by Jake Wengroff
If we can email virtually anybody in the world, why can’t we send them money just as easily? Or offer them a loan? These questions are the foundation of the beliefs, activities and objectives fueling decentralized finance (DeFi), notes Bitkom, a German technology trade association. Over the past few years, these ideas have sparked the “DeFi Revolution” and fueled the rapid growth of new unicorns like AirTech and MakerDAO. But what’s next?
Understanding the DeFi Revolution to Date
Launched via the Ethereum blockchain in 2015, DeFi is based on blockchain’s distributed ledger technology and is growing rapidly. Its common goal is to develop and operate without traditional intermediaries, such as banks, payment service providers or investment funds, yet still be able to offer the types of financial services provided by traditional banks and investment firms, such as loans, margin trading and portfolio management.
The growth of DeFi can be explained by the appeal it has to consumers. To access financial products on public decentralized blockchain networks, consumers do not need a government-issued ID, a social security number, proof of address or similar documentation. It is important to note, however that as DeFi projects like crypto wallets and exchanges grow in size, regulators will likely require that KYC (Know Your Client) and AML (Anti Money Laundering) procedures will be in place, so a government-issued ID is still needed for several of the larger platforms.
Benefits of DeFi
“This opens up access to financial products to billions of people who cannot access financial services because their data is not held on ‘traditional’ sources,” notes Jason Blick, founder and CEO of EQIBank, in an opinion piece in Forkast. “This is a momentous step forward in terms of financial inclusion.”
Another significant benefit of DeFi is that it removes most of the parties that have traditionally served as middlemen in financial transactions, such as PayPal or Visa. Fewer middlemen means fewer fees needing to be paid. By removing these intermediaries, DeFi injects more efficiency and profitability into each financial transaction.
DeFi protocols also include decentralized exchanges (DEXs), that enable buyers, sellers, lenders and borrowers to interact peer to peer, or with a strictly software-based intermediary, as opposed to a banking institution or another counterparty. These financial products are provided by DeFi apps through the use of “smart contracts” that encode the terms and conditions of loans and other agreements and liquidate collateral when the terms are not met.
Next Steps: Eye of Regulators
Its disruptive potential has brought DeFi the attention not only of traditional financiers but also of policymakers and regulators. While DeFi has the potential to transform the financial system, it lacks a clear policy landscape that could help accelerate benefits and mitigate risks.
“We are in a critical time for DeFi. Following its rapid growth, and the price activity in crypto more generally, governments are closely watching cryptocurrencies and decentralized applications,” said Sheila Warren, Deputy Head of the Centre for the Fourth Industrial Revolution Network and a member of the Executive Committee of the World Economic Forum.
With added guardrails and safety nets, more typically risk-averse investors will be attracted to DeFi-driven services. These new investors bring fresh capital and liquidity, enabling newer services to grow.
Added Trust and Protection, Allowing DeFi to Grow
DeFi has transformative potential for financial services worldwide but also creates an array of serious concerns, notes Kevin Werbach, Director of the Blockchain and Digital Asset Project at the Wharton School of Business at the University of Pennsylvania. “Policymakers and regulators need frameworks to address these issues responsibly.”
While the blockchain cannot be hacked, the applications built upon them can be vulnerable. This is especially true when they need to be developed rapidly, or when they reuse previous code. As such, investors, especially those who are new to crypto, need peace of mind that their assets will not be lost in the event of a breach.
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Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, he covers such topics as security, mobility, e-commerce and IoT.
Sources
World Economic Forum – Decentralized Finance heats up: new approaches needed for industry transformation
Bitkom – Decentralized Finance (DeFi) – A new Fintech revolution?
Forkast – How DeFi regulation can propel the next economic revolution