De-Fi Movement

What is centralised finance? Money has been the blood supply of society for centuries of civilization. It has been the foundation of a society’s or community’s progress. It has been the factor that has enabled individuals to be dependent on one another by creating a uniform unit of value that could be used and obtained during the trade of goods and services. However, there had always been the need to regulate the supply of money and its change of value through time, amongst many other reasons that required the presence of a medium in society. The kings, aristocrats, and churches initially were this medium, but as the world progressed into the industrial age, these feudal powers were soon replaced by banks and elected governments. However, while there was an evident and drastic change in power between the two eras, the existence of a medium has remained. The banks continue to manage the flow of transactions and the value of the currency, as well as play a significant role in a country’s economic and business activity through the power of loans and being able to impact interest rates.

Thus, the drawbacks of having an intermediary system like banks or governments run by humans stayed. The biggest drawback of this revolved around the fact that the public was made to disclose too much personal information (often far more than required), which led to a lack of privacy. A lot of this personal information was further stored within the centralised system’s records, posing a risk in terms of security. Alongside that, there is also a challenge in terms of accessibility to centralised banking. Individuals that fall under lower income brackets or those in remote, far-off, or economically disadvantaged regions of a country find it difficult to access these financial services since banks and central banks have traditionally established their branches and centres in busier, urban areas. As a result of this, there is less financial inclusivity towards communities living in underserved areas of a country, hindering financial services for a significant portion of a population.

To add on to the problem of financial inclusivity and its limited accessibility, there are high costs associated with traditional banking services: maintenance fees, transaction fees, and overdraft fees, among many others. Consumers that fall under the lower income bracket or those who indulge in frequent transactions will be more significantly impacted by these costs. Alongside this, the transaction processes within the centralised system become all the more time-consuming and slow-paced, drastically reducing its efficiency. For example, the transfer of funds, processing payments, and then settling the transaction would require the involvement of multiple bodies within the bank for tasks such as verifications (which are often manually done) and would take days for the transaction to finally take place, which may also result in delays. For consumers who would need funds immediately in case of an emergency, this process will be extremely inconvenient and perhaps even unnecessary. This is further fuelled by the bureaucratic nature of plenty of traditional banking services that are hostile to new technological methods that could speed up and increase the efficiency of the transaction process.

There is also a lack of control consumers have over their own money when it comes to centralised systems. Banks have significant control and say over a person’s funds and transactions. As a result, the control an individual would have had over their own money greatly reduces as there is an increased dependency and reliance on banks to handle their transactions and even make decisions on their behalf. This could be a sign of individuals having limited power over their own money, which may also give rise to frustration.

Lastly, if individuals from a lower income bracket were to require loans, Being unbanked due to inaccessibility or inability to afford the high transnational costs would discourage a bank from lending the individual, or even a startup, for that matter. A lack of collateral, which is often the case for unbanked populations, further dissuades banks from lending. This results in a lot of startups being reluctant to take risks in order to grow and potentially increase a country’s economic activity and will not assist unbanked individuals that need immediate financial assistance. Additionally, it’s the banks that can ultimately determine whether they have higher interest rates for loans and lower interest rates for savings, consequently reducing the net benefit to consumers.

It is due to these drawbacks that a need for a potential alternative to traditional centralised systems has arisen. The DeFi (Decentralised Finance) movement is one of its biggest advocates. Decentralised finance refers to a platform where financial transactions can take place without the presence of intermediaries, like traditional centralised reserves, in a decentralised manner. It uses blockchain technology to list out the transactions that take place on an online ledger. The aim of DeFi is to provide greater financial inclusivity to banked as well as unbanked populations through increased accessibility. This is due to the fact that DeFi is accessible to any individual with an internet connection.

