Finance is no exception to the rule that evolution is the answer to everything. Many policies of governments, central banks, and established participants in the industry have been brought into question since the 2008 financial crisis. The emergence of Bitcoin in 2009 provided the world – or at least a portion of it – with the tools required to develop.

The goal is to democratize finance by replacing centralized organizations like banks with peer-to-peer partnerships. Every financial service we use now – savings, loans, insurance, and so on – may one day live on a blockchain rather than in a bank.

This is due to the fact that decentralized financial platforms provide an alternative system rather than merely a plug-in to conventional banking and finance infrastructures. These platforms are designed to become self-sufficient from their creators and investors over time, eventually being controlled by a community of users whose authority is derived from owning the protocol’s tokens.

What exactly is decentralized finance?

Decentralized Finance (DeFi) or Open Finance is all about developing a worldwide, decentralized alternative to every existing financial service, such as insurance, savings, loans, and so on. It will make financial transactions available to everyone with a smartphone and an internet connection. It is a new financial system that is built on secure distributed ledgers, similar to the ones used by cryptocurrencies. The system eliminates banks’ and institutions’ control over money, financial goods, and financial services.

DeFi’s goal is to deliver financial services to 1.7 billion unbanked individuals and integrate them into the global economy. For many customers, one of the most appealing aspects of DeFi is that it removes the costs that banks and other financial institutions charge for utilizing their services.
– Instead of depositing your money in a bank, you keep it in a secure digital wallet.
– It can be accessible by anybody with an internet connection.
– Funds can be sent in minutes or even seconds.

To comprehend decentralized finance and how it works, it is necessary to first understand how it differs from centralized finance.

Centralized Finance

Banks, companies whose ultimate objective is to make money, hold your money under centralized finance. Third parties who enable money flow between parties abound in the financial system, with each demanding a charge for their services. Assume you use your credit card to purchase a gallon of milk. The charge is routed from the merchant to an acquiring bank, which then passes the card information to the credit card network.

The network clears the charge and asks your bank for payment. Your bank accepts the charge and forwards it to the network, who then forwards it to the merchant via the acquiring bank. Each organization in the chain is compensated for its services, mostly because retailers must compensate you for your ability to use credit and debit cards.

Decentralized Finance

Decentralized finance reduces the need for middlemen by allowing individuals, merchants, and organizations to execute financial transactions using developing technologies. This is performed using peer-to-peer financial networks that employ security protocols, connection, software and hardware improvements, and so on.

You may lend, trade, and borrow using software that records and validates financial transactions in distributed financial databases from anywhere you have an internet connection. A distributed database is accessible from several places; it collects and aggregates data from all users and verifies it using a consensus process.

Decentralized finance makes use of this technology to abolish centralized finance models by allowing anybody, regardless of who or where they are, to utilize financial services everywhere. DeFi applications give users more control over their money by providing personal wallets and trading opportunities that cater to individuals. For the first time, DeFi protocols make it possible to borrow or lend money on a wide scale between unknown individuals and without the need of middlemen. These programs connect lenders and borrowers and automatically establish interest rates based on supply and demand. Furthermore, those protocols are really inclusive, since anybody, at any time, from any location, and with any amount, may engage with them.

Indeed, the recent buzz around DeFi apps has been fueled in large part by the emergence of borrowing and lending protocols such as Compound. Loans in DeFi are frequently backed by over-collateralization, in contrast to traditional finance. Companies like as Aave, on the other hand, are actively focusing on permitting uncollateralized loans in the same way that traditional finance does.

But what’s the problem with our “traditional” banking systems?

DeFi has the potential to democratize financial systems by allowing anybody to access financial services, particularly those in underserved communities who do not (e.g., those who reside in distant places) or cannot (e.g., those who are unemployed or have criminal records). There is no governing body defining when and if a person can conduct a transaction. DeFi is a member-user consensus system that rewards good conduct while punishing negative “actors.”

Since there is no middleman, transactions are immediate, and costs are reduced because clearing and settlement processes are eliminated. As a consequence, it can address settlement delays and high-cost issues such as those seen in the GameStop and Robinhood sagas, which led in significant losses for traders and a $70 million fine to Robinhood for misleading customers.

