What is Decentralized Finance (DeFi) and What is its Future?

As the world of FinTech witnesses changes every day, not only in terms of technology but how money can be transferred and used in borrowing, lending, buying, selling, and the complex paradigm of providing financial services, there’s much more to expect and do. FinTech is becoming omnipresent as more and more people prefer convenience and use technology for most things in their daily life.

It's not easy getting acquainted with all the technical jargon and financial terminologies that we get to hear and read every day but since this is the era of technology, the conventional ways of working, transferring money, commuting, financial services, e-commerce, traveling and a whole lot more is evolving. With technology at the fore, every aspect of our daily lives involves FinTech in any capacity, one way or another.

DeFi (Decentralised Finance) is a phenomenon that has gained prominence recently. It uses cryptocurrency and blockchain technology to manage and make financial transactions. The idea and premise behind it is to reduce the tiers of regulatory bodies governing the route of financial transactions by reducing the regulatory conduits and aiding peer-to-peer exchanges (P2P). It eliminates the fee that banks and financial institutions charge for using their services since consumers need to deal with an array of middlemen to get access to financial services like loans, mortgages, etc. DeFi takes out the role of regulatory bodies i.e the Federal Reserve and Security and Exchange Commission in the USA and similarly the State Bank and SECP in Pakistan. Given the route and mode of financial payments and services is so curated and centralised, it is very hard to circumvent middlemen such as banks and financial institutions directly.

According to the CEO and co-founder of TrustToken. “DeFi takes the key elements of the work done by banks, exchanges, and insurers today—like lending, borrowing, and trading—and puts it in the hands of regular people.” This ensures that you save the money otherwise earned by the middleman for playing the part of an intermediary. The advantages that DeFi brings are tangible but with it, there are caveats as well. It is better to understand how DeFi operates to be able to gauge where it's going and whether it can be a phenomenon in the future.

Blockchain and Cryptocurrency are the essential technologies that enable “Decentralised Finance” because each transaction made is recorded in a computer code. Transactions are verified and recorded by parties who use the same blockchain, through a process of solving complex math problems and adding new blocks of transactions to the chain. In simpler terms, blockhain is a secure database or ledger where applications like dApps are used to process transactions and run on blockchain.

In the blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it. The blocks are "chained" together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.

Advocates of the system look at its advantages, in terms of being more transparent compared to the standard financial route but there are pros and cons for both. Let us delve into this and look at the advantages and disadvantages of both.

Pros of DeFi

• Peer-to-Peer transactions without the involvement of a third party thus eliminating extra costs.
• Anyone who has an Internet connection has access to the DeFi platform and can make transactions irrespective of where you are.
• It involves low fees and high-interest rates as the two parties directly negotiate interest rates to make the transactions and lend money through DeFi networks.
• Records of all the completed transactions are available on blockchain that does not reveal your identity.
• DeFi platforms are free from bankruptcy and default as it is not controlled or run by a centralsied financial institution.

Cons of DeFi

• Making transactions through DeFi is very complex and not commonly understood by everyone. It requires a good understating of the market, finance, and cryptocurrency to be able to do it.
• Decentralised finance is constantly changing and evolving.
• It is unregulated and its ecosystem is riddled with infrastructural mishaps, hacks, and scams.
• High level of volatility.
• Specific laws are enacted and ratified based on the existing financial ecosystem consisting of institutions and regulatory bodies, each having its own rules and SOPs. DeFi’s borderless transaction ability poses serious questions about the application of conventional rules and laws to this system.
• If financial crimes and scams were to take place across geographies and borders, who would be the investigating and regulatory body? What protocols exist in such cases, and who will enforce such rules and regulations?
• The more general caveats include system stability, energy requirements, carbon footprint, system maintenance, hardware failures and more.

Given how regulated and centralised the banking sector and financial institutions are, not everyone is a benefactor. Over one billion people around the world do not have access to banking facilities i.e., lack of financial inclusion 4. This only goes to show that the current banking institutions do not help the entire populous. The reason why this is so is because of accessibility, security, and reliability issues. As new platforms, technologies and avenues to make payments and transactions emerge, so is the ability to have access to borrowing, lending, taking loans, making payments, insurance, and more. DeFi is a modern and decentralised way of doing things and it is definitely the technology of the future as it brings forth a litany of solutions to conventional and basic financial problems. Though it has its own set of cons, the future is most definitely rooted in technology.