Traditional finance is comprised of all the exchanges, banks, and lenders in the world, all of which are centralized. However, a new phenomenon has emerged in connection with the decentralized blockchains. This is decentralized finance (DeFi), or financial products that are made available via the blockchain. This gives access to them to anyone, anywhere in the world, without the need to go through some middleman like a broker or bank.
Decentralised finance is considered as superior to traditional, centralized finance for several reasons. One is that there is no requirement to provide any form of ID, which opens it to the masses of people around the world who cannot provide ID documents. Another is that it is controlled by the users themselves, rather than by some massive faceless corporation. DeFi platforms allow users to connect on a peer-to-peer basis, or interact strictly with software that cannot be manipulated in any way.
There are a number of technologies and protocols that have gone into the creation of DeFi, and platforms can consist of blockchains, open-source software, or proprietary software. One defining feature is the inclusion of smart contracts, which automate the agreement terms between buyers and sellers and make DeFi possible.
Since 2020 DeFi has seen the amount of value locked into smart contracts increasing steadily, however it remains an industry in its infancy. It is still being re-imagined, and its infrastructure is still being created. There is no oversight or regulation of the space, but in time DeFi is expected to hold a large place in the world of global finance.
What is DeFi?
The combination of technology and finance is nothing new. In fact, nearly every transaction in the modern financial system uses technology in one way or another. However, technology remains little more than a facilitator for modern financial institutions. The financial institution is far more concerned with legal requirements, competing financial markets, and varying standards and regulations that underpin every transaction and product. By contrast, DeFi places the use of technology at the forefront, utilizing a stack of common protocols and blockchains to create a free financial system.
DeFi lives in the blockchain and cryptocurrency ecosystem now, but its potential scope is far greater. To fully understand the forces that led to DeFi’s development it is also important to understand the current state of our global financial systems.
Modern financial infrastructure has been created in a hub and spoke model. This places the bulk of financial activity at the “hubs”, such as New York, London, Tokyo, and Hong Kong. These hubs then provide economic support to the spokes such as Boston, Barcelona, and Bangkok where the financial activity isn’t as great as at the hubs, but is still vital to the functioning of the regional economies.
In such a model economic prosperity or hardship will radiate from the hubs to the spokes, and outwards to affect the rest of the global economy. This interdependency is also seen in the function of global financial services companies and banking institutions with their network of global, regional, and local offices and operations.
Due to the sprawl of these organizations they are under the regulatory and legal frameworks of multiple jurisdictions, and their broad reach makes them critical in the stability of the global financial system.
It’s true this model worked well up to the 20th century, however recent global financial crises have shown how flawed this model is for the modern world. The problems of a small number of companies has shown that the interconnectedness of the system can create a global recession.
Many are now coming to believe that decentralized finance is the answer. In DeFi technology is used to enable financial services globally, regardless of location, age, race, social or financial status. The DeFi offerings are built on public blockchains, and many replicate the existing financial products and services, while others are innovative and created only because the DeFi ecosystem exists. And most importantly DeFi applications return control of their own money to the people rather than letting massive global financial institutions control money and value.
The Components of DeFi
At the highest levels the components of the DeFi ecosystem are the same as those in the traditional financial systems. This means stable currencies are needed, and that a wide number of use cases can be addressed by DeFi. In DeFi stablecoins are common, as are services such as cryptocurrency exchanges and lending services. Smart contracts also make possible new forms of passive investing such as staking and yield farming. Best of all, this is all accomplished through the use of smart contracts. There is no need for any human intervention in the process, since the smart contracts continue working tirelessly once put into action.
Because DeFi is built on software, all its components also belong to a software stack. Each layer of the stack performs a specific function in the system. This allows for a characteristic known as “composability” whereby the components of each layer are composed to create a DeFi app.
The State of DeFi
Decentralized finance is very much in its infancy in early 2021. As of March 2021, there is $41 billion locked in DeFi contracts. A year earlier that figure was well under $1 billion. While that growth is phenomenal and the amount seems quite huge, it is important to remember that the global gold market is $2.4 trillion and that the traditional forex markets trade $6.6 trillion daily as of 2019.
As an emerging system the DeFi ecosystem remains riddled with hacks and infrastructure blunders. Scams are also becoming more commonplace as criminals are attracted to the growing amount of money in the DeFi ecosystem. The good news is that the creators of the DeFi protocols are fast to react and are adding protocols to reduce risks every day.
It’s also quite likely that the open and decentralized nature of this new financial paradigm will create issues within existing financial regulations and legal frameworks. The current financial system works under the assumption of separate regulatory and legal jurisdictions, however the borderless characteristic of DeFi opens up questions about this type of compartmentalized regulatory and legal system.
The smart contracts that underpin DeFi are another area of concern for regulation. DeFi is a clear example of the axiom “code is law”, where laws are defined by a set of rules, and those rules are written and enforced by immutable code. A smart contract includes the code necessary to conduct a transaction between two parties, however software systems can and do malfunction. What happens if a smart contract crashes or if a compiler fails? Who will be liable for these malfunctions?
Before DeFi can truly become mainstream these and many other questions and issues will need to be resolved.
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