Advantages Traditional Finance” versus’ DeFi

To accomplish a single transaction between parties, traditional financial systems rely on the systems of banks and intermediaries. This can take several days and is costly. A decentralized financial system is one in which transactions take place between two individuals without the use of a middleman. Smart contracts govern the transactions, which are (almost) immediate and (almost) free.

One of the primary benefits of DeFi is that it is borderless. These financial services are available to everyone, everywhere who has a smartphone and internet connection. This will transform banking for the underserved and unbanked. They can suddenly safely store value. With the click of a button, they can invest anywhere in the globe in anything using security tokens. Transactions conducted in this manner can be more efficient, flexible, secure, and automated than those conducted in traditional finance.

Furthermore, DeFi removes the gap between regular consumers and affluent individuals or organizations, who have access to a broader range of financial goods. Anyone may become a member of a DeFi lending pool and lend money to others. The risk is higher than with a bond fund or certificate of deposit, but the potential gains are higher as well.

And that’s only the start. Because DeFi services are based on open-source software code, they may be merged and customized in virtually limitless ways. They can, for example, automatically swap your assets between multiple collateral pools based on which presently gives the highest returns for your investment profile. As a result, the fast innovation witnessed in e-commerce and social media may become the standard in previously conservative financial institutions.

These advantages assist to explain why DeFi’s expansion has been so rapid. Over $80 billion in cryptocurrency were trapped in DeFi contracts at the latest market top in May 2021, up from less than $1 billion a year earlier. As of August 3, 2021, the market was worth $69 billion.

That’s a drop in the bucket of the $20 trillion global financial sector, implying there’s lots of space for expansion. At the present, the majority of customers are professional cryptocurrency traders, rather than the inexperienced investors who have flocked to platforms such as Robinhood. Even among bitcoin owners, just 1% have tried DeFi.

What are the dangers, and what should beginners be aware of?

Keep in mind that DeFi is a software program. As a result, it may have problems or “bugs,” which is the embedded technology risk of any program. Many failed DeFi initiatives were started using unaudited code, resulting in losses such as the YAM code bug catastrophe. In the future, the industry will most likely self-regulate by auditing every application before uploading it to a blockchain.

The cryptocurrency market is also quite illiquid. Every modest amount of “buy” or “sell” of these assets can have a significant influence on their value. Billionaire Mark Cuban demonstrated that he is not immune to danger by trading a DeFi app that failed in a single day.
“Even if I got rough on this, it’s really on me for being lazy,” he subsequently said to Bloomberg. The trouble about DeFi games like this is that they are all about revenue and numbers, and I was too lazy to perform the math to figure out what the essential indicators were.”

It is critical to interact with a trustworthy and transparent product in the same way that you would with any other. Transparency is a basic element of blockchain technology. As a result, if the makers of a DeFi program wish to remain anonymous — as in the failed Harvest Finance protocol designed by an anonymous team — this should raise a red alert about the service’s integrity or if it is a hoax.

Since many underdeveloped nations lack comparable legislation and oversight, hub access becomes challenging. Clients from countries with poorer institutional infrastructures must rely on expensive workarounds, often including multiple jurisdictions acting as regional centers (in particular as often seen in the Gulf). As a result, enterprises from poor nations frequently have to rely on intermediaries to gain access to services supplied by global financial centers (albeit at cheaper costs than by accessing them directly).

In the case of emerging market currencies, for example, services could be tokenized and delivered to the token holder regardless of the origins of the provider and recipient, with Bitcoin serving as an example: Bitcoin holders are linked through common technology rather than a massive balance sheet in a highly regulated payment hub. Finally, hub systems generate dependencies that may be unappealing from a political standpoint—for example, if RMB or EUR are settled in London or New York, English and US authorities gain authority over the currency, which may be utilized in political contexts. The future of finance may look different as a result of technological advancement. This calls for a closer examination of the underlying technologies, processes, and infrastructure that enable decentralization and decentralized finance.

