The Pros and Cons of Decentralized Finance
Table of Contents
Is DeFi right for you? What about when Facebook joins in?
What is Centralized Finance (CeFi)?
Centralized finance is the financial system as you know it. Look inside your wallet. You probably have a debit card which draws from your bank account. You might have credit cards, which represent money lent to you by a bank or other entity. There’s physical cash, minted and backed by the government of your country. Beyond your wallet, you might have a bank-issued mortgage, bank-issued personal loans, or investments in stocks or bonds through a brokerage. Those banks and brokerages interact with other, larger institutions such as your country’s regulatory authorities or the central bank (“Central” is the key word here.)
As you can see, our financial system is run on a network of powerful institutions. They make up what we call “Centralized Finance” (CeFi). CeFi facilitates the vast majority of transactions — pretty much any time money moves from one person to another. This gives institutions tremendous power over money and information. And, therefore, the world.
What is Decentralized Finance (DeFi)?
Decentralized Finance (DeFi) aims to create a financial services ecosystem outside the traditional institutional system. As you can tell, that’s a massive change from our current system and there are many, many different ideas on how to achieve it. But there are several underlying themes: the absence of any central authority, universal accessibility and inclusivity, and clear source code. In order to achieve those goals, DeFi projects are built on blockchain technology.
What are the benefits of DeFi?
So we know that DeFi aims to be a high-quality alternative to the traditional banking system without concentrating or “centralizing” power in any person or institution. But why? What are the potential benefits of a decentralized system?
DeFi tools have fewer barriers to entry than traditional systems. Most DeFi tools do not require extensive documentation to join. If they do require Know-Your-Customer information, it might be stored more securely using blockchain tools. Things like minimum balances, overdraft fees, or withdrawal fees are far less common in DeFi than in traditional banking. DeFi is also borderless, meaning individuals’ financial freedom is less dependent on the regulations where they live. For these reasons, many hope that DeFi can be a solution for underbanked populations, meaning the 7.1 million Americans and third of the world’s population who do not have bank accounts. However, DeFi has its own barriers, such as technical expertise and access to the Internet.
Financial data is among the most sensitive information in the world. Using DeFi, data can be stored on hundreds or thousands of different nodes, which prevents hackers from attacking or breaking into the system to gain control. (This is one of the major advantages of blockchain technology in general.) Consensus protocols prevent any one participant in a DeFi system from harming the entire network. Compare this to a bank, where a hacker, or even an employee, could access and misuse your data — or your money.
CeFi institutions assert control over our financial lives in countless ways. They set trading and bankings hours, which can delay payments; they approve transactions and can block or delay them if they see fit; they charge exorbitant fees; they calculate credit scores which follow you forever; they manage and manipulate your money opaquely. Remember the public outcries when Robinhood halted Dogecoin trading? DeFi aims to change all of that.
With DeFi, users maintain more control over their money and can process transactions more anonymously. Currently, banks use your data to target financial products, determine fees and rates, and sell it to third parties. But at large scale, DeFi would break the institutional oligopoly on data. Different mechanisms have also been proposed to use data in a more equitable way, such as Brave, which rewards you for viewing ads.
Decentralized finance allows users to earn far higher interest rates than at traditional bakes. Rates on DeFi platforms are far higher than at traditional banks. Depending on the particular cryptocurrency you hold, you could see annual yields as high as 20%. Using yield farming (which we’ll discuss in more detail in our next post), users can get astronomically high returns.
What are the drawbacks of DeFi?
Accessibility, security, autonomy, and profitability are obviously exciting aspects of DeFi. However, there are serious drawbacks with DeFi, especially because it is still in its infancy. Though some leading tools are used by millions of people, many of today’s DeFi projects are closer to proofs-of-concept than a full-fledged financial system.
