How DeFi Protects Users And Fosters Transparency
Fri, Jan 27, 2023 •6 min read
Category: Business Stories / Blockchain / FinTech
Decentralized finance (DeFi) is undergoing constant evolution triggered by dynamic changes in global economies, new regulations, and changes in the technological landscape. Current financial regulations were crafted based on the idea of separate financial jurisdictions, so DeFi’s borderless transaction capabilities present a challenge to this type of regulation.
Many businesses and consumers who assess DeFi products are worried about who would investigate a financial crime that happened across borders, protocols, and DeFi apps. What would enforcing the regulations look like in this context? These issues arise together with other concerns around system stability, energy requirements and carbon footprint, system upgrades or maintenance, and possible hardware failures.
Add to those recent PR fiascos like the collapse of FTX, and you can see why many start doubting whether DeFi and blockchain have a solid place in the future of financial services. Despite the FTX story, DeFi has a bright future ahead of it. We’re seeing several exciting initiatives taking place in the blockchain world, with work carried out around digital ledgers, new blockchain solutions for pricing carbon emissions, and the rapidly expanding world of Web 3.0. This makes blockchain and its DeFi applications likely to become even stronger.
Keep reading to learn more about DeFi’s advantages over Centralized Finance and why its future is brighter than you may expect.
What does Decentralized Finance (DeFi) do exactly?
Decentralized finance (DeFi) refers to a cluster of applications, services, and approaches that aim to replicate certain functions of the traditional financial system in an open, decentralized, permissionless, and autonomous way, based on blockchain. As any distributed ledger technology (DLT)-based application, DeFi promises to offer efficiencies driven by automation and disintermediation coming from blockchain and smart contracts. At the same time, DeFi gives rise to several risks for markets and their participants and calls into question the actuality of the current financial regulations.
An increasing number of investors are looking for opportunities that bring high returns, leading to an increase in the popularity of crypto-assets. The growing application of DeFi and its increasing interconnectedness with traditional markets presents an urgent challenge for policymakers seeking to maximize DeFi’s potential efficiencies while managing risks.
According to OECD, stablecoins issued by the largest issuers exceeded $150 billion at the end of 2021. This is a nearly 500% increase over the last year. During the same period, DeFi applications recorded a 50-fold increase as well. This trend reflects the rise of stablecoins in DeFi protocols employed by institutional investors interested in these markets for fear of missing out.
DeFi is growing dynamically because it offers advantages to both users and the market as a whole. It can improve liquidity, mitigate fraud risk, and increase the security of crypto assets over time. The risks it presents are comparable to ones associated with more traditional financial structures. For example, inflation is not an issue for DeFi, unlike in more conventional financial systems.
Control over DeFi applications is also distributed among network participants rather than centralized with a central authority - what we call the Centralized Finance (CeFi) model. In fact, the FTX exchange collapse highlights just how important it is for cryptocurrencies to remain decentralized to protect user funds from theft or other malicious activity. DeFi needs to rely on a more secure financial system if users and businesses want to face fewer incidents like that in the future.
Why centralization is a weakness
Over the past year, we have seen the downfall of FTX, Celsius, BlockFi, and Voyager Digital. These were all centralized exchanges (CEXs) or centralized finance (CeFi) platforms. You can probably tell where we’re going with this - the common denominator is the centralized nature of these solutions.
In both cases, operations are overseen by a central governing body. Some users consider CEXs almost as banks - they enable coin deposits and offer loans and a host of other financial services. Though CEXs are very friendly to newcomers and have high liquidity, they faced a lot of criticism in the past as going against the true spirit of crypto.
Cryptocurrency-enabled decentralized finance (DeFi) projects are designed to preserve the perks that were introduced by crypto-enabled technologies. Such benefits are the permissionless nature of these applications, fee elimination, widespread access, operational transparency, and self-sovereignty over assets.
As a result of the FTX fallout, DeFi saw a growth spurt as users moved their crypto assets to DeFi solutions. Volumes on decentralized exchanges were up by almost 11% that month. An opinion piece in Bloomberg speculates that FTX’s collapse may in fact cause DeFi to grow in the short term, as the event will tighten the need for regulation while boosting longer-term interest from venture capitalists.
DeFi needs to repair its industry reputation
The value of tokens locked within DeFi-related smart contracts (total value locked or TVL) reached around $180 billion in November 2021 from next to zero just a few months before, as investors got attracted to opportunities. This was primarily thanks to the fabulous annualized yield many DeFi projects offered. Another aspect was quick monetization via the early listing of tokens at the token generation event (TGE).
By the middle of 2022, things started to slow down. Popular projects such as Celsius Networks have struggled to maintain their initial momentum as regulatory uncertainty slowed down adoption by big-name partners. Tornado Cash, a decentralized finance application that processed anonymous financial transactions for around $7 billion in illegal activities, was sanctioned by US authorities for providing a platform for money laundering.
The cryptocurrency industry has since experienced a sharp decline in public interest and investment. Investor attention has shifted to other new hot topics, such as decentralized autonomous organizations (DAOs) and Web3 technology.
While many DeFi projects may fail or be abandoned, others will stand the storm and emerge as legitimate industry leaders. MakerDAO, Uniswap, and Aave still reach billion-dollar market capitalizations and are today positioned to become the backbone of the financial services industry of the future.
Many of these ventures are aware of the industry’s reputation problem as well as the perceived loss of a sense of purpose, so they’re busy working to find the next wave that will drive growth and restore legitimacy.
Blockchain has a bright future ahead of it
Despite the collapse of FTX, blockchain technology will continue to thrive. There are several initiatives taking place in the blockchain world, including new blockchain solutions for pricing carbon emissions and Web3. The failure of FTX underscores the need for more severe regulation in the cryptocurrency sector to ensure investor safety and encourage expansion. Transparency is essential to building trust, so the industry needs to do a better job of providing it if it hopes to attract more traditional investors.