-edged sword. On one part, it protects users from third-party interference and on the other part, users run the risk of being locked out of their wallets in the event that they forget their private keys.
Private keys are usually a string of 12 – 24 words that users must keep safe. Since the private keys are only known by the user, the loss of the private key is often fatal for the owner of a DeFi wallet with no way to recover them.
What Is The Difference Between DeFi and CeFi?
Centralized finance (CeFi) differs from DeFi on the grounds of centralization with centralized institutions performing the functions of storing, lending, and borrowing on behalf of users. This is in contrast with the decentralized and peer-to-peer nature of DeFi.
CeFi plays strictly by the rulebooks of regulators by abiding by the standards of anti-money laundering (AML) rules and Know Your Customer (KYC) rules. Most DeFi projects do not have the same comprehensive KYC and AML rules as their CeFi counterparts.
CeFi platforms are mostly custodial in nature and store the private keys on behalf of the users and go the extra mile in protecting the funds and sensitive details of users. The fees associated with CeFi platforms like Binance and other exchanges are typically higher than DeFi because of the costs associated with running the platforms and ancillary services that they offer.
Despite their differences, CeFi and DeFi share some similarities as they both advocate for the promotion and adoption of blockchain technology. They also offer similar services such as spot trading, borrowing and lending stablecoins, and sometimes, a user might find it difficult to know whether or not a platform is DeFi or CeFi.
Decentralized Finance with its unique offering offers a range of benefits by hinging operations on the novel blockchain tech. It is one of the many uses of blockchain tech that is geared towards democratizing global finance by removing all third parties and intermediaries that clog the process.
It is easy to confuse DeFi for CeFi platforms but keep in mind that DeFi is non-custodial in nature and permissionless. The AML and KYC requirements are also another distinguishing factor of DeFi over CeFi.