DeFi: why the finance world won’t stop talking about it

Our friend Kalie Mayberry comes back to talk about Decentralize Financial.

DeFi – this might have become such a ubiquitous nomenclature that you don’t even think twice when you see it. That might also mean you do or do not know what it stands for. So let’s start there – DeFi, aka Decentralized Finance, is a term often used to talk about almost any type of new digital financial system, including – yes, it’s true – cryptocurrency. But the decentralized component makes it stand out from prior forms of financial systems – in particular, through the use of the blockchain to replace many of the core components of traditional centralized finance. Let’s take a brief look at an overview of centralized finance to understand then better the difference being drawn with a decentralized version.

Traditional Centralized Finance

The majority economy in the United States (and most countries) currently work within a centralized financial market, in which institutions, such as banks and brokers, act as the intermediary between the consumer and the merchant. All transactions flow through the centralized market, as the centralized institutions provide both spaces for consumers to hold their funds and work with companies to build secure transactions. These institutions help to send the standards for pricing and uphold regulations and policies from the government and other organizations that operate within the system. A centralized system essentially holds this economy in a stable state by managing the supply and demand of money in the country and establishing relationships with other countries to operate finances across seas seamlessly.

One component of the centralized system in the United States that has been brought up in relation to decentralized finance is the Federal Deposit Insurance Corporation (FDIC). The FDIC provides automatic guaranteed insurance to all bank account holders with amounts up to $250,000, meaning account holders can get their money back if something happens to the bank (see: March headlines about Silicon Valley Bank). The FDIC was created after the Great Depression to instill more trust in the American banking system and has proven to be a helpful partner to the economic system in even the most recent decades.

Essentially, traditional centralized finance creates a single location where buyers and sellers can interact within the market and are overseen by third-party entities (most predominantly the government) who validate and justify the pricing and transaction status. Centralized finance is still run by the market, which helps to dictate the supply and demand of the market’s components, such as investment prices and the value of certain currencies.

Decentralized Finance

An alternative to the above-described centralized system is that of a decentralized financial system. While appearing opposite in many respects, decentralized finance ultimately still works within the market and is succumbed to similar dictations, including prices and values. The main difference is that there are no institutions within the decentralized financial system – the buyers and sellers are connected directly to each other without an intermediary. The decentralized financial system is not connected to the centralized system in any way. Therefore, the market not only dictates the price and value but also dictates who is connected to whom.

In place of the institutions of the centralized financial system, decentralized finance instead instigates peer-to-peer financial networks for trading using digital technologies, namely blockchain technologies, and trades using cryptocurrency and tokens. Peer-to-peer networks are the core software applications that allow functionalized finance to work. When a buyer and a seller are matched for a transaction, the software automatically instigates the transaction using virtual currency through a smart contract on the blockchain. In a way, this is the most centralized component of the decentralized financial system. Through the use of a blockchain (whether Bitcoin, Ethereum or a small, more privately held one), individuals interested in conducting a transaction within the decentralized market using a form of virtual currency (typically cryptocurrency) are connected through the financial network to conduct the trade. Those transactions are formed together into blocks and linked on the chain.

Transactions are then immutable and secure but also transparent to anyone viewing the blockchain. But this transparency is, of course, different from most transactions, aside in some part from certain investor platforms, as people’s credit and debit card statements are not public, in the same way, that neither are business transactions at your grocery store. But on the blockchain, everything is viewable to everyone because the network of peers upholds the transactions.

What’s all the hype?

The DeFi hype is mainly based on all this being a new – and ultimately, theoretically very viable – alternative to the current centralized financial system, which many people are less than happy about (and are not always as stable as they lead us to believe). Decentralized finance does not require a bank account or a credit card – individuals who have typically been left out of those products can participate in this system. These systems also don’t cost nearly as much as centralized systems. Within centralized systems, there is typically a fee connected with the transaction – whether you are using a credit card online or a debit card at the store, typically, the buyer or the seller is paying a fee per transaction to use the centralized system. Within decentralized systems, there are no fees nor interest (unless agreed upon by the buyer and seller). Those looking for a product can access anyone worldwide – not just the jurisdiction they are living in. This opens the possibilities for those living in underserved areas by banks and lenders, where they would typically need to travel quite a distance to get to a bank to conduct a secure transaction. Ultimately, the system is creating more access, lower costs, and overall better outcomes for the users, something that cannot always be said for the traditional centralized system.

(Interestingly, centralized finance is also exploring how to join blockchains and maintain a centralized (and insured and regulated) option while still taking advantage of Web3-related technologies.)

But, these systems are also fragile without oversight from financial regulators and the government, nor with insurance from a government-backed entity. There isn’t an entity like the Federal Reserve Bank trying to keep the rise and fall of the economy in check (although it’s debatable how good of a job they can do), making the market very volatile, as we’ve witnessed over the past year. And there isn’t anyone to look into the scams and frauds – no one to turn to when it goes bad, besides a corporation-investigative organization like the Better Business Bureau, which has limited power beyond ratings and awareness.

Additionally, there are barriers for the average person to access these systems, not only by requiring access to secure and reliable internet but needing knowledge about how to set up digital wallets, add cryptocurrencies, and navigate these systems. This requires more than the basic technological know-how that not all communities can easily access. It’s complicated and difficult to grasp – heck, even I don’t fully understand it.

Final Thoughts

But even if you might not be running out to put all your money into a digital wallet anytime soon, it is important to know about what these technologies aim to do, and where they could go in the future. While there are still barriers and challenges to work through, it can largely be seen as a step in the right direction to create a more inclusive and less privatized financial system that could ideally work for everyone. Even if DeFi doesn’t continue to look like how it has for the past decade, some aspects are being highlighted through its rise that is important – namely, that the centralized system doesn’t work for everyone, and increasing access by decreasing costs is an important goal.

Curious to learn more? Here are a few good explainers:

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