The world of finance has known many evolutions in its everlasting history and we could be witnessing what could turn out to be one of its most controversial developments up to date. Decentralized Finance or, as it is commonly referred to, “DeFi”, represents the cutting edge of the financing world, linking it to the newest technological innovations, and promising to make the provision of financial services available to a greater amount of people, thanks to tools which have distributed ledger technology at their core.
This area of finance is so vast and so rapidly evolving, that it is hard to even provide a definition of what it entails. However, in the simplest of terms, it tries to replicate financial transactions, without the need for a trusted intermediary, by using tools such as smart contracts and virtual algorithms.
DeFi and Smart Contracts
The services falling within the category of DeFi generally rely on distributed ledger technology and take the shape of softwares and protocols, thus implying the use of smart contracts provided through algorithms and made available by the blockchain technology. Users of crypto and tokenized assets will be provided with new ways to create, manage and transact in those assets. In fact, once required conditions are met, DeFi protocols allow users to employ those assets by simply following specific procedures, hence allowing future users to do the same for that given financial service.
What is more, arguably the main pro to the development of DeFi is that it will not require any human interaction, such as the oversight of a trusted intermediary, since all services will be provided according to predefined rules and algorithms, as per established by the provider. Another difference with classical financial services is to be found in the accessibility of DeFi services, since they will be made available to users directly via ad-hoc apps and specific crypto-wallets. Assets can then either be controlled by a private party, e.g. the provider of the service, or by a decentralized autonomous organization.
The amount and variety of services, which are offered through DeFi, is ever increasing, and the technology is greatly evolving both in terms of sophistication and regulation. Consequently, it is safe to say that DeFi represents a groundbreaking innovation, also thanks to the use of blockchain technology, which is a decentralized network without hierarchies, unlike the typical banking system.
One of the main advantages of DeFi protocols is to be identified in the use of smart contracts. The latter are becoming more and more popular thanks to the possibility of including contractual clauses and adding details directly through software codes and IT logs. These pieces of data are then used to create contracts, without human intervention. Once these contracts are concluded, they will then be executed upon the occurrence of pre-established contractual terms.
As explained above, DeFi operations heavily rely on the use of smart contracts, hence a brief description of those is surely due. Smart contracts are tools which are nowadays employed in order to automatically discuss, close and apply contractual or semi-contractual bonds.
Still, they must be kept separate from typical juridical contracts, with the reason for that being that the former factor in technical IT features, so that they cannot be merely regarded as the digital or IT version of the latter.
Users in a smart contract will not see as their counterpart a provider of financial services, but they will simply interact with a computer-based market, allowing the automatic implementation of transactions, such as the issuing of loans granted by crypto currencies, or the payment of interests on shares.
What strikes the eye, is that most DeFi platforms are designed to expand even more and finally become independent from their original developers. Those platforms are then also meant to be governed by a community of users, whose authority ought to be acknowledged on the basis of the control over the platform’s tokens.
Current Examples of DeFi and DeFi Platforms
The world of decentralized finance has its own devotees and its detractors, but it is undeniable that it’s becoming more attractive, and the number of supporters seems to be rapidly growing.
Many companies, which have recently been established, have as their main purpose the exploration of the benefits related to DeFi protocols. Among the most influential DeFi companies are Aave (AAVE), Synthetix (SNX) and Cardano.
AAVE is a decentralized non-custodial liquidity protocol, based on the Ethereum platform, where users either act as depositors or borrowers. This protocol uses smart contracts to perform transactions and liquidations throughout the process it enables. However, automated smart contracts and their exclusion of human intervention have created an environment where unforeseen circumstances and errors are ignored, favoring instant execution regardless of external factors. Furthermore, there are many legal hazards linked to this protocol, such as the lackluster legal knowledge of its developers in the field of traditional contracts. This may end up leading to many legal issues for its users in unforeseen circumstances such as a lack of liquidity. At their basis, smart contracts need to be instructed also in cases of external circumstances taking place, in order to avoid the loss of the assets for users, as it has historically happened through this platform.
Synthetix is also an Ethereum-based protocol, with the aim of creating synthetic assets, known as “synths”, which may be then used to trade derivatives, cryptocurrencies or other assets. Other commodities, such as silver and gold, are also treadable through this protocol. Therefore, what it ultimately does is linking non-blockchain-based assets to the crypto environment.
Finally, a notable example of a DeFi platform is Cardano. Using blockchain technology, this system aims at improving finance and banking by offering decentralized bank accounts, money transfers and financial apps for end consumers and businesses.
Pros and Cons of DeFi
Defi has been the subject of controversy more than once, due to its various advantages and disadvantages. Among some of these benefits are the elimination of intermediaries and thus removal of bank fees and service charges, easy accessibility (all you need is an internet connection and your account password), more control to people over their money, and, most of all, a high level of security. Regarding money, the rate of return offered on DeFi platforms is higher than the one offered by traditional financial institutions and there is no need to liquidate your assets to generate a return. This gives users the opportunity to avoid capital gains tax on the assets they trade on DeFi platforms. Further, smart contracts have removed the need for trust between two parties agreeing to a contract, due to the fact that they are written into the blockchain and automatically executed once the agreed action is completed. In fact, the creator of smart contracts, Nick Szabo, specifically wanted to import the POS (Point of Sale) to the digital realm with the creation of smart contracts. Of course, these must be programmed very carefully by an experienced developer, as even a single mistake or an unintended line of code could result in the loss of millions of dollars to one of the involved parties. Smart contracts are fast and accurate, with no paperwork involved and a high degree of transparency and security, they deliver an efficiency unmatched by normal contracts. They are one of the greatest creations of the DeFi space and are an integral part of the DeFi experience.
