DeFi (Decentralized Finance) in a Nutshell

Short for Decentralized Finance, DeFi is a financial system for the internet age based on cryptocurrency and blockchain technology. DeFi removes middlemen like banks, governments, and institutions from the financial system and makes it a peer-to-peer service.

With De-fi, the financial system is open, global, pseudonymous, and is not controlled by any centralized authority. No one can deny access to it and it is open to everyone for review, inspection, and scrutiny.

A Brief History

During the 2008 financial crisis, trillions of dollars were lost from the global economy, and trust between large financial institutions and the public was destroyed. The public ended up paying the price, while the large banks were bailed out.

In the wake of the crisis, the danger posed by centralized intermediaries was apparent to all. If banks failed, the financial system would collapse. It made the world realize that no nation and no currency can endure forever.

The conventional centralized system was solely based on trust in the government and financial institutions.

It was amidst this crisis that, on 31st October 2008, Satoshi Nakamoto serendipitously published his famous 9-page white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”, the content which would revolutionize and change the way we look at financial systems forever.

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.” (Satoshi Nakamoto, “Bitcoin open-source implementation of P2P currency”)

The Problem with Centralised Finance

Control

The government controls our money. They can print more money if they want to, they can stop you from borrowing money or having a bank account and they can take your money or make currency notes illegal when they want to. For instance, the 2016 Indian banknote demonetization left people standing in front of banks and ATMs in long lines for hours on end. This was a brutal blow for a nation that had the 2nd largest unbanked population with 190 million people who don’t have a bank account. The abuse of power happens quite often especially when a nation is on the brink of bankruptcy: Greece in 2016 and Venezuela in 2018 are recent examples.

Privacy

Financial transactions need personal identification, which can be the basis for discrimination and power abuse. For example, there is evidence of discrimination against the LGBTQ community in the US by financial institutions: “Same-sex couples were 73% more likely to be turned down for a mortgage than similarly qualified different-sex couples, and same-sex couples who were approved for mortgages paid about 0.02% to 0.2% more, on average, in interest and fees” (Hua Sun and Lei Gao, “Lending practices to same-sex borrowers”)

Inflation

The centralized financial system can inflate the market with quantitative easing, which has become more prominent after the 2008 financial crisis.

Restrictions

Banks can limit what you can or cannot do with your money. You have to follow their terms and conditions or they can deny access to their services. And they can be discreet about what they do with your money.

Expensive

There are premiums and high fees for financial services because intermediaries need their cut.

Human error

Since conventional financial systems are operated manually, the margin of human error is higher.

Speed

Money transfers and transactions can sometimes take days due to manual processes.

Why DeFi?

Open

DeFi is based on open source technology that anyone can look into, inspect and innovate on. It is open to everyone with an internet connection and no one can deny access to it. It is not controlled by anyone.

Global

You cannot enter the financial system of another country easily and in order to exchange currency, service providers generally charge a large fee.

Transparency

DeFi is completely transparent. You can keep a complete track of the money you have deposited, where that money is being transferred, and where it is being used.

Peer-to-Peer Transactions

Since DeFi eliminates the need for manual intervention, it is faster, reliable, and cheaper. And there are no off days and holidays.

Pseudonymous

In DeFi, identity protection is a priority and your transactions will be pseudonymous.

Technologies on which De-fi is based on

• Cryptocurrency: a digital currency in which transactions are verified and records maintained by a decentralized system using cryptography, rather than by a centralized authority.
• Blockchain: a system in which a record of transactions made in bitcoin or another cryptocurrency is maintained across several computers that are linked in a peer-to-peer network.
• Smart contracts: a computer program or a transaction protocol that is intended to automatically execute, control, or document legally relevant events and actions according to the terms of a contract or an agreement.

The Future of DeFi

Decentralized finance is still in its infant stage. It is still unregulated and has a long way to go. Thanks to the legalization of cryptocurrencies in nations like the US, the European Union, Canada, Australia, and El Salvador; the innovation and regulation for DeFi are well underway.

Current laws are based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless attribute presents some essential questions. Like, as who would be responsible for investigating a financial crime that occurs across borders, who would enforce the regulations and how would they enforce them.

Other concerns are system stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures.

The anonymous nature of DeFi is also a major factor preventing it from going mainstream. Since it can be used wrongly by the wrong people like drug dealers, arms dealers, and terrorists. This issue is currently being addressed, for instance, by focusing on the pathway of the transaction and not on the identity of the user. Other corporations like PayPal and Robinhood have asked Uniswap, the largest decentralized exchange, and OpenSea, the leading NFT market, to implement mandatory KYC checks before integrating their services. Would this help DeFi become mainstream and make it secure, or would it deter investors since anonymity is one of the coveted features of DeFi in the first place? Only time will tell, but one thing is for sure: DeFi will have a place in the future, in some shape or form.

Written By: Vidya Sagapam

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