DeFi (pronounced dee-fy) is short for “decentralized finance” Where “decentralized finance” in French. This is an emerging area that allows its users to carry out financial transactions without intermediaries. Totally decentralized, this system is rapidly gaining popularity as an alternative to traditional financial services. DeFi already allows you to do most of the things offered by traditional banks and centralized financial institutions, and much more.
DeFi vs centralized finance
DeFi refers to decentralized financial services powered by blockchains. It opposes “centralized” financial services provided by banks and other traditional financial institutions. This concept makes it possible to use cryptocurrencies for most of the services that traditional banks offer with fiat currencies. Thus, users can lend, borrow, earn interest, trade assets, buy insurance, and more. Thanks to DeFi, users can exchange directly with each other, this is called peer-to-peer exchange. Faster, cheaper and simpler, DeFi also offers new advantages and services every day.
With DeFi, your assets are accessed through secure digital wallets and transactions are concluded through smart contracts. Open to anyone with an internet connection, DeFi makes finance much more accessible. Indeed, in the world of centralized finance, not everyone is allowed to open a bank account or have access to specific financial services. As a result, DeFi is financially empowering billions of people around the world who currently lack access to banking services.
Centralized finance represents the financial system with which the world operates today. All banking operations such as payments and loans pass through intermediaries monitored by regulators. Decentralized finance, on the other hand, allows anyone to transact, through financial applications, through a blockchain network. This makes it possible to eliminate the intermediaries that are the banks. This dramatically reduces costs and significantly speeds up transaction times.
How does DeFi work?
Smart contracts execute transactions. These contracts execute automatically. Each party introduces conditions, which allow the smart contract to execute without the intervention of any centralized authority. Smart contracts use coded instructions, such as “if that…then…”. They run automatically, when the previously established conditions are met. They can also send funds to a particular account on a specific day, for example.
Many blockchains, such as Cardano, Binance or Solana develop decentralized applications (dApps). Today, Ethereum hosts the majority of these dApps. Indeed, as a platform for hosting decentralized applications (dApps) and thanks to smart contracts, Ethereum adapts to DeFi. Blockchain technology keeps transaction history and account status. Since DeFi is completely open-source, its protocols and applications are widely accessible. Additionally, Ethereum remains flexible, allowing developers to easily build dApps within the ecosystem. Indeed, there is already a DeFi solution for most financial services, but this does not prevent the creation of new products.
What are the risks and disadvantages of DeFi?
While DeFi offers new and exciting opportunities for financial freedom, these come with risks.
First of all, DeFi technology is brand new and somewhat immature. Funds may be lost or endangered. The DeFi Compound platform, for example, experienced a bug last September, accidentally awarding some of its users millions of dollars in cryptocurrencies.
Moreover, today, DeFi thrives in the absence of regulations. This implies that users have no protection when things go wrong. No public redemption system covers the concept of DeFi and there are no laws imposing capital reserves on DeFi service providers. Hackers are also a threat. Although this is also a risk in traditional finance, the extensive technological architecture of DeFi increases the risk of hacking.
Finally, collateral requirements remain high. Indeed, almost all DeFi lending operations require collateral of at least 100% of the loan value, if not more. This severely restricts eligibility for many types of DeFi loans, making them inaccessible to a large number of users who do not have the necessary funds.
A potential future regulation?
As DeFi disrupts traditional finance, governments are scrambling to decide who has the jurisdiction to regulate this new area and what those regulations might be. Depending on their implementation, the rapid growth of DeFi could experience a slowdown in the coming years.
The Financial Action Task Force (FATF) is one of the main players in this regulation. It also receives the support of the G7, whose mission is to fight against money laundering. He argues that DeFi platforms are not as decentralized as claimed. According to him, a natural or even legal person controls or influences their activities. These are then virtual asset service providers (VASPs), already subject to regulatory oversight. The FATF also suggests that if a particular DeFi platform does not appear to be managed by an entity, a jurisdiction can request the intervention of a VASP.
The directions of the FATF provide a framework for jurisdictions to decide how to regulate DeFi. In anticipation of possible regulation, it is likely that many DeFi platforms will accelerate their attempts to become decentralized. In this way, they want to dissolve the ties between specific individuals and their platforms. The way forward remains unclear, but it will be important for DeFi investors to monitor evolving regulatory frameworks.
DeFi allows everyone to access financial instruments and have full control over their financial life. Indeed, blockchain technology has succeeded in providing people with a system without an intermediary. Its total transparency allows each user to check what is happening on the blockchain.
DeFi develops tools and applications that allow as many people as possible to have access to financial services. It is constantly improving to better meet user needs: every day, new applications are created. While it cannot be denied that there are a number of risks and disadvantages, these are inherent in any financial investment.
Receive a digest of news in the world of cryptocurrencies by subscribing to our new daily and weekly newsletter service so you don’t miss any of the essential Tremplin.io!