The concept of decentralized finance (DeFi) is relatively new and represents the newest explosion in the cryptocurrency industry. Many speculators are capitalizing on the volatility that it has brought in recent times to trade the markets. However, the fundamental use case of the technology, which would determine its sustainability is not known by many.
Considering the wave that this has caused in the blockchain industry so far, and the possible disruption that it may go on to create, Coinstituency sampled the opinions of some key players in the industry. These ones took time to define, explain and evaluate the extent of impact that DeFi could have on the blockchain ecosystem and beyond.
DeFi as a Complimentary Protocol
One key disruption of this development, according to Piers Ridyard, CEO of Radix, the first layer-one protocol for DeFi is that DeFi will complement traditional systems. This will be achieved by the creation of new tools that will enable the introduction of new assets into the ecosystem.
Decentralized finance unbundles banking services (borrowing, lending, investing) into applications that can interoperate on a single public network and compete for users’ wealth with the best offerings. DeFi and fintech will complement the traditional system, creating new tools that wouldn’t have been possible before, while drawing in new assets in a way that requires close integration and cooperation.
Project steward of Zcoin, Reuben Yap explains that DeFi or decentralized finance is simply about unlocking the power of ‘programmable’ money to build financial systems that are open and devoid of central authorities. Many of which replicate traditional financial platforms that instead of using a trusted intermediary, rely on programs that self-execute on the blockchain. For example, you can have decentralized exchanges, borrowing and lending platforms, insurance and synthetics all functioning through decentralized apps (dApps) on the blockchain.
Yap notes other things that DeFi enable that are only possible through programmable money, such as:
Flash loans – This allows you to take loans without any collateral as long as the loan gets repaid within the same transaction,
Stablecoins – These are tokens that can maintain a peg to a stable asset either through collateralized debt positions (such as DAI) or
Algorithmic stablecoins – tokens that expand and contract a money’s supply (such as Basis).
Yap believes that the promise of DeFi is great, though currently much of its interest is fueled by ‘yield farms,’ which are basically elaborate money games. These attract people seeking incredibly high yields for depositing their cryptocurrency assets. Schemes such as Yam, Sushiswap and countless others have attracted hundreds of millions of dollars participating in them, despite not having any clear productive use. Other DeFi projects have also used their own token to reward participation on their platform, which can be seen as an incentive.
DeFi Vs CeFi
Bilal Hammoud, CEO & Founder of NDAX.io, a leading Canada-based crypto exchange gives an elaborate description of the technology. First, Hammoud shares the comparison between decentralized finance (DeFi) and centralized finance (CeFi). He explains that both DeFi and CeFi share the same goal of enabling people to use cryptocurrency for financial services. However, in a CeFi platform any assets deposited are entrusted by an organization whereas a DeFi model leverages the power of the Blockchain to be decentralized and transparent, with no intermediaries involved. No matter how they do it, they both aim to recreate traditional financial instruments in the cryptocurrency world.
According to Hammoud, businesses that choose to offer DeFi (decentralized finance) alleviate the risk that comes with depositing crypto into centralized exchanges where all funds can be lost due to hackers. These businesses are less vulnerable to hackers if smart contracts are well audited. In addition to that, due to the anonymity of the DeFi space, even if hacking does take place, users don’t have to worry about their personal information being leaked. This enables the businesses to offer global access and financial inclusion, allowing anyone around the world to have access to platforms with as little as a smartphone and internet connection.
However, Hamoud also notes that decentralized exchanges often have lower liquidity and is a relatively new concept. “The concept of Defi is simply relying on technology like smart contracts to govern the deposits and distribution of assets, says Hammoud. “Smart contracts carry their own risks as they are new and require a substantial amount of auditing.” He continues by noting that while Smart contracts could be the future of finance, unaudited smart contracts pose a major risk to the governance and the assets within the contract as was seen with the YAM project.
As of right now, the majority of the people are comfortable with putting more trust in central authorities to keep their assets safe. DeFi platforms also cannot offer services such as cross-chain exchanges, providing interoperability, and the Ethereum blockchain cannot scale fast enough which caused the transaction fees (gas price) to skyrocket to over 550%, an issue that doesn’t exist on CeFi.
Explaining, Hammoud clarifies that centralized exchanges (offering CeFi models) are able to offer consistently high liquidity due to high volumes and fast transaction speeds. They also have a stronger reputation than DeFi platforms and are mostly regarded as safe due to KYC and AML regulations that they abide by. However, since they hold a large number of assets, they are a prime target for security breaches and attacks. Also according to Hammoud, since KYC and identification are mandatory with centralized exchanges, a leak of personal information is a very possible event that could occur. Centralized exchanges are becoming more regulated which poses an issue for 3rd world users who are naturally unbanked and have no way to access these assets.
“In terms of Returns, Defi projects offer higher returns as they are available to a larger user base, while CeFi projects are safer, but with limited returns”, he says.
Using DeFi to Scale the Financial Industry
Users that choose DeFi are able to enjoy borderless, equality financing as compared to the millions of people who are denied access to loans, mortgages, bank accounts, etc. DeFi therefore aims to alleviate this problem by creating a financial system that has no institutional barriers. Hammoud notes that the current banking system leaves about 40% of the global population without any form of banking; therefore, with the adoption of DeFi, anyone around the world can access the system with as little as a smartphone and internet connectivity.
In addition to this, you will never be required to disclose any personal information or give up custody of your funds which greatly reduces the risk of any information being used without your consent or having your funds stolen. However, some downsides to using DeFi platforms that he points out include the total control individuals have over their assets. Also, losing private keys, forgetting passwords, or mistyping addresses and or smart contract bugs can mean losing everything, Additionally, the complexity of smart contracts and the full reliance on technology makes the network more vulnerable to attacks than in a traditional financial system.
A Blockchain-Enabled Transformation
In his opinion, on the other hand, individuals that chose CeFi models put their full trust into a corporation to handle and protect their assets. This comes with pros and cons. An obvious advantage is that the individual personally does not need to worry about keeping their own fund safe and can enjoy the convenience of others holding and securing their keys. However, the user must deeply trust the platform since their funds can be taken at any time with no way of retrieving them. The fact that an intermediary is involved means that there isn’t as much freedom as DeFi models can offer. However, there is a higher degree of flexibility on the platform as they can process fiat conversions, cross-chain exchange options, and can quickly adapt to the needs of customers.
Hammoud concludes by noting that it is safe to assume that blockchain is creating innovations and transformations to the traditional financial system. And it is very clear that users around the world have the appetite to take risks and are willing to experiment with new ideas such as ICO’s, Defi, Cefi, Stablecoins, CBDC’s and many more to come. While all of that is considered positive for the space, users are still encouraged to be cautious with investing irresponsibly in any of these trends as Scams, Regulations, and blockchain scalability are among many other risks that are still needed to be ironed out as the industry get a better grasp of this new technological revolution. “
Iyke Aru is a seasoned author and educator in the blockchain and cryptocurrency industry. He has been in the business of crypto content writing for many years with thousands of his articles across several platforms on the internet. Iyke is based in Nigeria where he stands out as one of the most informed and credible figures in the cryptocurrency industry. Outside blockchain and crypto, you will most likely catch Iyke playing or discussing football with friends and family.