Is Decentralized Finance ready to replace Traditional Finance?
In the past, the development of blockchain technology has facilitated the development. “Decentralized Finance (DeFi)” or a financial system without intermediaries which plays a greater role and meets the needs of financial transactions for certain groups of users. The financial system without intermediaries or DeFi has no national borders. No regulatory body is required. No need for financial intermediaries. It relies on blockchain technology in which the computer code is transparently revealed to allow developers to write smart contracts with each other. These are the hallmarks of DeFi, which has resulted in the development of DeFi today into an application. A decentralized application (Dapp) that offers deposits, borrowings and fundraising (Figure 1) is similar to the traditional financial system with centralized finance (CeFi), especially commercial banks.
In addition, the app is also able to trade cryptocurrencies and stablecoins easily on computers and mobile phones. This allows users to have lower financial costs and there are investment channels to get higher returns.
With features such as trustless lending, DeFi system design to work without a trust. Rather, the mutual acceptance of each user (or node) at the present moment, as well as the design mechanism to ensure that sufficient liquidity exists in the pool, would allow DeFi to exist and possibly be a parallel world to the traditional financial system.
However, it’s still difficult to replace traditional finance with DeFi as DeFi still has a number of constraints that need to be addressed before it can function as a full-fledged financial system, with such important limitations It can be summarized as follows.
1. Secured Loans
In Decentralized Finance (DeFi), collateralized loans are the most crucial part of open lending protocols. Given that DeFi empowers open, pseudo-anonymous finance, no one has a credit score or identifications associated with the loan users are taking out. Therefore, similar to mortgages, most DeFi lending applications will require borrowers to collateralize their loan as an incentive to hold them accountable for repaying the debt. However, the biggest difference between traditional collateralization and DeFi collateralization is that collateralizing a loan will require the borrower to over-collateralize the loan.
As a result, it can be seen that the “semi-anonymous” world of DeFi, unsecured loans, differs from the CeFi world where lending options exist. both with and without collateral.
2. Collateral Liquidity
Margin in the DeFi world requires mutually agreeable and tradable prices. Since it is a blockchain-based transaction, if a borrower on DeFi wants to use non-cryptocurrency or stablecoin collateral, but as a token produced by collateral conversion from the CeFi world (with a tokenization mechanism such as real estate or vehicles), it faces a key challenge: the token must be priced through a blockchain oracle that can be accepted by all. people in the system at all times Therefore, it will create confidence that is equivalent to placing a guarantee in the world of CeFi.
On the other hand, in today’s CeFi world, price discovery and acceptance of the uncertainty in price collateral for credit are already costs that commercial banks have to bear. For example home valuation Different appraisers may give different appraisals. And when the real sale announcement may not be the price as estimated, but because the bank is the lender itself The appraisal price doesn’t have to be accepted by everyone because in the end, the bank is the recipient of the uncertainty of the said price while there are still other channels to follow and ask.
However, compared to the world of DeFi which relies on local users to perform all these functions. In addition, the borrower is unknown and unable to follow up on demand. It should come as no surprise that the current DeFi world operates with only highly liquid mainstream tokens as collateral (e.g. cryptocurrency ETH and stablecoins, DAI and USDC) will be a key constraint in the practical application of the DeFi world engine for lending of the current financial system.
3. Borrowers Protection for DeFi Collateralized Loans
In the CeFi world, commercial banks have a cost for demanding and securing collateral. While demanding in the DeFi world has no cost because of the use of mechanisms over-collateralization (The margin value is always higher than the value of any tokens borrowed) so there is no need to ask.
In DeFi, there are few borrower protections associated with lending. Unlike in traditional finance where both borrowers and lenders have protections, such as loan insurance. DeFi is currently lacking in protection on both ends. In general, the primary protection mechanism associated with DeFi lending is the game theory and incentives behind over-collateralized loans. Users are unlikely to not pay their loan and default as there’s more capital locked as collateral. With this, borrowers are vulnerable to losing their private keys or having the smart contracts that hold their collateral hacked. In either one of these scenarios, the borrower or the lender would lose their capital with little to no recourse.
4. Higher fees
Gas cost is the fee a DeFi subscriber pays blockchain contributors to calculate smart contracts and record transactions on the block, but calculated according to the complexity of the user’s urgency And the price of tokens used to pay for gas in that network has turned the popularity of the DeFi world into a double-edged sword, meaning that the gas costs can go up to the point of sacrificing the value of the entire transaction.
If the purpose of DeFi is to improve access to the financial services of underbanked, often micro-transactions, the hidden cost of gas required by users. This may be higher than the cost of the existing CeFi system. However, efforts have been made to overcome this limitation, for example by adjusting the consensus mechanism or creating a parallel system to reduce computation on the main network, but it is undeniable that gas costs arise from the need for a network without intermediaries. Fees must be paid to incentivize contributors. Looking at another angle these costs are not necessarily incurred. If accepting a network with an intermediary, this raises an important question that follows adherence decentralization in exchange for paying gas costs in every transaction While there are restrictions on the types of transactions that can be performed.
5. Possibility of an exploit in a smart contract or loophole.
Decentralization in the context of DeFi requires a mechanism. This requires all participants to adhere to the smart contract (“code is law”), i.e., rely on a system design that provides each participant with incentives to perform the necessary functions of the system. Neither the borrower, the depositor nor the liquidator, each without the need to reveal their identity. It does not rely on any intermediary intervention or immediate troubleshooting to keep the system going.
However, The development of smart contracts requires a level of sophistication and knowledge that many blockchain developers are not prepared to acquire. Since DeFi is an open-source sector, anyone can repackage an existing protocol, give it a flashy name and start selling tokens. In most cases, developers do not go the extra mile to confirm that their codes are error-free or adaptable to unforeseen situations.
In the past, DeFi developers often incentivized users with governance tokens, whereby token holders have voting rights and empowered developers to make direction. Upon receiving approval in accordance with the motion and voting process specified, these tokens can be created and distributed at almost no cost. In view of CeFi’s concept, the token is like a common stock in a nearly unprofitable venture. The governance token is generously distributed to users on an ongoing basis, but it gained popularity until the price was higher. This can lead to a distortion of incentives that can lead to behaviors such as yield farming, creating transactions that do not stem from real loan demand.
In conclusion, even DeFi has a number of features that allow it to be a parallel world with the traditional financial system, but from all the limitations mentioned above If you want the financial system in the digital world to work with decentralized smart contracts, the creation of a lending protocol that allows for stable execution and does not generate biased incentives. It is an extremely important issue that today’s DeFi has to accelerate and develop. To truly function as a full-fledged financial system.
References:
Gleb Dudka, 2020
Kanis, 2021
Andrey Sergeenkov, 2021
Jesus Rodriguez, 2022
