An Introduction to Finance Decentralisation

Written By Ben Aubury

Introduction

Decentralised finance, commonly known as DeFi, is a revolutionary concept that has emerged in the world of blockchain technology. The concept poses a significant challenge to traditional financial systems by removing financial intermediaries and enabling individuals to have direct control over their assets and financial activities. By using blockchain networks and smart contracts, decentralised finance strives to provide a transparent, open and accessible financial ecosystem in the future. Nonetheless, it still has obstacles to overcome, such as various hacking attempts and system errors.

Chain 0: Mechanism

A “Smart Contract” is a contract that automatically enforces the terms of agreements between parties without the need for intermediaries like banks or brokers if previously set terms and conditions of the contract are satisfied. This eliminates the need for people to utilise a conventional financial intermediary party, such as a bank who can validate a financial transaction, as the transaction itself is hardcoded and transparently executed on the blockchain. Furthermore, decentralised exchanges (DEXs) constitute a crucial mechanism for DeFi. In essence, DEXs allow peer-to-peer transactions to take place corresponding to market fluctuations. That is, unlike in traditional finance where trading takes place on centralised exchanges, where orders are matched and executed by a central identity, transactions are automated by using smart contracts. Since smart contracts store the conditions required by both the borrower and the lender before a transaction is made, a decision can directly be made without the need of an intermediary. Moreover, automated market-making (AMM) algorithms allow decisions to reflect real market prices as these are algorithms that dynamically determine the price of assets based on the ratio of assets, which allows users to trade assets at fair and live market prices without relying on centralised price feeds.

Chain 1: Will DeFi completely replace conventional financial services?

Replacement of the old systems seems inevitable. As of now, this is not precisely the case. Naturally, given how early DeFi still is in its development timeline, the technology is unfree from new regulations imposed by different governments across the world. The evolving regulatory landscape will introduce uncertainty and limit the potential for DeFi initiatives to fully flourish. For instance, the Financial Action Task Force by G7 member states publicly acknowledged the need to regulate the technology as part of its efforts to regulate crypto service providers. More importantly, DeFi services are not free from security breaches and abuse of technology. The direct cause of this is because, as mentioned in Chain 0, DeFi relies heavily on smart contracts which, when exploited, can result in hacking incidents that can disrupt users’ access to capital. The fact that any transactions done through DeFi platforms are irreversible and untraceable also does help developers devise an effective solution to preventing security breaches from happening on DeFi platforms.

Chain 2: What are the novel advantages?

Now that one has become more familiar with the otherwise vague and distant concept of DeFi, why should one opt to use DeFi instead of conventional methods of finance? What are the benefits? The immediate benefits of DeFi is that the technology removes the need for intermediaries like banks and brokers from the entire transaction process. This eliminates associated fees that traditional financial institutions levy upon the users on their financial services. DeFi also accelerates the financial transaction process as peer-to-peer transactions are more direct than having to consult and seek advice from financial institutions. As a result, DeFi is regarded as a means to democratising financial services for underprivileged and marginalised communities. To illustrate, for those who are living in regions with limited access to traditional financial institutions, let that be due to geographical barriers or lack of funds to afford financial services, DeFi provides an easy way of managing their money. With simply access to networks, anyone who is willing to borrow or lend money can participate in doing so. Ultimately, individuals can thus have full control and ownership of their assets. For instance, users hold their private keys and can access, transfer or trade their assets without the need for approval from a centralised entity. This empowers users to freely allocate their resources in ways they wish to, without having to face the costs of regulatory capture, should they rely on rigid regulations set by conventional financial institutions.

Conclusion

In conclusion, decentralised finance (DeFi) is an innovative concept that challenges traditional financial systems by leveraging blockchain technology to create a transparent and accessible financial ecosystem. By utilising smart contracts and removing intermediaries, marginalised communities are empowered enjoying financial services in regions with limited access and are thus able to have full ownership and control over their assets. However, DeFi does certainly have limitations. Security breaches and hacking attempts remain a significant concern due to smart contracts being vulnerable to exploitation. Additionally, regulatory uncertainties pose a hurdle to the full-scale adoption and development of DeFi. Nonetheless, with further advancements and improvements, DeFi has the potential to reshape the financial landscape by offering more inclusive and accessible financial services to individuals worldwide.

Sources

Ben Aubury
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