The world of finance is going through a phase of churn, of course not for the first time, and this time the challenge is coming from not within but outside in the form of decentralized finance (DeFi). Although it is at the early evolutionary stage, the disruptive seismic effect induced by tectonic shift is clearly visible. Interest and investment in crypto and blockchain skyrocketed in recent years, and it is fact the highly sluggish and overly regulated financial system is feeling the heat as the benefits DeFi offers far outweigh the risk involved. It is beyond doubt that the DeFi development and crypto are the future of finance, and the only question that remains to be answered is how fast it matures and progresses towards widespread adaptation. Will it push the highly centralized financial system towards extinction? Well, it is too early to say so, but churning will force the existing financial system to either evolve fast or go extinct.
Interestingly, DeFi offers traditional financial systems numerous opportunities to improve operational efficiency and services, but all will happen only when the core business model of centralized control ends and adopts a blockchain-based peer-to-peer decentralized model of financial transactions.
What is DeFi?
The traditional financial system relies on centralized intermediaries, thus making the whole system cumbersome, time-consuming, less efficient, opaque, and inaccessible to many. Decentralized Finance (DeFi) removes all these challenges of financial intermediation using decentralized applications (DApps) built on public blockchain infrastructure. These are internet-based interoperable protocol stacks that leverage smart contracts- a critical component of DeFi to facilitate financial services.
In simple words, smart contracts are unique irreversible codes stored in decentralized blockchain platforms designed to perform predefined actions autonomously, without intermediaries. By its very nature, which is “decentralized”, each protocol is highly synchronized, uncensored, immutable, and non-retractable. Each contract carries all possible transaction-related information visible to everyone, thus making the whole system highly transparent and trustworthy. To eliminate the concerns of the high volatility of cryptocurrencies, the Stablecoins came into existence to ensure less volatility by pegging the market value to an external reference.
So, DeFi is open-source financial software operating independently on a blockchain network accessible to anyone for financial services like investing, lending and borrowing without the need of any financial intermediary.
What Makes DeFi Disruptive?
The enormity of the disruptive effect of DeFi on the existing financial system could be visualized by the very fact that the decentralized peer-to-peer model eliminates the need for a financial intermediary in any financial transactions.
“Unlike the traditional financial system, DeFi offers a unique combination of control and freedom over assets, making them free of the institutional dependency for financial decisions,” says a spokesperson for UIG Studio, a blockchain development company.
Another significant impact will be visible on business-to-business interactions as smart contract-based DApps could start acting as intermediaries between institutions, enabling the trade of tokenized assets in an open marketplace.
There is a strong belief that tokenization of real-world assets will have a disruptive effect, allowing owners to unlock illiquid assets through tokenization of the asset on a decentralized blockchain system. The owner could use tokens as collateral on DeFi protocols, disrupting the supply chain of existing financial institutions.
Challenges to Overcome
DeFi is undoubtedly revolutionary and the historical growth trajectory of crypto suggests that the path ahead is not challenge-free. Just like any nascent innovative technology or product, DeFi also has several challenges to overcome, be it scalability, security, structure, regulation, governance, trust, and many others.
The gross value locked into Ethereum-based DeFi protocol has already crossed $100 billion, and experts believe the triple-digit growth trend is likely to continue, at least in the near term. The biggest challenge ahead for DeFi, as was in the case of Bitcoin in the early days, is the evolution of the regulatory framework so that money laundering challenges could be avoided. It is all about how much time the evolution of the regulatory framework takes to shape.
The history of cryptocurrency hacks in the recent past suggests it is the weakness of the smart contract source code that is exploited by hackers to siphon digital assets. The increasing sophistication of cyberattacks is a challenge, especially when DeFi awareness is relatively low. Smart contract-related challenges could be solved technically, but awareness drive around the wallet and the private key is necessary at this stage.
Although DeFi is all about decentralization, control, and freedom, people show reluctance when they see the absence of a regulatory framework. The idea of decentralized community governance is new, so DeFi has the biggest challenge of overcoming the barrier of mindset.
Acceptance and success of crypto shows people are looking for an alternative to existing financial systems. Decentralized finance has every possible element, including highly advanced technology, speed, scale, and most importantly control, to be a great financial intermediary free peer-to-peer model of financial transactions. Existing financial and allied institutions will have to evolve and embrace DeFi to remain relevant in the fast-emerging digital economy.