Decentralized financing, also known as DeFi, refers to automated banking applications such as mortgage lending, insurance, financing, investment services, all outside the traditional banking system. DeFi is emerging as an advanced technology for conducting transactions and various types of financial transactions that can provide a full range of financial services, from day-to-day banking, loans and mortgages, to complex contractual relationships and asset trading. DeFi, which uses encryption and blockchain technology to manage financial transactions, aims to democratize finance by replacing older, central institutions with peer-to-peer relationships.
Today, everyone who wants to access financial services must deal with a number of financial intermediaries. In fact, for direct access to capital intermediaries and financial services, such as banks, stock exchanges and lenders, who are the guarantors of transactions, all the above intermediaries earn a profit percentage for each financial and banking transaction.
DeFi challenges the existing financial system, which to date is based on its central character, as it seeks to weaken intermediaries that acting as guarantors as custodians of financial services. DeFi's position, is through blockchain technology to develop for every individual entity a peer counterparty in financial transactions.
Using blockchain technology everyone who uses a DeFi application has the same copy of the public ledger, which records every transaction in encrypted code. Proponents of DeFi's applications believe that cutting off intermediaries from all types of transactions is one of DeFi's main strengths, and they argue that in essence, blockchain makes financial transactions safer and more transparent than private, opaque central systems used in traditional finance.
DeFi however is an emerging product that comes with some remarkable innovation but also with notable weaknesses and risks. A major disadvantage is that for the time being, almost all DeFi services are for digital currencies such as Ethereum and Bitcoin or stablecoins and not for real money issued by central banks. DeFI is supported by decentralized applications called "dapps" or other programs called "protocols". Users typically have access to software of "dapps" or decentralized applications, most of which run on the Ethereum network which is the second-largest cryptocurrency platform in the world, which stands out from Bitcoin platform, as it is easier to use for creating other types of decentralized applications beyond simple transactions. Then users connect their digital wallet to the application and select a service from the menu, which runs automatically. No human presence or intervention required. There are also almost no conditions for participation, except to have cryptocurrencies to pledge as collateral.
However, some remarkable risks for users are, that in case a transaction is not correct, they do not have the opportunity to resort to a central guarantor to settle the transaction. Also, almost all DeFi loan transactions require a guarantee equal to at least 100% of the loan value, if not more. These requirements for many types of DeFi loans greatly limit the eligible counterparty. Furthermore, DeFi uses wallets to store assets that are protected by private keys, which are large, unique codes known only to the wallet holder. If a user loses the private key, access to money is lost as there is no way to recover a lost private key.
On the other hand, DeFi interest rates are particularly attractive compared to traditional investment products. And not only that. Because they are in the digital realm, they are not bound by the physical borders of a state. They can have depositors and borrowers from all over the world, which gives them another advantage over the conventional bank. DeFi applications are available to all inhabitants of the planet.
But while DeFi is emerging as the future of funding that could lead to huge profits, many DeFi applications, such as the YAM meme coin, have crashed and burned. Also, other DeFi projects, faced the same fate and many investors lost a lot of money. In addition, DeFi errors are unfortunately still very common. Smart contracts are strong, but they cannot be changed when the rules are incorporated into the protocol, which often makes errors permanent, and thus the risk increases. The IT developers hope to finally fix these problems. Ethereum 2.0 could address scalability concerns through a concept known as sharding, a way of splitting the underlying database into smaller chunks that are more user-friendly to run.
The fact is that despite the big problems and weaknesses, so far, more and more people are attracted to DeFi applications, so it is difficult to predict how much they can be extended. The crucial question is, who finds them useful and why. Many believe that various DeFi projects have the potential to attract hordes of new users, making financial applications more comprehensive and open to those who do not traditionally have access to such platforms.
If eventually DeFi projects expand, major issues arise in terms of the regulatory environment that should govern DeFi. Compliance with DeFi means that participants follow the same rules as traditional financial services. The big problem arises with issues such as Know Your Customer (KYC), Anti Money Laundering (AML) and Combating the Financing of Terrorism (CFT).
While the rules set by the capital market communities for the entire financial sector may differ between states and governments, the fact is that they all, follow common rules regarding procedures such as, Know Your Customer (KYC), Anti Money Laundering (AML), and Combating the Financing of Terrorism (CFT). This seems that needs to be done on DeFi's compliance. By following such compliance, DeFi’s image can be greatly improve, and so compliance is likely to lead to DeFi's mass adoption, thus serve a larger number of people and businesses.
But adopting compliance on new financial products and opportunities such as decentralized financing is a difficult exercise.
In recent decades, perhaps the greatest challenge for humanity has been for everyone to be able to easily access the opportunities that arise around the world. Technology with the fourth and soon with the fifth industrial revolution seems to be able to largely meet this challenge to the whole range of opportunities including the new financial products.
The next and perhaps even greater challenge, with the assumption that most will have access to the opportunities that arise, will be that everyone will be able to operate under a common set of rules.
Until recently, the set of rules for operating in financial products have laid down by institutions such as central banks, and capital market committees. Today, however, it seems that more and more the rules are sought to be set by the inventors and users of the new financial products that are constantly emerging.
Perhaps the biggest challenge is for institutions, inventors, and users of new financial products to try to create a common ground so that together, they will transform the old set of rules. So, both traditional and new financial products will improve the financial industry, the global economy, and ultimately the whole of humanity.
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