The industrial revolution has not only led to the emergence of industrial machines for industrialization but has also contributed to the transmogrification of the entire financial ecosystem through technological advancement.
Contemporarily, blockchain technology has been widely recognized as the ecosystem's backbone for digital currency; likewise, DeFi has been designed to effectively and efficiently use the digital currency in the ecosystem as well.
These crypto assets like any other blockchain technology has greatly revolutionized the financial system after the establishment and acknowledgement of the whitepaper (Nakamoto, 2008). Accordingly, Aramonte, et al. (2021) postulated that the DeFi is currently growing on the crypto financial system. This necessitates its consideration for effective and efficient financial transactions.
Decentralized finance (DeFi) is a new financial system that is built on safe distributed ledgers, much like the ones used by cryptocurrencies. It serves as a contrary theory to centralized financial institutions such as the established banking system.
Unlike the centralized financial institutions, the DeFi emerged as an inhibitor to third-party transactions. Arguably, this new norm will eventually reduce fraud to nothing and promote high-tech security of the digital currency.
It is quite known that the traditional centralized finance institutions withheld money and ensure that the movement of money among parties attract fees as a charge for the services provided.
However, DeFi eradicates third parties and allows individuals and businesses to conduct financial transactions through technology via peer-to-peer networks, security protocols, connectivity, software, and hardware advancements.
Reasons to adopt DeFi.
Comparatively, decentralized finance has a higher rate of accessibility regardless of geographical location, provided there is an internet connection.
Security and transparency have been another weakness and threat for centralized financial institutions like banks. This is because, apart from the banks granting access, not everyone can record and review completed transactions. As a result, there is a lack of transparency and security when money is placed solely in the hands of banks. Regardless, the DeFi is based on blockchain, which makes it simple to record and review financial transactions. This promotes security and transparency due to the immutability of the blockchain technology.
It also has low fees in terms of charges and high interest rates: through the DeFi network, there is direct negotiation of interest rates and lending of money among two parties.
Consequently, DeFi promotes peer-to-peer (P2P) financial transactions, where parties may agree to exchange cryptocurrency for goods or services without intermediaries.
The Challenges Associated with DeFi
As an emerging technology, it also has some drawbacks. Accordingly, Aramonte et al. (2021) disclosed that there is a “decentralization illusion” in DeFi due to the inevitable need for centralized governance and the tendency of blockchain consensus mechanisms to concentrate power. The inherent governance structures of DeFi are the natural entry points for public policy.
The DeFi’s at its promising stage, offers services that are similar to those provided by traditional finance and suffers from some familiar vulnerabilities because of its high leverage, liquidity mismatches, built-in interconnectedness, and lack of shock-absorbing capacity.
The basic mechanisms giving rise to the aforementioned vulnerabilities and their interaction through profit-seeking and risk-management practices are all well-known from the established financial system (Doerr, et al., 2021).
Even though DeFi is complex to understand with a high risk of fraud and volatility, it allows for easy financial transfers, the ability to generate income, and is also alienated from centralized financial institutions, which have a high tendency of bankruptcy if not managed appropriately.
Nevertheless, the Crypto analytics firm DeFi Pulse established that the market value for decentralized finance is at $77 billion. However, global DeFi market was valued as USD 11.78 billion and predicted to meet a growth of 42.5% by 2030.
Based on aforesaid statistical illustration, it is obvious to delineate the assertion with Marecki, & Wójcik-Czerniawska (2021) that, exhilarating foreseeable future of financial and economic services running on Distributed Ledger Technology (DLT) which is a decentralized database with no central administrator is likely inevitable eventually. This further lucubrates an anticipated world without a traditional banking system.
DeFi is a significant technology to promote financial liberty. However, it is advisable to always consult experts for guidance to ensure positive utilization of any technological software or mechanism to promote legal financial liberty.
Author: Stephen Dansu
Research Assistant at ILAPI
Aramonte, S., Huang, W., & Schrimpf, A. (2021). DeFi risks and the decentralisation illusion
Cornell University arXiv. “DeFi vs. DeFi – Comparing Centralized to Decentralized Finance
Doerr, J. F., Kosse, A., Khan, A., Lewrick, U., Mojon, B., Nolens, B., & Rice, T. (2021). DeFi risks and the decentralisation illusion. BIS Quarterly Review, 21
Federal Reserve Bank of St. Louis. “Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets
Marecki, K., & Wójcik-Czerniawska, A. (2021). Defi (Decentralized Finance) Will Lead To A Revolution In The World Of Financial Services. Economy & Business Journal, 15(1), 284-290.
Nakamoto, S (2008): “A peer-to-peer electronic cash system”, White Paper.
U.S. Securities and Exchange Commission. “Funds Trading in Bitcoin Futures – Investor Bulletin
World Economic Forum. “Decentralized Finance (DeFi) Policy-Maker Toolkit
Wharton, University of Pennsylvania. "DeFi Beyond the Hype, The Emerging World of Decentralized Finance
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