Decentralized finance: The new finance protocol that can overthrow traditional financial services

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  Quantumrun Foresight
• June 16, 2022

Insight summary

Decentralized finance (DeFi), is reshaping the financial landscape by enabling peer-to-peer transactions without the need for traditional banks or regulatory bodies. While this offers benefits like lower fees and financial inclusion, it also poses challenges, such as fraud and regulatory complexities. The long-term implications range from shifts in job markets and business models to new governmental challenges and opportunities for financial inclusion.

Decentralized finance context

DeFi comprises a group of protocols, software, applications, and other technology infrastructures that enable peer-to-peer financial transactions such as lending, investing, borrowing, and trading. DeFi enables these transactions without the inclusion of corporations and regulatory bodies such as banks, which often have many requirements and typically apply fees for their services. Instead, DeFi relies on a public ledger (like cryptocurrencies) to verify that these transactions are legitimate.

Several blockchains support DeFi, the most popular is Ethereum, which was built to host smart contracts. Smart contracts are what make DeFi transactions possible. They are self-executing, meaning that if the funds are locked in and the conditions stipulated in the contract are met, the trades are automatically executed. Transactions executed using DeFi cannot be changed or canceled, a benefit as they will not be susceptible to human tampering. 

Different applications have been created to facilitate DeFi and replace the traditional services normally associated with large financial service providers. Some examples include smart contract wallets such as Argent and Parity Wallet, which can hold assets in lieu of bank accounts, and lending platforms like Compound, which can serve as saving accounts with higher interest rates.

Disruptive impact

Decentralized exchanges, commonly known as DEX, are changing the way we think about financial markets. By relying solely on smart contracts, they offer a level of independence that traditional, centralized exchanges can't match. This independence comes with benefits like lower fees and faster transaction speeds. However, it also opens the door for investors to engage in trades and derivatives that they might otherwise be restricted from, potentially leading to significant gains or losses.

While the low fees and instantaneous transactions of DeFi are appealing, they come with their own set of challenges. The most pressing concern is the risk of fraud. In a space where new digital coins and tokens can be created and traded rapidly, there's a real danger of assets vanishing as quickly as they appeared. This risk could become a significant barrier to entry for large financial institutions. If these institutions do decide to enter the DeFi space, we may see an increase in regulation and a landscape increasingly controlled by organizations with substantial financial backing.

For governments, the rise of DeFi presents a complex scenario. The lack of regulation in DeFi markets can make it difficult to enforce tax laws and prevent illegal activities like money laundering. However, the technology behind DeFi has the potential to bring financial services to underserved populations who don't have easy access to traditional banking. This feature could be particularly impactful in developing countries, where a large portion of the population is unbanked. 

Implications for decentralized finance 

Wider implications for DeFi gaining in popularity within the financial services industry may include:

• Regulatory bodies implementing uniform policies to safeguard against fraud, money laundering, and cyber threats, increasing the overall security and trust in DeFi platforms.
• The rise of DeFi apps like Etherscan offering real-time asset tracking, reducing the need for traditional accounting firms and transforming the auditing landscape.
• New blockchains adding smart contract features to their architectures, creating a more competitive environment that challenges Ethereum's dominance in the DeFi space.
• Financial inclusion becoming more achievable as DeFi platforms offer banking-like services to populations without access to traditional financial institutions, particularly in developing countries.
• Small businesses gaining easier access to loans and capital through DeFi platforms, bypassing the red tape and high fees associated with traditional banks.
• A shift in the job market as blockchain and smart contract expertise become highly sought-after skills, leading to new educational and training programs.
• Environmental benefits as DeFi platforms, driven by competition, adopt more energy-efficient consensus algorithms to attract eco-conscious users.
• Governments facing challenges in tax collection and enforcing financial laws due to the anonymous and borderless nature of DeFi transactions.
• Traditional financial institutions experiencing a decline in customer base and revenue as more people and businesses opt for DeFi services, leading to potential layoffs and restructuring.

Questions to consider

• If you made a DeFi transaction, what was your experience? 
• Do you think DeFi is a sustainable way for financial markets to operate or are the risks too great for average investors to tolerate?