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November 14, 2020
Can DeFi defy centralized finance?
Mateusz Rzeszowski
Can DeFi defy centralized finance?

Guest Blog Post by Mateusz Rzeszowski

For as long as money has been around, financial operations we call banking have taken place. What started as farmers lending grain to each other has in time become the economic behemoth of today’s financial institutions, with their offer serving an individual customer looking to invest or a modern country on the brink of economic collapse. To think of blockchain-powered decentralized finance (DeFi) as a potential disrupting force in such a solidified industry seems to many, and rightfully so, like a pipe dream. Innovation is a weird animal, however, in that bold ideas and untapped solutions oftentimes take unexpected turns. Take Bitcoin’s goal from Nakamoto’s whitepaper:

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. [...] What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. (Nakamoto 2008:1)

Now, did Bitcoin succeed in decentralizing e-commerce? Admittedly no, due to high transaction costs and low throughput, Bitcoin may never successfully compete with centralized solutions. But what that idea certainly did was create a completely new area of technology, paving way for innovation in a multitude of fields previously perceived as impenetrable.

An analogy can be seen between Bitcoin trying to decentralize e-commerce and DeFi looking to solve the problem of trust in banking. Namely, it seeks to decentralize that which has been centralized for centuries: financial services and products.

What is meant by decentralization of finance is ultimately very simple: to connect those interested in engaging in financial markets in a way that doesn’t require an intermediary institution, facilitated by blockchain. 

Practically speaking, blockchain-enabled smart contracts allow for the creation of complex interdependent systems of transactions. For potential users, this means that the usual intermediary becomes irrelevant: it is fully possible for a smart contract to match customers in a peer-2-peer fashion. No longer do we need two strangers visiting a bank with an intention of lending and borrowing, and the financial institution consequently passing the lender’s money onto the borrower for a substantial fee. By using a smart contract, the lender is able to essentially deposit his money on the blockchain for the borrower to withdraw under a specific set of rules, i.e., loan amount, interest rate, repayment schedule, etc. 

As the technology matures, the list of DeFi use cases grows incrementally. Today, these financial products include lending platforms, options trading protocols, prediction markets, decentralized exchanges (DEX), payment integrations, liquidity mining protocols, issuance of stablecoins, and many more.

With blockchain as the underlying technology, DeFi functions differently than established finance. While novel innovations allow us to eliminate intermediaries, they also bring unexpected challenges.)

Firstly, decentralized blockchains are permissionless, meaning that anyone can create and engage with smart contracts within the network. By extension, DeFi products are open by nature and require no verification of its users. This stands in stark contrast to the traditionally-regulated financial systems where KYC (Know Your Customer) and AML (Anti-Money Laundering) processes are always present, preventing criminal operations at the cost of friction in usage. 

Secondly, by requiring next to none infrastructure, DeFi can potentially bring financial services to millions of unbanked people around the world. The obvious limitation being, however, the need for background knowledge of how blockchains operate and how to engage with them. Still then, as we enter next phases of user-friendly, blockchain-powered improvements, this challenge can be expected to subside.

Thirdly, all operations in DeFi are auditable smart contracts, meaning that any of the participating parties is free to verify the code they’re about to trust their funds to. The immutable nature of blockchain means that after their funds are submitted, the smart contract’s execution is fully dependent on the code itself, eliminating the need for a third party. An aspect of this approach is clearly dangerous: unaudited code can be exploited, putting users’ funds at risk.

Fourthly, all transactions submitted to the blockchain are in essence as secure as the network itself. In the case of DeFi, this gives users the assurance that IF the smart contract code is valid, then there’s no plausible way of them losing their funds.

Lastly, decentralized finance oftentimes requires decision-making capacities on crucial issues, e.g., yield rewards in yield farming. Without a financial institution in the middle, changes to a particular protocol call for another kind of a governing body, creating challenges with regards to structuring an efficient and yet decentralized entity.

With many questions still unanswered, DeFi’s ultimate success or failure is tied to finding answers that earn and keep users’ trust in a trustless industry. Regardless of the final outcome, a paradigm expansion has already taken place with blockchain technology infiltrating yet another industry, pushing forward the vision of a decentralized, open world.