In the last few years, there has been a significant increase in global interest and investment in cryptocurrencies. This widespread momentum has prompted both individuals and institutions to venture into the realm of decentralized finance (DeFi). In this article, the Decenomy team takes a closer look at this evolving landscape and its impact on the global economy.
What exactly is DeFi?
Short for Decentralized Finance, DeFi, is a burgeoning financial system that is functioning on blockchain technology and rooted in the peer-to-peer concept. Through the application of the peer-to-peer philosophy and automated “smart contracts” on the blockchain network, DeFi democratizes finance and displaces conventional centralized institutions like banks, brokerages, and Non-Banking Financial Companies (NBFCs).
How does DeFi work?
At its core, DeFi utilizes smart contracts (self-executing codes stored on the blockchain) to automate financial transactions securely and transparently with zero human intervention. This reduces the chances of errors and increases efficiency. Users of the DeFi protocols can interact with these smart contracts through their wallets to engage in activities such as transferring funds, borrowing, lending, or accessing any services offered by the DeFi platform.
DeFi projects offer convenient and cost-effective access to capital, streamlined lending and borrowing processes, along with decentralized cryptocurrency and synthetic stock exchanges. Due to their decentralized nature, certain DeFi projects, such as Uniswap, have evolved into highly efficient financial markets serving both individuals and institutions. Furthermore, DeFi eliminates intermediaries, facilitating more efficient financial services at reduced costs.
As DeFi operates on a blockchain network and is typically open source, individuals with internet access can review the source code and examine all transactions. The immutability of blockchain data ensures that once information is on the blockchain network, it remains unalterable. This characteristic establishes a trustless financial system dependent on code.
Economic Impact of DeFi
Disrupting Traditional Financial Institutions
DeFi’s architecture of decentralization enabled by underlying blockchain technology may significantly reduce the role of centralized intermediaries in finance. Instead of payments, trading, lending, and other transactions facilitated by banks, brokers, and other institutions, DeFi allows peer-to-peer transfer of value on open protocols. Removing centralized intermediaries requires far less infrastructure overhead to support financial services at a global scale. It indicates the potential for vastly lowered fees on individual transactions as the high costs and profit margins extracted by those centralized players evaporate. Whether this potential to “disintermediate” Big Finance is realized depends largely on sustaining automation and decentralization across core DeFi building blocks.
Upgrading Global Payments Infrastructure
As a decentralized system for transferring value 24/7 at low cost, DeFi promises a payment infrastructure linking all countries that prove faster, cheaper, and more accessible than current options. Rather than slow and expensive wire transfers reliant on fragmented banking relationships, blockchain transactions can finalize and settle funds cross-border almost instantly for negligible fees using purpose-built protocols for global remittances and micropayments. Widespread DeFi adoption would free individuals and small businesses from localized payment platforms still controlled mainly by risk-averse incumbent institutions.
Expanding Financial Inclusion
DeFi’s permissionless accessibility allows those previously shut out from the formal financial system to now participate. An estimated 1.7 billion adults globally still lack even basic banking services, but decentralized finance presents an avenue to bypass banks altogether. Armed with just an internet connection, previously unthinkable financial products like decentralized savings, escrow services, and peer-to-peer credit become available regardless of geography, status, or regulation. This financial inclusion isn’t a one-way offering of slightly modified traditional services but instead lets the unbanked help build an entirely new open financial system Lego block by Lego block.
Providing Currency Alternatives
For populations relying on crumbling national currencies, whether the Bolivar’s epic collapse in Venezuela or fragile eurozone economies like Greece, cryptocurrencies and decentralized stablecoins offer alternatives to store value amid serious macro instability. This escape hatch is more than just Bitcoin allowing upper-income citizens to diversify globally, but instead lets those dependent on volatile local currencies plagued by fiscal mismanagement to “opt-out” and transact in now battle-tested censorship-resistant programmable decentralized money designed for reliability.
