The term DeFi stands for “Decentralized Finances.” It encompasses any type of financial platform or ecosystem that operates using decentralized ledger technologies, the most common of which are blockchains. Although most people have an idea of what it means for a platform to be decentralized, the exact implications of decentralization aren’t as intuitive, nor is it so clear why DeFi is the future of finances.
What Does “Decentralized” Mean?
In the context of finances, the word decentralized is used to describe a system where no single entity has the power to modify the way in which it operates, nor does the entity have exclusive access to the information or the sole faculty to validate transactions.
Generally speaking, there are different levels of decentralization. It’s rare to find a system that is completely centralized, with a single entity controlling all transactions, or fully decentralized, where every participant has equal control and access to information.
The Advantages of Decentralization
Distributed ledger technologies allow the automation of certain processes that would normally require an intermediary entity such as a central bank, government, processor, or broker. Additionally, as the technology’s name implies, it distributes the ledger of transactions among multiple participants or nodes, making the system more secure and transparent.
Decentralization can affect all instances of a DeFi system. The first and most notable is the currency used to trade within the system. Most DeFi systems are based on a fungible token or cryptocurrency that is employed to carry out each of the transactions within it. On top of the advantages this provides in terms of security and transparency, it helps avoid the inherent risks of using fiat currencies, such as potential inflation due to efficient monetary policy or other external factors.
In terms of accessibility, DeFi also provides various advantages over traditional financial models. The automation of verification processes coupled with the higher transparency and security can make it easier and less costly for people to participate in financial systems, from easy banking to innovative ways of affordable collective investing.
Smart Contracts and Flexibility
One of the most important innovations that come from decentralized ledger technologies is smart contracts. In simple terms, smart contracts are automated protocols within a blockchain’s programming that activate when certain conditions are met. Broadly speaking, they allow us to define and exercise property in many innovative ways.
These may include things like special types of equities that are easier to buy or can be traded collectively without intermediaries, real-life assets tied to digital non-fungible tokens, and new forms of intellectual property that can be auctioned and traded as if they were stocks.
The possibilities of DeFi are endless when it comes to new ways for people to participate in the financial world, trade, and invest.
A Potential Solution to The Unbanked Crisis
According to the World Bank’s data, about 1.7 billion adults in the world don’t currently have a bank account or any type of access to the financial system. The vast majority of unbanked adults live in developing countries. This represents a global problem insofar as the lack of access to financial services means a lack of access to capital, posing great obstacles to economic growth and development.
The ease that DeFi platforms provide in their use, coupled with their advantages in transparency and security, can make it the ideal avenue for people in developing countries to access the financial system, with far lower costs than creating brick and mortar banks in places where there currently are not.
One of the main factors that make it difficult to overcome the problems related to the banking crisis is the fact that traditional banking institutions have no real incentives to bank the unbanked population, as it requires large investments in infrastructure and personnel. Likewise, the costs of accessing traditional banking are far too high for most of the unbanked population to be worth it due to fees and other expenses related to traditional banking. DeFi platforms offer a much cheaper and often more efficient alternative.
Potential Downsides of Decentralization
Despite all of the advantages that decentralization offers, it also carries certain risks. Chief among them are the challenges posed by the lack of centralized failsafe systems to allow a specific entity to modify protocols and ledgers when there’s an exceptional situation that demands it. In other words, when things fail, it’s very hard to decide who will fix them and how.
Likewise, the impossibility of modifying ledgers means that transactions are permanent, which in turn makes it impossible to reverse funds from a transaction made using the wrong address code or network. If you, for example, ever mistype the bank account number to which you want to send your money and end up sending it to someone else, it’d normally take just a phone call to get your money back. No such possibility exists with decentralized platforms.
Lastly, since blockchains and other distributed ledger technologies are based on complex programming, there’s always a chance for there to be bugs in the smart contracts, potentially leading to some faulty transactions. As stated before, it’s not easy to determine who would patch these bugs out and how.
The Future of Finances
Given the advancements of current technologies and the widely diverse protocols and models of decentralization that DeFi platforms employ, it can be said that the benefits of DeFi widely outweigh the risks. At least that’s what the markets suggest with the rapid growth of the most important DeFi platforms through the last year.
As DeFi technologies are polished to the point where they earn a wider acceptance and trust from investors of all sizes and locations, new solutions will be found to mitigate or even fully eliminate the risks that come with decentralization. When DeFi truly becomes a mainstream part of the investment world, there’s nothing stopping it from being on par with traditional banking and financial services and eventually even replacing them.
The future of finances is one where everyone will be on equal footing when it comes to investing and trading, where intermediaries will be of little necessity, and every person in the world, regardless of their location or income level, will have proper access to banking and financial services. This could all be achieved through innovative DeFi platforms that provide decentralized, secure, and transparent alternatives to the traditional model.