Determining the jurisdiction of courts and relevant law in a DeFi world, in whatever shape it takes—anywhere along the range from totally centralized to entirely decentralized—becomes more challenging. Consider a distributed ledger system that is not incorporated, such as those used for Bitcoin or Ether. To assess a court’s jurisdiction and the appropriate legislation, private international law and civil procedural law turn to the substantive claim. In various countries, the substantive claim about distributed ledgers may be founded on wholly different legal ideas, including but not limited to contracts, torts, joint venture and partnership law, antitrust law, and, in certain jurisdictions, blockchain-specific laws. As a result of decentralization, there is ambiguity about which courts and laws apply.

The same concern—determining jurisdiction—applies to financial regulation. While we conceive of finance as global, which makes sense given the hub structure. The reality is an universe of individual legal jurisdictions and regulators that are coordinated via a variety of soft-law systems. Traditional approaches focus on the company that delivers the service, the client to whom the product or service is offered, or the market in which it is exchanged. Each of them is problematic in the age of DeFi: in a network economy, numerous organizations offer parts of a service, consumers are equally distributed over the globe, and marketplaces and individual providers lose value as supervisory access and control points.

Furthermore, technology that enables decentralization may render entity-based techniques less successful in general. The frequently proposed alternative, a concentration on functions, may be less than persuasive where services are done by a collection of algorithms in a permissionless system for two reasons:

First, where decentralization is advanced, it would necessitate the supervision of a plethora of small contributors to the services, many of whom lack the size and financial resources to pay supervision fees and many of whom contribute only gradually and partially to the overall service; and, second, machine learning technologies may permanently change the nature of these functions. DeFi may compel us to look beyond the businesses engaged and focus our oversight efforts on the underlying technical infrastructure that connects all contributors. In reality, the technology linking all relevant organizations, rather than just those nominally affiliated to the project, will be responsible for an increasing proportion of the risks in DeFi initiatives.

Data security and privacy

Decentralization in the datafied world means that data may be accessed from several places rather than just one. Because the cloud and DLT run on arrays of servers rather than single servers, storing data in the cloud or on a DLT entails distributing data over several servers. Data protection and privacy violations may be extremely costly for institutions that rely on DeFi. The idea is that regardless of what data security laws are in place, any data created in this manner will be ‘decentralized,’ leaving conceptions of ‘data ownership,’ or, more accurately, ‘effective data governance,’ just theoretical. Even if there was legal standing to sue for data protection or privacy violations and data erasure, some data particles would remain—the internet does not forget in this sense.
At the same time, we are seeing jurisdictional (re-)concentration of data today as a result of jurisdictional data obligations and data localization policies such as the EU’s General Data Protection Regulation (GDPR). The main cloud service providers (Amazon, Microsoft, IBM, Alibaba, Google, and Apple) are gradually locating data in data centers across a growing number of unique jurisdictions. Any of these data centers ‘contains’ the data of a certain customer, such as a big financial institution or technology firm. The final consequence of this mix of technology, regulation, and economic incentives is not what DeFi proponents anticipated: as a result of this interaction, centralization is frequently at the core of decentralization.

DeFi is therefore a threat to the conventional legal function of the state, both in the ideal and in reality, whether from the position of purpose in the DeFi ideal or the reality of technological growth.

Conclusion

From both the DeFi and regulatory perspectives, a particular global strategy to handling global DeFi systems may be suitable and perhaps vital. Such an approach could be based on IOSCO’s Multilateral Memorandum of Understanding, which lays out common minimum approaches as a precondition for joining, possibly in conjunction with supervisory college structures for systems involving multiple operators across multiple jurisdictions, of which Libra is likely the most significant potential example so far. For example, the Libra 2.0 white paper specifically mentions a ‘supervisory college’: a committee of regulators from the countries in which it will operate, convened by its home regulator (in this example, the Swiss Financial Market Supervisory Authority (FINMA)).

Consider DeFi to be a financial service vending machine. A vending machine is a non-cost, automated service that operates 24 hours a day, seven days a week. However, because all economic activity is transaction-based – whether retail, gaming, technology, or social media – DeFi apps may expand beyond financial services and connect the virtual and real worlds by integrating with the services or goods we use.

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Natasha Dean

With an eye for detail and understanding of this exciting industry. My experience has given me an understanding of crypto trends and how to effectively break them down. I have a soft spot for NFTs and the Metaverse.