While there are a good number of platforms used for decentralised finance (eg: Binance Smart Chain, Polygon, Avalanche, etc), Ethereum is undoubtedly the most popular blockchain platform that is used for De-Fi at present, which this article will mainly focus on. Ethereum’s programmable nature allows developers to create decentralised applications (DApps) that can automate various financial processes, including lending, borrowing, etc. Ethereum’s native cryptocurrency (Ether) serves as the fuel for executing smart contracts and interacting with the Ethereum network. While Ethereum was made for the same purpose as its predecessor, Bitcoin, the two differ in several ways. Bitcoin was primarily designed as a digital currency, while Ethereum was created as a platform for executing smart contracts and building decentralised applications. Bitcoin’s scripting language is limited compared to Ethereum’s, which enables more complex programmable functionality. Additionally, Ethereum has a shorter block time and supports a wider range of consensus mechanisms, including the planned transition to a proof-of-stake consensus algorithm called Ethereum 2.0. Bitcoin also didn’t have a platform where there was an elaborate description of goods that were on sale, aside from entities being allowed to send one text explaining its value. The lack of elaboration could’ve made consumers unhappy and dissatisfied after a transaction on Bitcoin. However, in Ethereum, entities are given the liberty to give an elaborate description of the goods and items being sold and why they are of value, reducing the chances of information failure and consumer dissatisfaction. In layman terms, a Bitcoin platform was like an App Store where all the apps available for sale were present, but there were only one liner description on why the app was of value, while Ethereum in this scenario is like today’s App Store where there’s an entire paragraph as a description on the value of any app. It could thus be said that Ethereum is a modification of the Bitcoin platform, a case seen in the constant evolution of cryptocurrency as it seeks to cut down on its cons.

There are more features of Ethereum that make it an improvement, as well as making DeFi a potential alternative. It consists of a smart contract capability that enables the creation of several different decentralised applications, for example, DeFi protocols that can automate transaction processes on the blockchain. Since Ethereum has widespread adoption in the world of cryptocurrency and blockchain, it has a large and active community of users due to its network effect. This makes it easier for financial transactions to take place. However, like Bitcoin, Ethereum, due to its over-reliance on technological goods and proof-of-work consensus mechanisms, will require the consumption of significant amounts of energy. The dependency on technological goods like phones will increase the requirement for mining materials such as cobalt, which will have a hazardous effect on the environment. Ethereum 2.0, though, aims to reduce its extensive consumption of energy.

Looking at De-Fi on a broader scale, there are additional benefits it has over centralised financial systems beyond greater financial inclusivity and the elimination of human intermediaries. Since De-Fi is built on a public blockchain, all the transactions that take place on this ledger are visible, and users who wish to verify the transaction history of another user they are trading with can view their transaction history. Since this blockchain technology is backed by hundreds of computers, it makes it nearly impossible for any individual or business to hack into it or alter any transaction. As a result of this, De-Fi offers viewers far greater transparency in comparison to centralised systems, and this is without requiring consumers to reveal much of their personal information, which keeps their privacy secure. Since transactions involving cryptocurrencies take place online and cryptocurrency itself is a self-evolutionary process in terms of technological advancement, De-Fi is open to future innovations and allows programmers to build and deploy financial applications that can further give room to innovation in the financial sector.

However, the De-Fi platform is not without its cons. While it promises to be financially inclusive and does indeed give scope for financial inclusivity, There is a huge segment of the world population, concentrated in the Global South, that doesn’t have access to the internet. This could either be because people are unable to afford technological devices like phones or because of a lack of internet connectivity in remote areas. The consequence of this, thus, is that a huge number of the global population don’t have access to the most required tool to trade online: the Internet. This means that even if De-Fi lets consumers have easy access to its services, the lack of a technological link present in several regions across the globe still makes it impossible for many consumers to access this financial service. Secondly, the governments, for all their imperfections, are still, in most cases, the legitimate authorities of their respective nations, and since very few De-Fi services are backed by the governments, it is bound to consequently reduce the amount of faith the public would have in this platform and persuade them against using this financial service.

The biggest challenge pertaining to the world of decentralised finance is the risk associated with it. Since De-Fi doesn’t have a uniform style of transaction process and relies on smart contracts based on each transaction between two parties and its predetermined conditions, there are plenty of smart contracts that are automated on the blockchain platform, and some of them, thus, may end up containing bugs and be vulnerable to exploitation. This vulnerability poses a heavy risk to a consumer’s funds. Furthermore, Ethereum, despite having a blockchain service backed by several computers, isn’t entirely immune to hacking and can be vulnerable to transactions being altered on the platform.

Lastly, there is the challenge of monetary regulations. Governments and centralised systems control a nation’s monetary policies. In cases like inflation or a period of economic uncertainty, these systems have the power to regulate a country’s monetary policies. These monetary policies, however, may prove futile if De-Fi becomes the new mode of financial trade. Additionally, there are a lot of question marks surrounding the regulatory framework around the De-Fi services, which exist amongst centralised systems.

To conclude, De-Fi has already, with its benefits, established itself as a serious potential competitor to centralised finance. However, the number of risks associated with it and the lack of clarity around its regulatory environment still make it an uncertain choice for consumers. Thus, until these risks and uncertainties around its regulations are answered and eliminated, it would be inaccurate to suggest that De-Fi can replace centralised finance in the near future.