We are accustomed to a financial system where governments, banks, and other intermediaries control money flow. For example, they decide whether you can have a bank account, how much money you can borrow, and the interest you will pay. They can even print more money to keep the markets liquid. Given its centralized nature and reliance on a handful of intermediaries, this traditional financial system is called Centralized Finance (CeFi). If we go back long enough in history, our system was decentralized. We bartered goods and transacted directly with one another. However, a big issue with this system was a lack of trust between transacting parties, necessitating a trusted intermediary that could be relied on as the bookkeeper of transactions. Thus, there is a good reason a CeFi system was needed, which evolved into what we currently have. Over time, however, CeFi institutions have wielded a lot of power and influence, sometimes adversely impacting consumers.
Imagine a system with no banks or intermediaries but a block of code that behaves like one. And what if anyone can see this code and understand how the network operates? That is precisely what Decentralized Finance (DeFi) is – an ecosystem of financial projects and applications built on a distributed ledger technology called Blockchain. DeFi promises to satisfy the need for openness, transparency, and security and pave the way for a new financial system that is open to all and works without intermediaries. Even though it is in the early stages, DeFi is gaining momentum and attracting lots of interest from fintech and large finservs alike.
How does Defi Work?
DeFi is a trustless and permissionless system. Trustless does not mean that participants do not trust each other but rather that they do not rely on an intermediary as the trust mechanism. Similarly, permissionless means that anyone can participate in the system without requiring approval from a third party, such as a bank, to participate in the system. The structure of DeFi platforms is such that a community of users holding tokens of the protocol governs it. This distributed governance is called Distributed Autonomous Organizations (DAOs) and gives each member an equal stake in making decisions that can be automated using smart contracts. Smart contracts are equivalent to policies that a financial institution would follow to allow transactions on their network. Transactions are filled and executed in an automated fashion with no human intervention. Once executed, the transactions on the Blockchain are immutable, which means that they cannot be deleted or altered. The open ability to trace transaction creates transparency in the system. Defi eliminates location-based limitations and, given its virtual nature, can significantly reduce the unbanked population across the globe. We could send or receive money seamlessly with no regional regulations, currency conversions, or interchange fees. In short, DeFi can make the current financial system more efficient, accessible, and faster.
The Ethereum Blockchain is the most popular for DeFi and already has several real-world use cases in lending, derivatives, asset management, trading, and insurance. Most DeFi systems are closed-loop, meaning they are not connected to the physical world and require specialized mechanisms. Oracles and bridges facilitate such communication. Another feature of DeFi is that it allows developers to iterate and build a new generation of financial services apps called dApps. So, DeFi is more than just sending and receiving digital currency in a trustless system. It offers software tools and a new paradigm of developing applications to replace legacy financial systems.
The case for DeFi
The evolutionary potential of DeFi is immense. It is poised to transform the business model of transaction banking with the atomization of services and technology-reliant financial management. Being highly scalable, it has the potential to support a global financial ecosystem. The permissionless nature and interoperability of DeFi make financial services accessible from anywhere on the planet. In low-income regions where it is hard to afford banking services or people need to travel long distances to access them, DeFi is a viable option. It is also easier for small and medium-sized enterprises to raise funds and earn interest on assets through DeFi.
DeFi can easily connect borrowers and lenders in the lending markets giving rise to an expanding peer-to-peer lending market. The handling of lending, interest payments, and deposits is done through smart contracts on a large scale. In addition, interest rates can be automatically based on the supply and demand in the market. In short, DeFi can pose serious challenges for large traditional financial institutions that are reluctant to adapt.
The Case Against DeFi
Despite its tremendous potential, DeFi in its current state has many risks ranging from unfavorable regulatory environments, severe scalability issues of the Ethereum Blockchain, volatile cryptocurrency valuation, and limitations in building distributed apps (dApps). A network is only as strong as its underlying infrastructure. Blockchain networks’ reliance on oracles and bridges creates additional points of failure. The recent hacks of the Ronin and Wormhole bridges, which resulted in significant losses for consumers and firms, highlight significant vulnerabilities in this network architecture. In the absence of trusted governing bodies backing a DeFi network, users and investors face a lack of protection resulting in potential losses of crypto assets.
Another essential attribute of traditional currency is its fungibility, meaning you could easily swap a dollar bill with another of the same value. You could also walk into a store and spend it without worrying about its history as long as you acquired it from a legal source. With cryptocurrency, the perpetual immutability can create privacy issues for consumers, even when they’ve earned it lawfully. Another major issue with most cryptocurrencies today is that they aren't a reliable store of value. For example, the value of bitcoin is driven by its scarcity and hype rather than strong underlying fundamentals, partly why its value fluctuates wildly. Stablecoins solve this problem by pegging themselves to stable assets that create certainty in the system, but are still evolving.
Finally, despite its promise to reach the underbanked, DeFi and cryptocurrency is currently only accessible to a small, affluent percentage of the population due to the uncertainty, and high transaction processing costs (also called gas fees).
Traditional financial systems haven’t been without limitations and challenges, but they have matured over several centuries. While DeFi may not need centuries to evolve, it still has a long way to go before it becomes mainstream.
From a technology leader’s standpoint, DeFi offers a host of exciting technologies to explore and use, even discreetly, to make processes efficient using digital assets. By creating a private Blockchain (closed-loop system), leaders can experiment with distributed apps (dApps) and examine how cross-chain protocols like Swim work to understand how they may augment or co-exist with their core businesses in the future. DeFi will likely not replace the traditional financial system anytime soon, and it will also not be a lift and shift approach. Firms need to understand its potential and how to leverage it as an augmenting force rather than view it as a threat. In some ways, it is like electric vehicles (EVs) - we know it’s future potential. Internal combustion engines are still produced but all major manufacturers are at the same time retooling for the EV generation.