An area where this is particularly apparent is DeFi, short for decentralised finance. DeFi is one of the most exciting – and rapidly developing – areas of the blockchain and cryptocurrency world. Financial technology based on secure distributed ledgers similar to those used by cryptocurrencies can provide many different kinds of financial services without the need for traditional financial-services intermediaries, such as banks, brokerages or insurance companies. That has the potential to lead to a financial system that is more open and accessible than before. But it will come with its own set of risks and complications.
Understanding the Scope of DeFi
DeFi builds on the core ideas behind Bitcoin – a digitally native, decentralised payment system – and extends them into an array of financial services, including lending, borrowing, trading, investment and risk management – all running on top of public blockchain networks. Often open-source, DeFi systems can be used by anyone who has the right know-how and digital assets. By its nature, DeFi is relatively transparent and open. In theory, adding more transparency could be the step needed to finally democratise financial services, making them cheaper and available for a global market.
Opportunities Presented by DeFi
The principal attraction of DeFi lies in its promise to provide financial services in a fair and open way. No longer do centralised institutions have any role to play. As a result, the typical user paying fees should be lower and the interest rates on deposits higher. You are also more directly in control of what you do. Since the technology never sleeps, you can do all your business without ever setting foot in a bank.
Innovation is another benefit. A smart contract automatically executes a transaction and enforces the terms of an agreement, unmediated by humans, enabling new financial instruments. Plus DeFi is very ‘horizontal’; developers can innovate and integrate new tools and services quickly.
DeFi can improve financial security and privacy, if the tech is soundly designed and free from attack. Since users don’t have to share their identity or entrust their capital to anyone, personal data hacks might be less likely than in the traditional finance sector.
Risks Associated with DeFi
While DeFi are full of innovations, its risks cannot be overlooked. The most prominent risk is the technological risk. A smart contract is decentralised only in the sense that there is no central third-party standing between the two sides of the contract. Blockchain code is as reliable as the code it is written in. Bugs or other vulnerabilities in the code may lead to the loss of funds that were supposed to be returned due to a programming error or malicious attacks.
Another risk is that the assets used in DeFi – digital assets – are volatile. The price of cryptocurrencies fluctuates dramatically, and this volatility could impact the stability of DeFi services and products. Second, and almost as important, DeFi is largely unregulated, meaning that there is no legal recourse for users if things go wrong.
Liquidity is another issue. Many DeFi protocols involve users placing assets into a liquidity pool and, if there is insufficient liquidity, large transactions might not be possible without moving the price of the asset. There are also cross-platform interoperability problems, making it tricky to move assets efficiently around the DeFi ecosystem.
Conclusion
DeFi certainly looks promising in reshaping the way modern finance operates, offering a more inclusive, efficient and transparent system. But, like any new piece of tech, it also comes with considerable risks, especially given the fledgling nature of the infrastructure and the extreme volatility in crypto markets. If you’re one of those who wants to get into DeFi, it’s important to understand both the opportunities and the risks. It’s also essential to research thoroughly and be careful if you’re looking to capitalise on these opportunities as DeFi radically changes the world of finance.
It remains to be seen how the DeFi space develops as it matures, whether it can tackle these challenges without violating its founding principles of openness and decentralisation, and whether the future of finance is literally planet-sized and under our feet.
