- Decentralized finance (DeFi) epitomizes “open finance” by leveraging blockchain and smart contracts to create a decentralized financial system. It eliminates reliance on traditional intermediaries, ensuring transparency, security, and broader access to financial services for all.
- DeFi represents a fundamental challenge to the traditional financial model by combining it with cutting-edge technology to provide more financial freedom, opportunity and security to users around the world.
- Developments in DeFi are gradually deconstructing and reshaping many aspects of the financial ecosystem, and DeFi has the potential to become an important part of more people’s financial activities.
- DeFi faces both smart contract and regulatory risks that could challenge its long-term growth and sustainability.
With the maturity and popularity of blockchain technology, the field of decentralised finance (DeFi) has emerged as the new darling of the fintech sector. Its decentralisation, transparency and a high degree of autonomy have brought unprecedented innovation and dynamism to the financial sector.
Basic principle and technology of DeFi
DeFi, known as decentralised finance, is also known as “open finance”. It is a financial system based on blockchain technology, aiming to achieve the decentralisation and universality of financial services.
DeFi is a combination of cryptocurrencies represented by bitcoin and ether, blockchain and smart contracts. Smart contracts are the core technology of DeFi, they are automated contracts that run on the blockchain and can automatically perform certain operations under preset conditions.
Instead of relying on traditional financial institutions and intermediaries, DeFi is automatically executed by smart contracts, and data and transaction records are stored on the blockchain, which ensures the transparency and security of financial services. DeFi also offers wider financial participation, as anyone can use the DeFi application, simply by connecting to the blockchain network.
Also read: Pavlovsky exits DeFi platform Marginfi due to policy disputes
Why get involved in DeFi?
1. Disruptive impact on traditional finance
DeFi reduces reliance on traditional financial intermediaries such as banks and clearing houses through smart contracts and blockchain technology. This disintermediation not only reduces transaction costs but also speeds up the transaction process.
Uniswap acts as an automated market maker (AMM), allowing users to interact directly with the contract to exchange tokens, thus avoiding the intermediary fees found in traditional markets.
DeFi enhances financial inclusion by allowing anyone with internet access around the world to participate without the need for a traditional bank account or credit background. For example, DAI Stablecoin allows users anywhere in the world to be able to hold and trade dollar-valued crypto assets without the need for a U.S. bank account.
DeFi increases transparency and security, with all transactions being public and immutable, such as the Compound platform, which allows the community to publicly audit its smart contract code.
2. Innovation and opportunity
DeFi is driving innovation in financial products through blockchain technology, offering services not covered by traditional banks. For example, Synthetix allows users to create and trade synthetic assets that mimic the performance of real assets without requiring users to hold those assets.
DeFi platform such as yearn.finance offers new types of investment opportunities by automating strategies for users to find the highest returns across different protocols.
DeFi’s rapid iteration and development is also part of its appeal, with an open source and modular design that allows new features to be quickly integrated and updated, such as the Aave protocol that continues to add new lending assets and lending features.
3. Integration with other technologies
Combined with artificial intelligence, DeFi platforms such as Nexus Mutual allow for more accurate risk assessment and insurance rate calculations. In addition, integration with Internet of Things (IoT) technology enables real-time asset management and trading, with smart contracts automatically executing transactions based on real-time data provided by IoT devices.
The development of cross-chain technologies, such as Polkadot and Cosmos, has even enabled the interconnection of DeFi products and assets between different blockchains, which not only expands the user base but also increases the liquidity and diversity of funds.
Also read: French fintech Tempo to use DeFi instead of remittances
Pop quiz
How does DeFi disrupt traditional finance?
A. DeFi relies on traditional financial intermediaries.
B. DeFi allows anyone with internet access around the world to participate without the need for a traditional bank account or credit background.
C. DeFi decreases transparency and security.
D. All transactions of DeFi are public and mutable.
The correct answer is at the bottom of the article.
Relevance of DeFi to everyday life
Thanks to DeFi, people who are normally excluded from traditional financial services can now access them, improving their living conditions.
Matteo Coppola, co-founder and CEO of Fluid Tokens
DeFi can greatly simplify the process of sending money across borders, reducing transaction costs and processing time. For those who regularly need to transfer money internationally, especially global expatriates and those who often work across borders, DeFi offers a more efficient and less costly option.
Due to the tamper-proof and decentralised nature of blockchain, DeFi increases the transparency and security of financial transactions. This means less risk of fraud and higher trust for consumers, especially when dealing with large transactions and investments.
DeFi provides everyday investors with access to emerging markets and innovative financial products that may be difficult to find or have a high barrier to access in traditional financial markets, such as cryptocurrency loans, liquidity mining and synthetic assets.
DeFi can offer more flexible crowdfunding and lending models through its smart contract platform, making it easier for entrepreneurs and small businesses to access startup capital. This decentralisation of finance reduces many of the barriers to traditional financing, such as high bank fees and complex approval processes.
DeFi allows users to manage their money with little or no intervention from intermediaries, providing greater financial autonomy and privacy. Users have direct control over their money and investment decisions without having to rely on traditional financial institutions for accounts and services.
As more merchants and services accept cryptocurrencies, DeFi is also changing people’s spending and payment habits. For example, using cryptocurrencies to pay for goods and services directly, and skipping traditional payment processors, may result in lower transaction fees and faster processing.
Risks and challenges of DeFi
While DeFi offers numerous advantages, it also faces several challenges and risks that need to be addressed for its widespread adoption and sustainability.
Eitan Katz, CEO and co-founder of Kima
Firstly, smart contracts may have coding vulnerabilities and errors that can lead to theft of funds or abnormal contract execution. These vulnerabilities could be exploited by hackers, causing losses to the project and users.
Second, smart contracts may be subject to attacks in which hackers can review the contract and attempt to exploit the vulnerabilities therein, which may result in loss of funds and abnormal contract execution.
In addition, risks to smart contracts may be triggered by improper user operation or unexpected circumstances, such as entering incorrect parameters or performing improper operations.
Finally, some smart contracts may have imperfect or insufficiently tested functionality, which may result in the contract not executing as expected or failing to meet users’ needs.
On the other hand, the DeFi project also faces regulatory risks. As the DeFi project crosses national borders, the regulatory laws it faces may be unclear or contradictory, creating uncertainty in the operation and development of the project.
Regulators may require DeFi projects to comply with regulatory standards for traditional financial operations, such as anti-money laundering and know-your-customer provisions. Projects that fail to meet these compliance requirements may face fines or closure.
Regulators may impose regulations on smart contracts in DeFi projects and require contracts to meet specific security and transparency standards. If a contract fails to meet regulatory requirements, it may be considered illegal or non-compliant.
To mitigate these risks, DeFi projects can enhance code review and security testing to improve the stability and security of smart contracts. At the same time, project owners should actively cooperate with regulators, comply with local laws and regulations, and work to ensure the privacy and security of user data.
The correct answer is b, DeFi allows anyone with internet access around the world to participate without the need for a traditional bank account or credit background.
