What is decentralized finance? Bitcoin and blockchain expert explains the risks and benefits of DeFi

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(THE CONVERSATION) Strong supporters of cryptocurrencies and the blockchains they run on have promised a lot.

To them, these technologies represent salvation from corporate power on the Internet, government intrusions into freedom, poverty, and virtually anything that afflicts society.

But so far, the reality has mostly involved financial speculation with popular cryptocurrencies like bitcoin and dogecoin rising and falling with alarming regularity.


So what are cryptocurrencies and blockchain used for?

As an expert in emerging technologies, I think decentralized finance, known as DeFi, is the first solid answer to this question. DeFi refers to financial services that operate entirely on blockchain networks, rather than through intermediaries like banks.

But DeFi also comes with a host of risks that developers and regulators will have to deal with before it can become mainstream.

What is DeFi?

Traditionally, if you want to borrow $ 10,000, you first need some cash or money already in the bank as collateral.

A bank employee reviews your finances and the lender sets an interest rate for your loan repayment. The bank gives you the money from its deposit pool, collects your interest payments, and can seize your collateral if you don’t pay it back.

It all depends on the bank: they are in the middle of the process and control your money.

The same is true of equity trading, asset management, insurance and virtually all forms of financial services today. Even when a fintech app like Chime, Affirm, or Robinhood automates the process, banks still play the same role of intermediary. This increases the cost of credit and limits the flexibility of the borrower.

DeFi reverses this arrangement by redesigning financial services as decentralized software applications that operate without ever taking over user funds.

You want a loan ? You can get one instantly by simply placing a cryptocurrency as collateral. This creates a “smart contract” that finds your money from other people who have made a pool of funds available on the blockchain. No bank loan officer needed.

Everything works on so-called stable coins, which are currency-like tokens usually pegged to the US dollar to avoid the volatility of bitcoin and other cryptocurrencies. And transactions settle automatically on a blockchain – essentially a digital transaction ledger that is distributed over a network of computers – rather than through a bank or other intermediary taking a stake.

The rewards

Transactions done in this way can be more efficient, flexible, secure and automated than in traditional finance.

In addition, DeFi eliminates the distinction between ordinary customers and wealthy individuals or institutions, who have access to many more financial products. Anyone can join a DeFi loan pool and lend money to others. The risk is greater than with a bond fund or certificate of deposit, but so are the potential returns.

And that’s just the beginning. Since DeFi services run on open source software code, they can be combined and changed in almost endless ways. For example, they can automatically transfer your funds between different collateral pools depending on which ones currently offer the best returns for your investment profile. As a result, the rapid innovation seen in e-commerce and social media could become the norm in traditionally stable financial services.

These benefits help explain why DeFi’s growth has been soaring. During the recent market spike in May 2021, more than $ 80 billion worth of cryptocurrencies were stuck in DeFi contracts, up from less than $ 1 billion a year earlier. The total market value was $ 69 billion as of August 3, 2021.

This is just a drop in the bucket of the $ 20 trillion global financial sector, suggesting that there is plenty of room for more growth.

Right now, users are mostly experienced cryptocurrency traders, not yet novice investors who have flocked to platforms like Robinhood. Even among cryptocurrency holders, only 1% have tried DeFi.

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The risks

While I think DeFi’s potential is exciting, there are also some serious reasons for concern.

Blockchains cannot eliminate the risks inherent in investing, which are the necessary corollary of the potential for returns. In this case, DeFi can amplify the already high volatility of cryptocurrencies. Many DeFi services facilitate leverage, in which investors essentially borrow money to amplify their gains, but face a higher risk of loss.

In addition, no banker or regulator can return funds transferred in error. Nor is there necessarily someone to reimburse investors when hackers discover a vulnerability in smart contracts or other aspects of a DeFi service. Almost $ 300 million has been stolen in the past two years. The main protection against unexpected losses is the “watch out for investors” warning, which has never been enough in finance.

Some DeFi services appear to violate regulatory obligations in the United States and other jurisdictions, such as not prohibiting transactions by terrorists or allowing any member of the general public to invest in restricted assets like derivatives. It’s not even clear how some of these requirements could even be enforced in DeFi without traditional intermediaries.

Even very mature and highly regulated traditional financial markets experience shocks and crashes due to hidden risks, as the world saw in 2008 when the global economy nearly collapsed due to an obscure corner of Wall Street. DeFi makes it easier than ever to create hidden interconnects that have the potential to explode in spectacular fashion.

Regulators in the United States and elsewhere are increasingly talking about ways to control these risks. For example, they are starting to push DeFi services to comply with anti-money laundering requirements and take into account the regulations governing stablecoins.

But so far, they have only scratched the surface of what might be needed.

From travel agents to car salesmen, the internet has repeatedly undermined the bottleneck power of middlemen. DeFi is another example of how software based on open standards can potentially dramatically change the game. However, both developers and regulators will need to increase their own performance to realize the potential of this new financial ecosystem.

This article is republished from The Conversation under a Creative Commons license. Read the original article here: https://theconversation.com/what-is-decentralized-finance-an-expert-on-bitcoins-and-blockchains-explains-the-risks-and-rewards-of-defi-161479 .


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