DeFi — New Opportunities New Risks
DeFi is a competitive marketplace of decentralized financial applications that offer financial instruments such as exchange, save, lend, and tokenize.
“What decentralized finance shows us is that financial instruments can move entirely to the blockchain,” says Philip Gradwell, Chief Economist at Chainalysis, a blockchain data platform by Elliptic.
When we talk about moving financial instruments entirely to the blockchain, we need to understand that it’s not going to be easy, but highly fruitful. DeFi provides us with several opportunities which traditional finance lacks. However, DeFi can also pose a great risk due to negligence to detail by the investor.
To ensure sound knowledge about a field so vast, in this article we’re going to talk about the opportunities DeFi presents, as well as learn precisely what kind of possible risks and challenges are there.
Let’s first talk about the opportunities DeFi provides us with.
The opportunities presented to us by DeFi all revolve around the five flaws of traditional finance: inefficiency, limited access, opacity, centralized control, and lack of interoperability. Let’s go through them one by one:
Inefficiency
DeFi can handle high-volume, low-friction financial transactions that would otherwise be a major organizational strain in traditional finance. DeFi develops reusable smart contracts in the form of Dapps that are used to carry out specific financial transactions. These Dapps are open to any user looking for that specific type of service, such as executing a put option, regardless of transaction size.
Limited Access
As smart contract platforms advance toward more scalable implementations, user friction decreases, allowing a broader spectrum of users to participate, and thereby mitigating traditional finance’s second flaw: limited access.
DeFi provides direct access to financial services to huge underserved groups, such as the worldwide unbanked population and small enterprises that employ significant percentages of the workforce (almost 50% in the United States, for example). The impact on the world economy as a whole is significant.
DeFi gives any user, regardless of wealth or geography, access to the complete financial infrastructure of the company.
Opacity
Opacity is the third drawback of traditional finance. The open and contractual nature of DeFi agreements simply overcomes this challenge. In terms of transparency, smart contracts provide an instant benefit. All parties are aware of their counterparts’ capitalization and, to the extent necessary, may understand how funds will be allocated. The parties can read the contracts to see if the terms are acceptable, eliminating any doubt about what would happen when they interact under the terms of the contract.
Overall, DeFi reduces counterparty risk and hence generates a bunch of benefits that are not available in traditional finance.
Centralized Control
The fourth problem in traditional finance is the tight control exercised by governments and institutions, which have a near-monopoly on variables like the money supply, inflation rate, and access to the best investment possibilities. DeFi decentralizes control by handing it over to open protocols with transparent and immutable features. A parameter of DeFi, such as the inflation rate, can be controlled by a community of stakeholders or even a programmed algorithm. If an administrator has special privileges in a Dapp, all users are aware of them, and any user can easily establish a less-centralized counterpart.
As a result, DeFi attempts to create protocols that incentivize stakeholders naturally and elegantly while also maintaining a healthy balance through rigorous mechanism design.
Lack of Interoperability
We’ll now discuss how DeFi addresses the lack of interoperability that plagues traditional finance. Traditional financial products are difficult to connect with one another, requiring at least a wire transfer and, in many situations, being unable to be recombined. The potential for DeFi is vast, and new technologies are coming at a breakneck pace. The ease with which DeFi products can be assembled is fueling this expansion.
Any additional protocols allowing for borrowing and lending can be used once some basic infrastructure has been established, for example, to build a synthetic asset. A higher layer would enable leverage to be achieved on top of borrowed assets. As new platforms emerge, this composability can continue in an expanding variety of directions.
While DeFi can provide solutions to all of the disadvantages of traditional finance, it also poses some new risks and challenges, as any new revolutionary technology would. Let’s now discuss a few of them.
Risks and Challenges involved in Decentralized Finance (DeFi)
- Talking about security. DeFi solutions are based on smart contracts that interact with user funds directly or indirectly. When a smart contract has more money attached to it, it becomes more appealing to attackers. As a result, smart contracts can be compared to public bug bounty schemes in which any user who discovers a flaw in the contract can exploit the flaw and potentially steal money. The fact that the contract code and all previous interactions with it are stored transparently on the blockchain makes finding flaws considerably easier. As a result, smart contract developers must devote significant time and effort to creating contracts that are free of flaws.
- The transaction throughput of blockchain technology and its applications is limited. The basic reason is that transactions, smart contract deployments, and contract function invocations all share a finite amount of space in the ledger’s blocks. As a result, when a large number of programs and their users fight for a limited amount of space in blocks, miners choose the transactions with the highest fees. As a result, customers must tolerate either extremely high fees or lengthy confirmation times for new transactions. This is related to limited scalability.
- In addition to scalability and throughput, concerns about contributing to climate change arise as a result of energy use.
- Applying national legal standards to decentralized global networks often raises regulatory problems and enforcement challenges.
However, blockchain platforms have already begun to find reliable solutions to mitigate these risks. In December 2021, Hybrid blockchain platform XinFin partnered with Trustology, a leading Financial Conduct Authority (FCA) registered institutional crypto custodian wallet provider to give XDC Network’s native XDC utility coin with safe, institutional-grade on-chain custody. The currency fuels the XDC Network, a Layer 1 hybrid blockchain network that also serves as a settlement mechanism, thanks to its interoperable smart contracts. The collaboration will serve as a first step toward establishing a safe, compliant trade finance network spanning decentralized finance (DeFi) apps and marketplaces, allowing non-bank investors to participate in more funding opportunities.
Doing your research is important
Whenever a new technology comes in, it’s natural to feel excited over it. The more popular it becomes, the more we are drawn to it. In this fit of excitement, we often lack in our research and end up risking a lot. Having half-knowledge about something is worse than having none at all. Overcoming risks and challenges is crucial for DeFi to achieve mainstream adoption. Because, finally, we regard DeFi as the most significant opportunity of the next decade, and we anticipate the reinvention of finance as we know it.
Further Readings
https://medium.com/yodaplus/everything-you-need-to-know-about-decentralized-finance-f5d03e7359aa
