DeFi: What it is and how it works?

Decentralized Finance (DeFi) is an open financial infrastructure based on smart contracts distributed on a blockchain platform, such as Ethereum. The functions such as custodianship, legalization and central clearing of transactions are regulated by smart contracts. The independence from a centralized authority and institutions is a key feature of DeFi. 

After its launch in 2015, Ethereum provided an open-source platform for decentralized economic activities such as crypto-assets. By using the decentralized governance models, organizations have developed decentralized marketplaces, gaming zones, banking services on a distributed ledger called a blockchain.

In this article we will discuss the benefits and risks associated with decentralized finance along with its comparison to centralized finance.

Decentralized Network Model

Let’s look into decentralized network models to better understand the functioning of a decentralized financial system.

Image by: Blockchain Engineer

In a decentralized network there is no single regulatory authority or storage. The data, images, files etc. are distributed and duplicated on all the nodes in the network. This means that the decentralized applications can be run smoothly even if a unit in the network is not working. On the contrary, distributed networks have servers that act as a central authority while the data is distributed and stored in the interconnected nodes. In a centralized network, all the nodes have to be connected to a centralized server. The network will crash if the server stops working. 

Through decentralized networks, the data is stored through mutual consensus. In DeFi, this mutual consensus is achieved through smart contracts. The data control is also distributed, which means nobody has direct control over the data. The authenticity of the data increases as more nodes join the network. When there are more nodes to vote on the smart contract, the risk of vote pooling decreases.

Decentralized Applications

The platforms through which users can perform peer to peer financial activities are called Decentralized applications or dApps. dApps on blockchain are those applications that allow permissionless and transparent execution of financial algorithms through decentralized applications. However, the concept of dApps is not limited to finance, a variety of decentralized applications can be executed on a blockchain. Many applications run on decentralized peer to peer networks such as Golem, BitTorrent and Popcorn Time.

Benefits Of Decentralized Finance

Financial transactions facilitated and regulated by large financial institutions serving as intermediaries are more vulnerable to monopoly, self-interest and knowledge lock-in. Decentralized Finance ensures immutability through blockchain, which means that the data once stored in the blockchain cannot be altered. This feature also protects data from third-party interference. 

Traditionally, the intermediaries between the economic actors had a substantial role in shaping the financial system. For example, insurance companies and commercial banks. In a decentralized financial system, the role of financial intermediary is reduced to being negligible. These intermediaries played a dominant role in centralized financial systems and provided services such as asset management, liquidity and cost advantage. 

This type of financial infrastructure is built on open source blockchain protocols and decentralized applications. The financial transactions are secured by deterministic algorithms. Every change in the transaction is transparently published on the distributed ledger. Thus ensuring uninfluenced rights to financial access, interoperability between peers and transparency. 

The financial transactions facilitated by peer-to-peer networks reduce the  involvement  of centralized institutions and transaction costs. A network effect is created that does not require a monopoly. In this type of system holding a monopoly is really difficult because excluding other peers from participating in the network requires an impossible number of servers and high electricity.

This transformation in the global financial market can change the regulatory framework of how currencies are exchanged and regulated. Financial incentives, user activity, and distribution of currency in a decentralized financial system still require governance. 

DeFi vs CeFi

The traditional Centralized Finance (CeFi) environment might also appear difficult to the non-experts, that is, usually the consumers. It is because the consumers are generally unaware of the underlying guidelines and regulations associated with economic assets and merchandise. The lack of transparency is one of the major reasons behind it, making the consumers more intimidated and reluctant towards new investment opportunities. 

However, in Decentralized Finance (DeFi), the financial ecosystem claims to provide transparency and greater control to the consumers. This feature is backed by the underlying technology that we call the blockchain. DeFi offers higher economic incentives to the users through security and greater control over the distribution of assets.

Alternative to centralized financial system regarding assets and loans like Coinbase and Celsius. The digital financial systems are built as non-custodial projects. These projects are not owned or managed by centralized legal authorities. However, the entities voting for smart contracts have the governing authority to manage or influence the decentralized financial transactions on a blockchain ledger.

Potential Risks in Decentralized Financial System

Decentralization of data means that the data is easily accessible. Saving data on the cloud or blockchain means that the data is permanently available. This poses a serious threat to data privacy and data control. The concept of data control appears appealing in theory. However, if an owner wants to remove the data some data particles, signatures or transaction history would always remain.

DeFi enthusiasts believe that finance through a blockchain system is not just an innovative model, it is a way to democratize finance, administration and politics. However, DeFi has many implementation risks as the system is highly tech-dependent. DeFi still has some centralized elements in it as well such as cloud storage. The independent peers in the network still have to follow some centralized protocols regarding censorship.

Although DeFi works through various interconnected servers that transparently verify the transactions, these servers can be influenced by external politics. The network has this inherent ability to reduce the risk of manipulation, the threat of other cyberattacks are still prevalent. The network data is vulnerable to security breaches if a node is infected with software malware or a Trojan. Each access point to the data is at the risk of data breach and malfunctioning can spread through the network.

Way Forward

Blockchain technology empowers a decentralized financial system by lessening the transaction charges and generating a disbursed transaction verification system. It is the foundation of new decentralized business processes and monetary enterprises. 

The future of financial regulations through decentralized mechanisms will be borderless, interoperable, inclusive, and progressive. It is reshaping contemporary finance and shows guaranteed efficiency in commercial and noncommercial financial models.

Important elements of DeFi are financial technology (FinTech) and regulatory technology (RegTech), cryptocurrencies, and digital assets. However, the emerging technological evolutions in global finance need to be evaluated through their legal implications as well. Special efforts need to be made on the re-concentration of wealth to avoid the risks of monopoly. 

The requirement of regulations should not be eliminated, rather, it should be replaced with embedded regulations. This can be done by reimagining the regulatory approach of DeFi. Since the decentralized financial sector is still in its embryonic stage, prototype testing of regulations and implementation is easy.

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