Understanding Decentralized Finance (DeFi)

Kwami Ahiabenu

The Financial world is experiencing significant transformation and innovations daily. Some of these innovations are creating new forms of financial intermediation with far reaching implications for how our society organizes its economic activities.

One of the fast disruptive innovations occurring in the financial ecosystem is decentralized finance built for our new digital society. It is purported to be an alternative to our current financial system and promises to create a new order where the traditional, opaque and highly controlled financial system will yield to new processes. As at November 2021, there is an estimated $236 billion total value locked (TVL) across all protocols signifying phenomena growth rate of the decentralized finance DeFi market. This is especially good for countries with high inflation and unstable currencies.

What is Decentralize Finance (DeFi)?

Decentralized finance is characterized by an open-source technology, immutable smart contracts, distributed, peer-to-peer technologies based on blockchain, the most popular one being Ethereum blockchain. DeFi enables users to undertake major financial transactions including payments, savings, money transfers, assets management, gaming, borrowing, insurance and investments among others.

Through the use of DeFi platforms, users are able to take loans and pay back without the stringent rules and conditions typical in traditional banking services. Decentralized finance can be described by a suite of financial products, services and solutions available to any users in the world with an internet connection premised on blockchain technology which process transactions based on a set of computer codes. The decentralized lending system works by connecting prospective borrowers and lenders together to transact with or without collateral. When collateral is required, some users accept Non-fungible tokens (NFT) as collateral which is redeemable when the loan recipient defaults.

NFT is also processed using blockchain technology and can be used to represent ownership of any unique item both in digital or physical form, including music, collectible, furniture, computer, real estate, digital artwork, art, deed etc. Creators, including musicians, can tokenize their music and sell them to audiences who are able to pay through crypto currency. NFT’s can only have one given owner at any point in time and no one is able to modify the record of ownership or replicate it, making them safe.

The rise of DeFi is seen as a solution to challenges such as the lack of access to financial services, extreme high costs of financial services due to intermediary institutions especially in the money transfer process as well as long and complex procedures in using some types of financial services especially financial trading.

DeFi comes with a number of advantages such as no human error and mismanagement; quick and permanent access, being highly programmable; immutability that is tamper-proof; interoperability, making it easy to customize interface and integrate a host of third party applications; transparency since each transaction is visible to all, verified by network users, open source therefore anyone can view, audit and build on it; permissionless; it guarantee self-custody meaning each users have full control of personal data and assets.

DeFi comes with disadvantages such as the lack of scalability, that is, the inability to scale up blockchain from multiple perspectives; uncertainty as instability in blockchains can be easily be transferred to another host; concerns of liquidity since DeFi currently does not have enough funds to match what is available in the traditional financial systems. Further shared responsibility means end users are responsible for any challenges with processes or funds and not a central body also smart contract vulnerability means any error in smart code can lead to loss of funds. Similarly a lack of insurance means there is no protection of users in case of hacks or other frauds that may occur through the use of DeFi. It is estimated that DeFi users and investors suffer over $10.5 billion in losses in 2021 to date, due to theft and fraud. Also, DeFi is increasingly becoming a tool for laundering proceeds of crime using decentralized mixers, decentralized exchanges (DEX) and cross chain bridges. In the same breath it must be pointed out that law enforcement agencies are now equipped with a greater level of tools to investigate these crimes by following the money.

In conclusion, DeFi remains a significant challenge for regulators. Although a number of regulatory options are being perused, there are no easy answers. However, DeFi is an important part of the finance ecosystem now, therefore all entities including regulators must increase their investment in understanding how it works and develop mechanism to deal with its shortcomings.

Kwami Ahiabenu, II is a Technology Innovations Consultant
E-mail: kwami AT mangokope.com

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