In the last few years, the concept of decentralization has gained a lot of attention across all industries. This has been fuelled by the entry of blockchain technology, which has supported the growth of numerous cryptocurrencies.
Decentralized finance, in particular, has become a widespread concept driven by the public’s disillusionment with the centralized financial system. This is especially true given the alarming rate of cyber-attacks, which often leave individuals at risk of financial loss and personal data exploitation.
Besides privacy concerns, decentralized finance has the potential to extend access to financial services to the 1.7 unbanked population. It faces fewer barriers than traditional banking services, prompting start-ups to take up open source finance to bridge the existing market gap.
What makes Decentralised Finance a Better Choice
Decentralised Finance (DeFi), is an ecosystem of financial solutions built on top of a blockchain network. At their core, these solutions bring in the permissionless and transparent nature of blockchain into the financial industry. This means that users are given absolute control of their assets and can interact with other users through peer-to-peer transactions, thereby eliminating the need for a central authority. As a result, financial services become more affordable and frictionless compared to traditional banking services.
Additionally, unlike centralized financial services, DeFi doesn’t require complex infrastructure to reach the general public. In fact, as the internet penetration rate increases, so does DeFi become accessible to everyone since it’s internet-based.
Decentralized Finance Use Cases
There already exist several solutions that provide open-source financial services. These solutions fall in 4 major categories:
i) Borrowing and Lending
Open source borrowing and lending services are the most popular application in the decentralized finance ecosystem. Thanks to the lack of a central authority, these solutions make borrowing and lending affordable, faster, and more accessible. In some cases, your credit score may be overlooked, especially when you agree to collateralize your digital holdings.
ii) Monetary Banking Services
Decentralized finance is fintech applications offering monetary banking services. This means that the applications can serve as issuance platforms. Currently, most DeFi applications focus on the issuance of stablecoins, insurance mortgages, and securities.
By offering stablecoins, DeFi applications contribute to the maturation of the blockchain industry since the stablecoins are less volatile. This makes it possible for the coins to be used by merchants and investors as a store of value.
DeFi’s entry into the mortgage and insurance market has helped eliminate the role of intermediaries. This has reduced the underwriting and legal fees in the case of mortgages. At the same time, it has helped lower the cost of premiums in the insurance market by spreading risk among the parties involved. Also, DeFi applications make it easy for companies and businesses to launch and issue tokenized securities to investors. Other platforms allow the creation of blockchain-based derivatives and synthetic assets, contributing to the growth of the financial industry as a whole.
iii) Decentralized Marketplaces
Decentralized marketplaces are relatively new in the industry, as evident from their limited share of the market. However, as more people come to appreciate anonymity and privacy, decentralized marketplaces will rise in popularity.
These marketplaces are peer-to-peer platforms that allow users to trade assets without the need for a trusted intermediary to hold their funds. All trading transactions are automatically executed by smart contracts. As such, they have lower trading fees and require less maintenance compared to their counterparts.
iv) Payment Processing
Sending payments, especially across borders, has long been a major pain point for business and those working overseas. The biggest problem facing these transactions is the expensive amount of fees charged by banks and traditional payment processors for sending remittances.
With the likes of the Stellar blockchain leading the way, DeFi is committed to making cross-border payments more affordable. In turn, businesses will extend their market outreach now that they can accept payment from customers across the world.
Why Hasn’t Decentralised Finance Skyrocketed?
Given the numerous advantages of DeFis, one would expect it to have gained massive usage. Unfortunately, this hasn’t been the case – based on the 25 million cryptos users against the 1.7 billion unbanked population. This is due to the following challenges:
Scalability has been the biggest problem facing the entire blockchain industry, and decentralized finance applications are no exception. Currently, DeFi applications can’t process as many transactions as traditional financial services can. For instance, Visa can process about 24,000 transactions per second, which is way more than 15 transactions processed by Ethereum DeFis in one second. If decentralized finance applications and the blockchain industry, in general, is to appeal to the world, then developers must work on improving the bandwidth to handle more transactions.
- Technical Risks
In their simplest form, DeFi applications and the blockchain network are pieces of software. As such, they are prone to bugs and hacks undermining their growth. A good example is the Ethereum blockchain, whose ERC-20 standard is plagued by constant bugs that render applications built on it inefficient. Also, there have been several DeFi applications that have been hacked, creating uncertainty among crypto enthusiasts.
Since DeFi applications are currently unregulated, the market remains vulnerable to manipulation. In the traditional banking industry, manipulation is almost impossible thanks to the strict monitoring and regulations put in place by authorities.
The most common practice is the manipulation of price feeds, also known as oracle manipulation. Oracles, in this case, refers to third-parties that supply blockchain with a particular type of data. For example, the Ethereum blockchain doesn’t determine the price of ETH. The price is determined by oracles, such as exchanges.
Oracle manipulation occurs when a DeFi app uses only one or a limited number of exchanges as the only source of data. This means that traders can trade large amounts of cryptos to sway the price movements, thereby manipulating the information provided by the oracle ( exchange).
There’s no doubt that decentralized finance is set to become the future of the financial industry. But for it to mature and appeal to all stakeholders, decentralized finance needs to mitigate the hurdles hindering its growth. Moreover, DeFi applications are working independently of each other, which fragments the market. Perhaps if they were to work harmoniously, some of the problems facing the industry would be solved.