As we’ve discussed, CeFi is built around and run by powerful institutions. While that causes a number of concerns, those institutions do make up much of the global economy, and our day-to-day lives. People who are entrenched in the cryptocurrency and blockchain worlds may be able to exist entirely within DeFi, but most people won’t. Very few employers pay in cryptocurrency and few businesses accept it. A financial profile, including bank accounts and credit history, is still essential for most people. It would be difficult to mortgage a house or get a car loan using only DeFi. Living off the grid is hard.
In fact, getting into DeFi without using CeFi can actually be a challenge. Let’s take Bitcoin as an example. In theory, Bitcoin is fully decentralized; it is managed autonomously on the blockchain. However, to actually use it, you probably need to link a wallet to an existing bank account, unless you use a Bitcoin ATM. Transacting with Bitcoin will entangle you with institutions, making your behavior far less anonymous and untraceable than you would hope it to be. (If it were truly untraceable, the FBI would not be able to easily recover ransom payments.) At present, most crypto transactions are handled through a central exchange, somewhat defeating the purpose of DeFi.
Poor user experience
Since DeFi is relatively new, participation requires additional effort on the part of the user. Finding the best application for your particular needs can require a lot of research. It also helps to know the ins and outs of cryptocurrencies and blockchain in general, so you can be more informed on your decisions (which is why we write these articles!)
DeFi applications transfer responsibility from a centralized authority to the individuauser. While this can be a benefit, it can also be a serious problem. CeFi banks will usually verify transactions to ensure money goes where it is supposed to. Because they are centralized, they have mechanisms to reverse transfers or correct errors. But in DeFi, if you make a mistake, such as sending money to the wrong address, you might be helpless to do anything about it. The novelty of DeFi platforms can also lead to technical problems or malfunctions. Resolving these issues might be more difficult than with a CeFi bank, which is more likely to have a customer service department to help you out.
Lack of oversight
As we’ve said, people love DeFi because there is far less institutional and governmental oversight. However, those laws and structures do provide some benefits to CeFi which DeFi lacks. For instance, most American bank accounts are insured by the Federal Deposit Insurance Commission or FDIC. This was created after the Great Depression, when millions of people lost their life savings due to bank failures; in essence, the government guarantees that you won’t lose your money if the bank collapses. While certain stablecoin projects might be FDIC-insured, most DeFi accounts will not enjoy such insurance mechanisms.
There are many other such financial backstops. In America, the Securities and Exchange Commission regulates financial markets and the Federal Trade Commission protects consumers and enforces antitrust law. Similar regulatory bodies exist in pretty much every economy. While these bodies are not perfect, they attempt to create fairer marketplaces and penalize bad actors. At present, DeFi is much more of a free-for-all.
Volatility and risk
Pretty much everyone knows cryptocurrencies can go up in value. That’s much of the reason why Bitcoin and crypto have become common knowledge in recent years. However, that upside also comes with downside. The fact is, cryptocurrencies are generally far more volatile than fiat or government-issued currencies. While any currency, asset, or other store-of-value has risks, holding your money in crypto likely exposes you to far more risk.
There are also risks due to the DeFi infrastructure. Many DeFi projects are young, sometimes precarious start-ups. They exist in a competitive, relatively under-regulated market. Many would consider these to be less reliable and less durable than a CeFi institution. However, history has shown that even the largest banks can collapse quickly, and smaller, newer DeFi tools might be nimbler and more adaptable.
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Pontem’s other products include the browser code editor Move Playground, the Move IntelliJ IDE plugin for developers and the Solidity to Move translator ByteBabel - the first implementation of the Ethereum Virtual Machine for Aptos.
Where can I learn more about DeFi?
DeFi is only gaining momentum and there is still a lot of room for improvement. Every day seems to bring new developments and capabilities in the DeFi space. We believe that it has incredible potential to augment, or even replace the traditional financial system in the future.
Do you want to learn more about DeFi? It’s an incredibly complex topic, so we have a lot more content on the way. Stay tuned to learn more about DeFi, crypto, and how Pontem Network can help you get the most from it all!
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