What is DeFi & why it matters.

Over the past 2 years, Defi has earned a lot of attention, scepticism, excitement and confusion. Just in the last quarter Ethereum, the…

Over the past 2 years, DeFi has earned a lot of attention, scepticism, excitement, and confusion. Just in the last quarter Ethereum, the infrastructure that supports DeFi, processed US$ 1.5 trillion in transactions. Even though the number of transactions is huge and rapidly growing, it is still too early to understand the full potential of DeFi and its future impact on the shape of finance and the global economy. In this article, I will try to make sense of DeFi, its benefits, and the potential challenges related to its adoption.

DeFi proponents say it can address challenges within the traditional financial system and open new opportunities for monetisation, especially when it comes to the new Web 3.0 era. Opponents quote the lack of regulation and a ‘familiar’ centralised body that could regulate and protect user interests.

But first, what exactly is DeFi?

“DeFi,” which translates to “Decentralised Finance” is the ecosystem of blockchain-enabled services and products that eliminates traditional financial intermediaries with its autonomous infrastructure.

“DeFi” is a result of three innovations that happened in the past decade: Bitcoin, Ethereum, and Initial Coin Offerings. Bitcoin brought blockchain, which was originally designed to accommodate its peer-to-peer transfers. Ethereum brought Solidity, a universal and powerful programming language designed to allow for a diverse number of applications. And lastly, a recent boom of Initial Coin Offerings — a crypto variation on an initial public offering — brought to light a range of innovative companies and projects that have since formed the basis for a new decentralized financial ecosystem.

Why does DeFi matter today?

Imagine a world where anyone with an internet connection, anywhere in the world could open a new bank account within a second, borrow, invest, or exchange any digital asset directly without having to use a bank or broker, while always retaining full control over his/her assets— this is the world of DeFi (and this is the world of Web 3.0).

DeFi aims to reconstruct and reimagine financial services. Because it is based on blockchain, is fully automated and not governed by any central authority. Consequently, DeFi by its very nature is permissionless which allows for the frictionless, transparent transfer of any asset.

Benefits of DeFi

Low barriers to entry positively impact end-users

The fast-paced innovation in DeFi is fuelled by its permissionless and open-source nature. Currently, anyone can launch a new unaudited, and unregulated smart contract or protocol as a financial product or service on a global scale. The huge number of projects being developed in DeFi, such as Compound or UMA, makes end-users the ultimate beneficiaries — DeFi allows them not only to seamlessly move capital across the entire DeFi ecosystem but also, due to a high supply of services and products, do it at the lowest possible cost, without switching penalties involved.

Mitigates counterparty risk

Counterparty risk, the risk associated with a party in a financial transaction defaulting or failing to meet their obligations has increased in importance since the 2008 financial crisis. It is considered one of the top three risks facing the treasurer or company. The self-custodial, self-monitoring nature of DeFi mitigates the counterparty and credit risk, as assets on DeFi platforms are never in the custody of a centralised party. Now, this is a big deal, as apart from the elimination of credit risk, the risks associated with misuse of funds or hacks can also be managed.

Makes risk management transparent

Capital reserves in DeFi are continuously monitored — consequently, the users of DeFi peer-to-peer and secured lending arrangements (e.g. Maker, SushiSwap) can assess both the quality of the collateral and the degree of leverage in the system at any point in time. This is currently not possible because of the opaqueness of the financial system.

Modern infrastructure for the Web 3.0 world

The open-source technology of DeFi paired with programmable smart contracts and decentralized governance offers greater efficiencies across the entire value chain. In the new Web 3.0 world, the importance of instantaneous settlements is paramount. DeFi democratises access to the opportunities offered by the global financial markets that are unavailable to the countries currently marginalised by high infrastructure setup and operating costs. The unification of the financial system would eventually allow for benefits, such as private insurance and low-cost international payments, to be passed on to end-users.

In addition, DeFi’s real-time transaction data will provide transparency never seen before in the capital markets. Especially for investors in these markets. DeFi’s shared database will offer new ways to discover prices, allocate resources and make strategic decisions.

..And its challenges.

Balanced regulatory frameworks.

The objective of regulators has always been to ensure transparency and protection of freedoms and privacy of users while providing clear law enforcement guidelines.

The regulators have been reluctant to acknowledge the evolution of blockchain for years. Due to the rapidly scaling number of applications of blockchain (the total assets pledged as collateral in DeFi applications has soared in the past year, growing from less than $2bn to more than $50bn*), the urgency of regulatory frameworks for blockchain has been recently growing while also raising unprecedented questions about the nature of financial regulation.

Regulators have traditionally monitored all the activity of intermediaries such as banks. However, in the case of DeFi which eliminates intermediaries, such increased oversight could pose an existential threat and stiffen its innovation. As of today, the clear regulatory way forward for DeFi remains unclear.

Delivering a user-friendly experience.

The current user experience of moving money in DeFi is far from frictionless. Low coverage, the management of crypto wallets, private keys and sophisticated passwords, high processing fees, and expensive off-ramps — are just some of the obstacles that currently intimidate non-tech savvy users, slowing broader adoption. The good news is — with blockchain applications rapidly growing, so is the capital investment in DeFi space, bringing optimism about customer experience improvement to the early adopter community.

Decentralised-materialised.

The permissionless nature of the DeFi network sits at the core of DeFi’s value proposition and is costly to implement at scale. Instead of trying to work out how to strategically adopt DeFi into their business models and tech strategies, some global firms have recently been attempting to ride the current wave of publicity around DeFi by marketing their tactical projects. One can argue that even these low-quality projects are positive for DeFi adoption, however, in a long run, they might result in lessening the impact DeFi has got to offer.

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DeFi will not break the financial system, as some critics state, but likely strengthen and improve its liquidity in the long term. As with any new and evolving technology, DeFi has many challenges that need to be solved. Some still consider DeFi as an idealised movement, a dream, a utopia.

But in the world today, where NFTs raise millions and where the Metaverse captures the people’s imagination, it is not hard to envisage that in the upcoming Web 3.0 era, DeFi is likely to take a central role not only in relation to the exchange of assets but also in relation to the exchange of value as a whole.

*data collected by DeFi Pulse.