Spurring Innovation Across Industries
The blistering pace of technical and crypto-economic innovation across the DeFi ecosystem spurs progress in ancillary sectors too. Talent development in cutting-edge blockchain protocols seeds human capital, and spreads lessons on governance and incentive alignment well beyond finance verticals. Venture investment into DeFi projects now dwarfs early-stage funding even for Bitcoin, reflecting a rich pipeline of experimentation in decentralized payments, credit, insurance, synthetic assets, and prediction markets. As market-leading DeFi applications succeed and fail publicly, the ripple effects to platform business models, emerging market fintech infrastructure, and hardware and protocol design for an increasingly tokenized digital economy make DeFi’s long-term influence overarching.
Bottlenecks of the DeFi system
The previously mentioned benefits of utilizing DeFi elucidate its remarkable growth in recent years, amassing a TVL of over $50 billion. Nevertheless, while decentralized exchanges offer groundbreaking advantages, they also entail certain risks such as:
Evolving Global Regulation
As a new technological phenomenon touching finance and software, DeFi occupies a complex regulatory gray area across jurisdictions. Ongoing policy debates around crypto more broadly will shape decentralized finance, including directives around KYC compliance, derivates trading, cross-border payments flow, tokenized securities, stablecoins, and consumer protection safeguards. As contracts enshrined in code, the immutability of DeFi protocols once live presents challenges to modifying applications that run afoul of new laws. This rigidity could spark showdowns with regulators should certain aspects of DeFi not sufficiently align with shifting governmental stance on crypto financial innovation in the public interest.
Security & Hacking Hazards
The advent of hacked DeFi protocols siphoning user funds presents massive risks as the sector matures from its experimental phase. The permanence and non-custodial nature of self-executing DeFi apps on the blockchain means when vulnerabilities get successfully exploited, there are no legal means for users to recover lost digital asset value. Yet the complexity required to field sophisticated financial functions like lending and synthetic assets in an immutable transparent protocol likely implies future successful attacks even against the most battle-tested DeFi projects as pot sizes grow. Maintaining security and intelligent insurance coverage against smart contract risks is paramount to wider adoption.
Market Volatility Risks
While promising to revolutionize aspects of finance, DeFi remains highly volatile as an emerging alternative asset class. Total value locked across DeFi protocols has repeatedly gained and lost tens of billions of dollars in short periods tracked closely to crypto market sentiment and major price swings. Such turbulence can be expected to continue as speculation, regulation, hacked funds, and imbalances in highly complex incentive designs roil blockchain-based finance. Avoiding huge detrimental impacts from such volatility may require adoption from more risk-averse institutions.
Complex User Experience
Beyond backend protocol security and market risks, DeFi suffers large barriers to mainstream traction in the sheer complexity faced by users across many application interactions. Between governance token diagnostics, staking and mining mechanisms, multi-step processes in decentralized trading and lending, and the general difficulty of managing keys and assets across many protocols and wallets, DeFi usability remains years behind centralized consumer fintech and neobank options. While powerful for those who take time to deeply understand this rapidly evolving landscape, subpar user experience significantly caps wider adoption by global retail audiences in the near term.
Conclusion
In summary, despite the continued dominance of centralized systems driven by user-friendly interfaces, security features, regulatory oversight, and insurance provisions, the rise of DeFi has carved out a niche for decentralized crypto exchange protocols. With an increasing number of individuals entering the digital asset realm, DeFi must enhance its capabilities to ensure greater security and scalability. This evolution is already underway, as evidenced by the Ethereum network’s transition to Ethereum 2.0. In the foreseeable future, Decentralized Exchanges (DEXs) are poised to render cryptocurrency trading more equitable, private, and autonomous, thereby catalyzing the advancement of decentralized finance and its supporting infrastructures. The ongoing developments and trends in crypto investments present promising prospects for the future of Decentralized Exchanges.