On the other hand, there are also cons of the DeFi space, ranging from minor faults to significant and unavoidable drawbacks. One of the more significant disadvantages is the information asymmetry prevalent between retail and institutional investors in the DeFi space. Since only experienced developers with a history of analyzing code can read the public ledger, the transparency that DeFi boasts as one of its biggest strengths can also be a weakness, available only to an exclusive club. Similarly, once smart contracts are written and coded into the system, they can never be reversed. Thus, any external factors affecting the outcome cannot be accounted for and they cannot request intermediary intervention like they would be able to in a bank since intermediaries do not exist in the DeFi space. There is also the risk of DeFi platforms being used for illicit or outright illegal purposes. Due to the kind of anonymity available to users, people can use them for money laundering, stock parking, and even funding non-state military actors.
Another important aspect is the relationship between loans and collateral in DeFi. Traditionally, one can borrow up to 100% of the collateral’s value in centralized finance. However, in DeFi, assets put down as collateral are classified by quality and based on their ranking, a certain amount of budget is allocated to be borrowed by the user. The more volatile the asset’s value, the lower the collateral factor and the smaller an amount available for the user to borrow. This covers lenders in the event of the collateral falling in value, and also for borrowers to avoid auto-liquidation, i.e., automatic liquidation of the assets once a certain threshold is reached to prevent exorbitant losses to the lenders.
Other problems include transactions taking more time and money to be confirmed at busier periods in the space, low transferability between the numerous individual blockchains, and a scarcity of insurance in case of hacks or other fraudulent activity.
Reaction of Banks and Authorities towards DeFi protocols
As per stated, DeFi presents us both with some relevant advantages and with some hazardous disadvantages. Hence, reactions towards the development and evolution of such technologies have varied significantly.
Traditional banks are urging authorities to regulate on the matter, furthermore, asking them to slow down the pace of evolution and diffusion of such protocols. On the other hand, these banks have started cooperating with crypto currencies’ agencies around the world, aiming not to be left behind.
In terms of legislation, this matter is still not heavily regulated, at least in Europe, due to the technicality of the subject, but it is likely that regulators will take action implementing pieces of law, which DeFi subjects will need to comply with. These anticipated rules will mainly try to give more stability and precaution to this world. What could come as a consequence is that the benefits for those who are deeply invested in this world will be shrunk.
Other measures which could be required include the duty to conduct audits of the codes, and a detailed explanation of risk guidelines.
The future of finance? Conclusion and final statements
In an increasingly tech-reliant future, DeFi looks like the perfect match, without the need for intermediaries, fund managers, or bank tellers. Users do not even need to leave their house; all they need is an internet connection. In a world where Amazon is one of the biggest companies in the world, virtual shopping is most people's choice for buying clothes, and many, many people prefer a kindle to paper books, the appeal of DeFi is no surprise.
With all that being said, DeFi may be more detrimental than helpful in the long run. This is less of a shortcoming of the concept of decentralized finance, and more of a characteristic of the specific way the current form of DeFi functions. Primarily, most of the so-called advantages of DeFi can actually become disadvantages. As mentioned before, the “transparency” of DeFi can become opaque unless you are experienced with programming and can read complex lines of code. Smart contracts are efficient and executed instantly but cannot be amended to reflect real world happenings and the inevitable effects of external factors. The whole space is decentralized and each blockchain is individual, hence there is a lack of interoperability between two separate blockchains. And so on, for each strength there is some drawback that cannot be ignored.
Moreover, the kind of collateral requirements outlined in DeFi will not be conducive to business; a lot of money will be left on the table for a higher collateral factor or to avoid auto-liquidation. From an economic perspective, this effect will be multiplied in aggregate demand models, reducing output several times over and hurting the economy rather than helping it. Why would a business borrow on the DeFi space when it could borrow substantially more through traditional channels and post the same collateral? From a business point of view, it makes little sense to leave any money on the table, forget percentages like 30-35%-the kind of over-collateralization needed to secure DeFi borrowing.
But most of all, it will be immensely hard to explain to the average Joe the intricacies of a complex platform like DeFi, something that even many industry experts do not fully comprehend. When many people struggle while filing their taxes, expecting them to understand how smart contracts work is quite a leap. Also, from a mindset of convenience, right now it is quite easy to tap your card and pay for something, instead of taking out your phone and waiting for the transaction to go through, since Defi is known to become slower and more expensive in times of congestion. Ultimately, humans are resistant to change and in its current form it is hard to see why people will go out of their way to use this and give up the ease-of-use they enjoy with ‘plastic money’.
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