Decentralized Finance (DeFi) has been cropping up a lot lately in Crypto news and rightly so! It’s an ambitious and interesting proposition. If it achieves more mainstream adoption it could represent a major threat to traditional financial systems.
What is DeFi
DeFi or decentralized finance is a structure of financial applications running on top of blockchain systems. The idea is to create financial services and products using decentralized networks and open source software.
Whats Wrong with our Financial Systems
Our traditional banking systems are completely centralized and hold absolute power over accounts. This means that:
- Banks can delete or freeze accounts
- They can refuse to let you open an account
- Some banks won’t let you use your account to buy and sell crypto
- You need documents such as a passport to open an account
Banks also rely on slow outdated systems. If you have ever tried to send money overseas you’ll soon realise that it can take days for your money to arrive.
To open a bank account you need to have documentation. Lack of documentation is a major limiting factor for many migrant workers. Not having a bank account means they can only transfer money home using organizations like Moneygram and Western Union. These organizations typically charge large fees. Charges can average 7% and even up to 10%.
Then there is the story of high fees and charges. According to reports large American banks took in over $30 billion in overdraft fees in 2019. In a society where most families are living from one pay check to the next these fees are pushing them further into debt.
The Benefits of DeFi
DeFi is permissionless. You only need Internet and a Smartphone to access it. Smartphone ownership has increased significantly over the years particularly in developing countries. It is in these developing countries that most of the worlds 1.7 billion unbanked people live.
DeFi gives them access to financial services such as loans. With loans they can set up businesses, pay for education and improve their quality of life.
DeFi is decentralised. Records are kept simultaneously across thousands of computers instead of a central server. This means that all the transactions are publicly auditable unlike traditional bank records.
Censorship resistance is also another key feature of DeFi. In the traditional financial system it is possible for central parties to invalidate and stop transactions. With DeFi this is not possible,
DeFI can also let your money earn interest. Dapps such as Compound use smart contracts which enable you to lend out your cryptocurrency and earn interest. This is in stark contrast to many banks where if you leave your money in a savings account you earn little or no interest, even negative interest rates can be applied.
In fact most times you are paying the bank fees to mind your own money!
The Downside of DeFi
The majority of problems and risks associated with a DeFi project are generally associated with the technologies they are related to. The challenges with blockchain are generally responsible for fueling the downside of DeFi.
Inaccurate pricing oracle information can also be a downside of DeFi. Pricing oracles send information back to blockchains. They act like messengers sending real time price info. There are different types of oracles – centralised oracles such as Coinbase and decentralised oracles, used by DeFi platforms and decentralised exchanges.
If there is huge demand transactions on DeFi protocols could become highly expensive during the period of congestion.
Also DeFi is reliant on a blockchain. If there are any technical problems with the blockchain the DeFi project could become extremely unstable.
Key management is a real vulnerability for DeFi protocols. If key holders lose control of their keys, they lose access and effectively ownership, of their tokens.
Multi-signature key approaches have been developed placing user deposits in custody of consortiums. However, placing admin keys in multi-sig key
arrangements can be exploited.
Liquidity is also another concern with DeFi. At the moment the DeFi market is not as big as the traditional financial systems. Users could find it difficult to put their trust in a sector that does not have much liquidity as the usual financial sector.
DeFi projects are undoubtedly a method to provide financial inclusion for a broader population, especially the unbanked and people in developing countries. I for one will be watching DeFi carefully to see how it evolves.
If anyone would like to learn more about DeFi the University of Nicosia is running a free online course. Check it out. I’ve signed up already.