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Exciting times are ahead: In the foreseeable future, financial and economic services will run on Distributed Ledger Technology (DLT) – a decentralized database managed by multiple participants, with no central administrator. The year 2023 will mark the acceleration of this transformation.
Like the internet, which has become such a pivotal part of our everyday lives that we cannot imagine life without it, so too will Decentralized Finance (DeFi), and DLT, the technology it utilizes. When we use the internet, we don’t ask how it works or why we should use it; we simply use it for the mobility, flexibility, efficiency and connectivity it provides. The COVID-19 pandemic has underscored the Internet’s benefits. It enabled us to connect to services, products and people and facilitated a smooth transition to a remote, contactless global economy.
Now Web 2.0 – the Internet, is evolving to Web 3.0 – Distributed Ledger Technology.
What is Decentralized Finance (DeFi)?
The core idea of DeFi is to take complex financial services and products traditionally offered by legacy financial institutions, codify their component rules and procedures, and convert them into self-executing code.
Simply put, these are automated, self-executing products and services, where the user/consumer directly interacts with the application, without the interference from any third party intermediaries such as banks, insurance companies, agents, etc. The benefits are a 24/7, instantaneous service with very low to no cost.
Think of it as an automated vending machine. A vending machine is a 24/7 no-cost service, with no interactions from third party intermediaries.
DeFi applications, of course, are much more complex than a vending machine and can provide services beyond simply purchasing a soda or a bag of chips. Furthermore, because every activity in the economy is transaction based – be it retail or gaming or tech or social media – DeFi applications go beyond financial services and would be integrated in any service or product we use today, while connecting the “virtual world” with the “physical world.”
What’s wrong with traditional finance? What are the benefits of DeFi?
DeFi applications utilize blockchain technology, and with that it is a decentralized, peer-to-peer system, accessible to anyone, anywhere, and has the potential to democratize financial systems –making it possible for anyone to have access to financial services, especially the underserved communities, who either do not or cannot have access to financial institutions — think people who live in remote areas or are either unemployed or have a criminal history.
With DeFi, there is no controlling organization dictating when and if you can transact. It’s a member-user consensus system that incentivizes good behavior and penalizes bad actors.
Currently, when using traditional financial services, if you apply for a loan, a bank will consider you a low risk if you have assets for collateral, and a high risk if you don’t. Thus, in most cases those who need a loan the most will not receive it – which is a bit counterintuitive.
DeFi does not limit the unbanked or underbanked from having means of transacting. DeFi transactions don’t request any information on your financial history or your credit score. As long as you have a smartphone and the required assets on hand to put up as collateral, you will be eligible for a loan. Interest rates on these loans tend to be lower because there is no third party involved for taking a fee to facilitate the transaction.
Since it has no intermediaries, transactions are instantaneous – no need for clearing and settlement processes – and thus costs are diminished. Therefore, it can solve settlement delays and high-cost problems.
DeFi, of course, isn’t perfect. There’s a reason some people think of it as a fad and others are hesitant to dive in. There are risks associated with being a nascent technology.
What are the risks associated with DeFi?
The main risks are Technology risk, Liquidity risk and Product risk:
Technology risk
Bear in mind that DeFi is an application, a software, meaning it can have bugs or loopholes in the code, which even if they are not intentional, could be exploited. Many botched DeFi projects have been launched with unaudited code, resulting in losses like the YAM code bug disaster. The industry will likely self-regulate itself in the future to audit any application before uploading it to a blockchain.
Liquidity risk
The crypto market is very illiquid, and hence every small quantity of buying or selling of these assets, may have a huge impact on their value. Failing to assess this risk and inappropriately evaluating the DeFi application, can cause sever losses even to sophisticated investors.
Billionaire Mark Cuban made it known he is not immune to risk when he traded a DeFi app that crashed in one day. He later admitted to Bloomberg “Even though I got rugged on this, it’s really on me for being lazy. The thing about DeFi plays like this is that it’s all about revenue and math and I was too lazy to do the math to determine what the key metrics were.”
Product risk
Like in any product or service you engage with, it is important to engage with a reputable, transparent product. This is a very immature industry and yet to establish its brand or reputation.
Anyone can create a cryptocurrency or a DeFi application, thus, it can be difficult to parse through what is serious and what is a joke. Meme coins in particular are incredibly volatile. Designed after a meme, they are meant to go viral one day – skyrocketing its value – then disappear the next.
Not only does the application need to have an economic use case and purpose, but it also should have economic sustainability. The Terra (Luna) fiasco is an example of a DeFi without economic sustainability. Like with any financial product – traditional or DeFi — you should evaluate it diligently.
One of the fundamental features of blockchain technology is transparency. Therefore, if developers of a DeFi application prefer to remain anonymous – like the botched protocol Harvest Finance, developed by an anonymous team – that should raise a red flag about its trustworthiness or whether it may be a scam.
DeFi – reshaping the financial industry as we know it
Blockchain technology and DeFi is relatively a nascent technology. But due to the increasing interest of governments, corporations, and financial institutions around the world in the implementation of this technology, and the many projects that are being examined and evaluated globally, it is very likely that in the foreseeable future – 10 to 15 years from now – DLT will be the “rails” of all financial products and services.
Banks and financial and economic activities will be automated, run by codes and algorithms, with no human interaction at any stage of the process, essentially a self-driving bank. In the age of Economy-of-Things, where machines can talk to each other, DeFi will enable every product or service to become self-driving. The concept of “embedded finance” – integrating financial services with a traditionally non-financial, service or product – will be significantly enhanced.
An example is when an online store offers “buy now pay later” option that converts the purchase into an automatic loan from a third-party lending institution. Imagine if your home gym equipment offers you rewards tokens as an incentive for your performance, and you can then send these tokens from your gym equipment to pay for your loan.
DeFi can enable such a scenario. You can put your imagination to work, and the possibilities are endless. In addition, DeFi will play an integral and instrumental role in the evolution of the metaverse by enabling transactions between the virtual and the physical world.
As the technology matures and projects are tested and examined thoroughly, DeFi products and services will become compliant and secure and with the appropriate auditing and monitoring, to ensure users’ security and privacy. This is essential for any technology to become mainstream.
This transition is taking place, and DeFi shouldn’t be thought of as an interesting concept, but an active transformation that is taking place as we speak. DeFi is indeed the future of finance.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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