Decentralised finance provides people an alternative channel for lending, investing and trading money without depending on traditional banks. The rising success of defi ought to be a red flag to traditional banks that consider the latter as their alternative source for those financial services.
Incumbent institutions might learn from the openness, efficiency and inclusiveness of DeFi, and DeFi could perhaps benefit from the experience, compliance with regulatory requirements, and opportunity to reach new customers that established businesses offer. Certainly, there are several advantages to be gained by both sides from connecting with each other. But is there a downside as well?
Investing in Decentralized Finance
While decentralised finance (DeFi) removes the need for traditional financial gatekeepers by allowing users to pool capital for investment, make loans from that pool, and trade in whatever assets are associated with those loans – while allowing end users to remain in formal legal control of the funds.
The transparency and automaticity creates trust that is often opaque in most traditional financial systems, while also streamlining automation to radically lower transaction costs while returning more of the value created from people’s financial activity to them.
DeFi poses a host of policy questions: how to define it, whether the underlying technologies of DeFi are sufficiently sufficiently decentralised, and who is in fact forming part of the regulatory compliance of the apparatus within complex ecosystems. DeFi holds numerous substantial stakes for innovation and cooperation in the global markets.
Decentralized Exchanges
DeFi is a quintessentially decentralised system for peer-to-peer trading and financing in which users exchange with and lend directly to one another without the involvement of middlemen; there is no centralised organisation governing the use of platforms, and anybody who has access to an internet connection and a crypto wallet (i.e, nearly anyone) can freely utilise it anywhere in the world.
Cryptocurrency users, unprotected from government guarantors like the FDIC, could have no one to complain to if an exchange were to crash – or if their smart contract had a bug.
Risks related to Know Your Customer and anti-money laundering regulations could limit use by users These risks represent a second potential hazard. Unfortunately, though, not enough testing has taken place on those risks to quantify them.
Smart Contracts
DeFi automates trading and exchange protocols using smart contracts – computer-readable if-then statements about the fulfilment of trading conditions that get triggered automatically, once programmed – published on blockchains (digital public record distribution systems) that allow participants to audit these protocols without revealing the identity of the transacting parties.
With central authorities, underwriters and other government agencies shut down, with exorbitant fees for human error eliminated, and with banks done away with altogether; individuals simply no longer pay intermediaries for depositing, borrowing and lending with each other. They only pay minuscule fees to computers for carrying out these kinds of basic transactions.
These tools are being used to build a borderless, open, and secure global financial system encompassing open marketplaces for trading products and services across borders, as well as peer-to-peer lending services and more. There are, of course, serious obstacles that need to be overcome for this vision to become a reality.
Composability
Decentralised finance provides the infrastructure for peer-to-peer financial transactions: there are no (trusted) middlemen, no service fees, and greater access to global economies via Internet access relationships. DeFi protocols might also reduce collateralisation requirements (given that borrowers typically don’t have assets above their current value) and trade traditional anonymised data points for creditworthiness at character level or financial history.
DeFi comes with risks, too. Without overarching regulatory institutions to oversee and guide them in their investments, users of this new technology must exercise more discipline and caution. And without layers of security protecting centralised exchanges, a new era of hacking is likely to arrive. As a result, those banking institutions must also team up on DeFi projects, building it in a manner that can enable both innovation and investor protections, while preserving stability in the markets.
Risks
DeFi, using cryptocurrencies and blockchain networks, can improve the speed, reliability and accessibility of financial services – but they also have downsides.
As a result, DeFi runs the chance of operating outside of conventional regulatory frameworks: it’s not clear that DeFi would survive heavy-handed regulatory policy-making (financial regulations tend to discourage innovation), and it lacks some of the standard protections offered by centralised institutions. For now, many DeFi players are well-versed in practicing self-care and keeping an eye on crypto’s volatile nature. Such risk-seeking is often rewarded. But for wider adoption in the future, DeFi will need to establish business models with clearer and better-understood incentives. It will need to convince users that these incentives are enforceable – and that entering DeFi’s frontier doesn’t inevitably lead to dark valleys.
In addition to the systemic risks presented by the increasingly complex features of contemporary financial markets, attention has been given to the possibility that the size and concentration of these markets in too few institutions have made the latter even more vulnerable to economic shocks or crises – very much a point made clear by the events of 2008.
If there are undetected bugs in the code of a DeFi platform, the financial losses from these errors could be enormous if left unchecked. This is another major risk, which can be mitigated with adequate investment into the project, such as having experienced teams that conduct thorough professional audits before going to market.
