What are we talking about when we talk about decentralized finance? How have they changed the concept of money? From the possibility of promoting financial inclusion to volatility, we assess the benefits and risks of the phenomenon
In less than a decade, they have changed the definition of money, but not everyone is aware of the many facets that distinguish the most important cryptocurrencies, as well as the levels of market capitalization they have achieved and the different technologies behind them.
One of the most important spin-offs, although still to be explored, is what is called DEFI, decentralized finance.
It alludes to the phenomenon defined as Decentralized Finance, which is an emerging ecosystem of financial applications and protocols built through the organization of services, similar to banking, built on infrastructure that assumes the absence of hierarchies, such as blockchain, or otherwise less centralized than the banking system. One of the relevant features of these types of projects is the automatisms that allow transactions to be executed without outside intervention, often relying on the enormous power of smart contracts. Smart contracts, literally smart contracts, represent an incorporation of contractual clauses encoded in computer language, software, or computer protocols, which are used to conclude relationships of a contractual nature by giving autonomous execution to the programmed terms upon certain conditions defined ex-ante.
Despite the fact that smart contracts appear as instruments used to autonomously negotiate, conclude or enforce contractual or pseudo-contractual relationships, they cannot be included in the group of legal contracts. The reason for this can be found in the fact that they present technical and technological peculiarities such that they cannot be juxtaposed with the purely computerized or digitized version of a contract. In practice, users do not have a financial services company as their contractual counterparty, but find themselves interacting with a computer-controlled marketplace that allows for the automatic execution of transactions, such as the issuance of loans secured by cryptocurrencies or the payment of interest on holdings. Interestingly, then, most DeFi platforms are structured to become independent of their developers over time and to eventually be governed by a community of users whose power derives from the possession of protocol tokens.
How much is the DeFi economy worth
Decentralized finance is still in the early stages of its evolution, but already as of October 2022, more than $11 billion has been deposited in various decentralized finance protocols, a figure that represents more than tenfold growth over the course of 2020. Currently, the DeFi economy is worth about $100 billion. In the wake of this seemingly uncontrollable growth, Nasdaq has even decided to create an exchange index (DEFX) to track the largest DeFi products. There are currently about 200 DeFi projects and 90 percent of them leverage the Ethereum network.
Comparing them to traditional banks, DeFi platforms seemingly look very similar, but appearances are often deceiving. The most prominent example is BlockFi, which, with its BlockFi Interest Account, is the most institutionalized solution in this area, as it is backed by the likes of Coinbase Ventures, Morgan Creek Capital Management, Winklevoss Capital, and others. On this platform, consumers deposit cash or cryptocurrencies while earning monthly interest, as if they were dealing with a bank. But one big difference is the interest rate; in fact, depositors can earn a hundred times higher returns on BlockFi than on average on bank accounts. Another big advantage is the ease of use: to start earning interest, one simply needs to make a deposit in one of the supported cryptocurrencies.
The spread of decentralized finance phenomena has stimulated the first value judgments about the ongoing phenomenon. Many observers argue that crypto finance promotes financial inclusion. In other words, people who for a long period of time have been excluded from access to traditional banking institutions now have the opportunity to engage in transactions quickly, cheaply and without prejudicial obstacles.
Such solutions offer the opportunity to bring to an end the difficulties of many related to finding a personal loan that costs little, possibly backed by deposit accounts that offer decent returns, even in the face of a less-than-excellent credit record, a typical case of individuals’ approach to traditional banking institutions. In fact, alternative service platforms generally do not require credit checks, although some do take identity information from the customer for the purpose of making required tax and AML reporting. It should also be added that on a DeFi protocol, users’ personal identities are generally not shared, as they are judged solely by the value of their encryption.
Once again, however, not all that glitters is gold. Although the financial services offered by crypto platforms are more profitable in terms of profit, there is a growing phenomenon whereby consumers are unknowingly taking significant risks through the use of these products. First of all, although cryptocurrencies have gained popularity over the years, they remain extremely volatile, as was evident when the price of Bitcoin and Ethereum collapsed in recent months. Of course, the interest rates on crypto current accounts can be highly attractive, considering their high yield, but if the platform itself providing the account or cryptocurrency fails, investors’ assets obviously will not be guaranteed as they would be in a traditional bank (think of the operation of the Interbank Guarantee Fund) or in a traditional investment account.
Another issue inherent in DeFI is the fact that such applications often represent a disintermediation of traditional licensed operators, such as banks and supervised intermediaries, who are used to playing an almost “governmental” role in traditional finance, collecting and reporting data to the authorities, including information on capital gains on investments made by their clients, also with a view to ensuring tax payments. In other words, clients’ market participation in the approach with traditional players depends on compliance with strict rules of conduct. In contrast, DeFi programs are unregulated applications, created by programmers more interested in the gains that can be made in capital markets than in compliance with rules.
It should also not be overlooked that despite their increased security from the use of blockchain technology, crypto networks can still be vulnerable to hacking and fraud, and there are insufficient regulations to protect consumers in such cases.
Against this backdrop, traditional banks have reacted on the one hand by asking regulators to slow down their crypto competitors, and on the other by starting to work with cryptocurrencies.
Both Visa and Mastercard have announced plans to bring crypto to their networks, and major banks worldwide have invested hundreds of millions of dollars in blockchain companies.
It is likely that traditional financial institutions will continue to integrate blockchain technology and cryptocurrencies into their products and services. On the other hand, crypto enthusiasts and new entrants related to the DeFi world will need to be prepared for government regulations that will ideally provide greater stability and protection, resulting in a curb on the benefits that new comers in the DeFi galaxy currently enjoy.
Perhaps new DeFi entrants will not be required to collect customer information like traditional banks. Still, regulators could create new standards and requirements for technology and products, such as mandating code audits and setting strict risk parameters.
The battle between traditional financial operators and the DeFi world has just begun, and the outcome appears uncertain.
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