What the hell is decentralized finance?
An expert on bitcoins and blockchains explains the risks and rewards of DeFi
What is DeFi?
Traditionally, if you want to borrow US$10,000, you first need some assets or money already in the bank as collateral.
A bank employee reviews your finances, and the lender sets an interest rate for the repayment of your loan. The bank gives you the money out of its pool of deposits, collects your interest payments and can seize your collateral if you fail to repay.
Everything depends on the bank: It sits in the middle of the process and controls your money.
The same is true of stock trading, asset management, insurance and basically every form of financial services today. Even when a financial technology app such asChime,AffirmorRobinhoodautomates the process, banks still occupy the same intermediary role. Thatraises the cost of credit and limits borrower flexibility.
DeFi turns this arrangement on its headby re-conceiving of financial services as decentralized software applications that operate without ever taking custody of user funds.
Want a loan? You can get one instantly by simply putting cryptocurrency up as collateral. This creates a “smart contract” that finds your money from other people who made a pool of funds available on the blockchain.No bank loan officer necessary.
Everything runs onso-called stablecoins, which are currencylike tokens typically pegged to the U.S. dollar to avoid the volatility of bitcoin and other cryptocurrencies. And transactionssettle automatically on a blockchain– essentially a digital ledger of transactions that is distributed across a network of computers – rather than through a bank or other middleman taking a cut.
The rewards
Transactions made this way can bemore efficient, flexible,secureand automated than in traditional finance.
Moreover, DeFi eliminates the distinction between ordinary customers and wealthy individuals or institutions,who have access to many more financial products. Anyone can join a DeFi loan pool and lend money to others. The risk is greater than with a bond fund or certificate of deposit, butso are the potential returns.
And that’s just the beginning. Because DeFi services run on open-source software code, they can be combined and modified in almost endless ways. For example, they can automatically switch your funds among different collateral pools based on which currently offers the best returns for your investment profile. As a result, therapid innovation seen in e-commerce and social mediacould become the norm in traditionally staid financial services.
These benefits help explain why DeFi growth has been meteoric. At the recent market peak in May 2021,over $80 billionworth of cryptocurrencies were locked in DeFi contracts, up from less than $1 billion a year earlier. The total value of the market was $69 billion as of Aug. 3, 2021.
That’s just a drop in the bucket of the$20 trillionglobal financial sector, which suggests there is plenty of room for more growth.
At the moment, users are mostly experienced cryptocurrency traders, not yet the novice investors whohave flocked to platforms like Robinhood. Even amongcryptocurrency holders,just 1% have tried DeFi.
The risks
While I believe the potential of DeFi is exciting, there are also serious causes for concern.
Blockchains can’t eliminate therisks inherent in investing, which are the necessary corollary of the potential for returns. In this case, DeFi can magnify thealready high volatilityof cryptocurrencies. Many DeFi services facilitate leverage, in which investors essentially borrow money to magnify their gains but face greater risk of losses.
Moreover, there isn’t any banker or regulator who can send back funds transferred in error. Nor is there necessarily someone to repay investors when hackers find a vulnerability in the smart contracts or other aspects of a DeFi service.Almost $300 millionhas been stolen in the past two years. The primary protection against unexpected losses is the warning “investor beware,” whichhas never proved sufficient in finance.
Some DeFi servicesappear to violate regulatory obligationsin the United States and other jurisdictions, such as not barring transactions by terrorists, or allowing any member of the general public to invest in restricted assets like derivatives. It’s not even clear how some of those requirements evencould be enforced in DeFiwithout traditional intermediaries.
Even highly mature, highly regulated traditional financial markets experience shocks and crashes because of hidden risks,as the world saw in 2008when the global economy nearly melted down because of one obscure corner of Wall Street. DeFi makes it easier than ever to create hidden interconnections that have the potential to blow up spectacularly.
Regulators in the U.S. and elsewhere are increasingly talking about ways to rein in these risks. For example, they are starting topush DeFi services to complywith anti-money laundering requirements andconsidering regulations governing stablecoins.
But so far they have only begun to scratch thesurface of what may be required.
From travel agents to car salespeople, the internet has repeatedly undermined thebottleneck power of intermediaries. DeFi is another example of how software based on open standards can potentially change the game in a dramatic way. However, developers and regulators will both need to up their own performance to realize the potential of this new financial ecosystem.
This article byKevin Werbach, Professor of Legal Studies and Business Ethics,University of Pennsylvania, is republished fromThe Conversationunder a Creative Commons license. Read theoriginal article.
Story byThe Conversation
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