Decentralized finance, known as DeFi for short, is a trend in the crypto sphere gaining steam and showing promise, though credible reservations remain. Decentralized finance is predicated on two primary principles:
- Decentralization, which is provided by blockchain technology
- Non-custodial products, meaning that there is no middleman between the user and the financial product being utilized, only a protocol
With these founding principles laid out, what is decentralized finance? What are its benefits and drawbacks, and how is it being viewed through the all-seeing eyes of regulators?
What, Exactly, Is Decentralized Finance?
Breaking down the term “decentralized finance” may be a simple, yet effective starting point for explaining the emerging phenomenon.
Let’s start with finance.
According to Investopedia, the noun finance refers to “matters regarding the management, creation, and study of money and investments”. For the sake of the DeFi discussion, the management and creation of money and investments may be the most pertinent features of this definition.
The Corporate Finance Institute (CFI) provides specific examples of finance, including “investing, borrowing, lending, budgeting, saving, and forecasting”. Lending, investing, forecasting, and borrowing may generally be the most relevant of these examples when it comes to decentralized finance.
And what about the “decentralized” aspect of DeFi?
Merriam-Webster provides two definitions of “decentralization”:
- the delegation of power from a central authority to regional and local authorities
- the dispersion or distribution of functions and powers
Each of these definitions apply to decentralized finance. Collectively, decentralized finance appears to be the engagement in finance-related activities such as lending, borrowing, investing, and forecasting through means that have no central authority, where instead management over a financial system (insofar as there is management) is dispersed.
From a 1,000-foot view, this is an accurate depiction of the core tenets of DeFi. Now to get a bit more specific…
Decentralized finance comprises financial platforms and services built upon and powered by blockchain technology. These services vary in their purpose and specifics, but may generally allow users to borrow or lend cryptocurrency, purchase and sell coins, speculate on the future value of commodities, and purchase or sell tokenized assets.
Like other evolutions in the finance sector over the years, decentralized finance is a new way of engaging in the economic activities that facilitate the making (or losing, if you’re unlucky) of money. The primary pull factor is that, rather than requiring a middle man/institution, it is the users who control the mechanisms that facilitate their transactions (at least in theory).
What Allows DeFi to Work?
In short, blockchain technology and specific protocols allow decentralized finance to function. Beneath both of these critical elements is the internet, without which blockchain technology would not be possible.
One definition of a protocol is a “set of rules or procedures that govern the transfer of data between two or more electronic devices”. When protocols exist on a blockchain, a network of computers, known as nodes, carry out specific protocols. These protocols govern features of a blockchain such as:
- The algorithmic mechanisms by which nodes communicate
- The means of approving transactions within the blockchain
- The means by which new nodes are accepted into the blockchain
These protocols undergird blockchains in general, and are therefore the enablers of decentralized financial products. The specific ends to which DeFi application founders use these protocols determines what each product can do for its users.
What Are the Benefits of Decentralized Finance?
The benefits of decentralized finance vary from one general DeFi category to the next, and even one application to another.
But, generally speaking, the benefits of decentralized finance lie primarily in decentralization as a principle. Without decentralization, the benefits of DeFi become far less obvious.
The thinking goes that centralized financial institutions are flawed in several ways, including but not limited to:
- Lack of control over how the system works by those who prop the system up (the financial consumer)
- Lack of transparency into how decisions affecting the financial system are made
- Lack of control over and transparency into how your specific deposits are handled
- The potential that arbitrary or bad-faith decisions by financial institutions or regulatory bodies could put your deposits at risk
Proponents of DeFi aim to flip these flaws on their heads. Their goal: to use the antithesis of centralized financial institutions—decentralized financial products—as the selling point for their DeFi products.
In an ideal decentralized financial system, benefits would include:
- Democratic control by participants (financial consumers) over how a system works
- No central authority with outsize power to affect the fate of participants’ deposits
- Greater reach to customers regardless of geographic location, as all one would theoretically need to participate is an internet-connected mobile device
- Less vulnerability to outside breaches due to decentralized security protocols
- Greater autonomy to customize specific blockchain protocols democratically, which may allow dynamic shifting of interest rates for lending cryptocurrency as one possible benefit
Trustworthiness is a key benefit of DeFi, as agreements are solidified by smart contracts which manage the exchange of coins. Rather than simply having faith that a bank will come up with your assets (which they’ve lent out in the meantime) when you request them, smart contracts provide guarantees that your coins will be delivered when predefined conditions are met.
Keep in mind that these are ideals of decentralized finance, and time will tell the extent to which real-world DeFi products live up to these gold standards.
What’s the State of DeFi Today?
As of now, decentralized finance is virtually synonymous with the Ethereum (ETH) blockchain, known for its customizability and user-friendly interface. DeFi Pulse notes how existing, Ethereum-based products in the DeFi space offer:
- Lending and borrowing of cryptocurrency
- Decentralized exchanges for purchasing cryptocurrency
- The ability to bet on fluctuations in the value of assets by purchasing synthetic derivatives
- Peer-to-peer payment services
- Tokenized asset management
You can view an extensive list of DeFi products, including industry lending leaders such as Aave, Maker, and Compound here.
It is fair to state that decentralized finance mirrors the slate of non-decentralized financial products, sans the middle man (traditional financial institutions). Another difference between DeFi and more traditional financial products is the relative youth of the decentralized finance sector, which continues to evolve at a rapid clip.
How Do Regulators View DeFi?
There seems to be a looming spectre that regulators will come for DeFi products, sooner or later. Just as the Security and Exchange Commission (SEC) eventually cracked down on ICOs in the name of curbing digital fraud, some have gone so far as to state that “regulators are circling” the DeFi sector.
As with any regulatory matter, speculation and opacity will rule until regulators—the SEC or otherwise—make an overt move. Calls for self-regulation as a means of warding off outside regulation may, if history is any indicator, range from naive to overly optimistic.
The perception that those who create DeFi products are not spawning truly decentralized products, but are rather in it for their own personal gain, is surely not helping the case of those who hope to rebuff outside regulation.