Primarily, DeFi is the phenomenon of removing third parties, such as banks and financial institutions, from transactions. DeFi operates through peer to peer (P2P) transactions, where two individuals agree on an exchange of cryptocurrency for goods or services via decentralised finance apps (dApps), utilising cryptocurrency and managing transactions via blockchains. A dApp called MakerDAO was the beginning of the DeFi evolution, from moving money between two parties, to enabling lending, borrowing, trading, and much more.
This was made possible through DeFi technology known as ‘Ethereum’ (a decentralised blockchain), with stable cryptocurrencies, which, through collateral digital assets, have equivalent value to the US dollar. Over the next few years DeFi technology had constructed a market for borrowers and lenders to operate without the need for holding your money in a central bank or financial institution. By entering into an agreement recorded in a blockchain, known as a smart contract, DeFi transactions are completed when both parties have reached a consensus and each side of the smart contract has been fulfilled.
One example that encapsulates how decentralisation changes typical financial transactions, is the example of loans. Usually, to take out a loan, you would apply for a loan contract dictated by the bank and pay fees and interest based on the strict terms that the financial institution offers. With DeFi, loans are referred to as ‘peer to peer lending’, and use algorithms to match loan applicants with lenders who are offering contracts that align with the applicants repayment wishes. This gives applicants more choice and flexibility when choosing a loan, as lenders could be from anywhere in the world, stipulating different repayment options to the standard contracts that are offered by centralised entities.
Many also argue that this scenario is an example of how DeFi makes financial services more flexible and accessible for people who may not be able to apply for, or even afford, loans and other services, through normal centralised financial routes. Instead of lengthy financial and credit vetting processes, DeFi transactions are processed when both sides agree on conditions that are set out in a smart contract.
Although P2P transactions are processed through a consensus mechanism and secure blockchains, there are still many risks associated with DeFi. As a result of its decentralised and digital nature, anyone with internet access can participate in DeFi from anywhere in the world. The main reason for caution surrounds the notion at the heart of DeFi: there are no trusted third parties involved, and therefore, there is no regulation. For example, if you have ever been a victim of any kind of scam or financial fraud, your bank can normally intervene and even retrieve the money you may have lost – with DeFi, there are no trusted external regulators to prevent such occurrences, or other criminal activities such as money laundering. Adding to this idea, Aqilla’s founder and CEO, Hugh Scantlebury notes that, “without bank or government involvement by way of ‘self-sovereign identity’ authentication, the whole concept lacks the basic structure of trust.” With this in mind, why would anyone want to participate in DeFi, and how realistic is it that decentralised financial services will be the future of financial functions?
Two of DeFi’s main goals, as a result of removing third parties from transactions, are increasing accessibility to financial services (as discussed above), as well as rapidly reducing transaction times. For example, when applying for a bank loan, applications can take months to be processed and approved, with P2P lending, applications and lenders are matched via algorithms, reducing lengthy approval processes. As such, 44% of UK finance leaders believe that decentralised currencies will prove ‘extremely’ viable as a long-term payment solution, giving users more control over their finances through services that cater to individuals, opposed to the profiteering of big centralised banks and financial institutions. With around $80 billion of value locked in DeFi, and the decentralised, global blockchain market expected to grow to over $65 billion by 2026, it becomes clear why individuals, and even businesses are beginning to take note of potential opportunities that a DeFi future could offer.
It is clear that DeFi is still in the very early stages of its progression, with many issues to be solved before it can become any type of norm in the way the world operates financially. Where current financial legislation is devised by different jurisdictions, the borderless possibilities of DeFi pose numerous questions and challenges that need to be addressed before it becomes the future of finance as we know it; questions such as, how can it be regulated, who should be responsible for dealing with any resulting criminal activity, and how can we ensure it remains accessible for those who may be excluded from centralised financial services?