Decentralized finance (DeFi) continues to build momentum as a disruptor of the finance sector. But will it ultimately transform the industry completely?
While this is unlikely in the near term, DeFi – combined with blockchain and distributed ledger technologies – is exposing inefficiencies and costs in existing processes and asking serious questions of traditional centralized finance models.
While some new market entrants tout DeFI as eventually replacing an incumbent financial system weighted against the individual, many banks and other finance institutions are evaluating the opportunities DeFi presents to win consumers willing to embrace new digital-only models and organizations.
So what is DeFi? Put simply, DeFi cuts out the middleman in financial transactions and interactions between two parties – effectively making exchanges, brokers and banks redundant. Smart contracts – contracts that execute on the basis of code that incorporates an agreement between the two parties and reside in a blockchain network – enable these transactions that, as Deloitte notes, occur peer-to-peer or through liquidity pools and automated market matching.
Proponents of DeFi like leading open source blockchain and smart contract provider Ethereum, claim with the new model, markets are “always open”, with no centralized authorities blocking payments or denying access, while previously slow and human error-prone services are automatic and safer, due to being handled by code “anyone can inspect and scrutinize.”
Leading DeFi applications include:
Despite DeFi still being at a fledgling stage, the industry is surging; according to DeFi Pulse, the value of assets used in decentralized finance climbed to $100 billion in late 2021. With DeFi and dApps – applications that operate autonomously and run on decentralized, or blockchain, systems – new financial services and models are accessible to any user with internet access. dApps are kept secure by ‘consensus mechanisms’ that aim to ensure general agreement on network states to enable activities to proceed.
One of the leading financial services dApps is MakerDAO, an open source project on Ethereum and a Decentralized Autonomous Organization (defined on MakerDAO’s website as “a social or technical community centered on a particular mission or project”) that manages the Maker Protocol, one of the largest dApps on Ethereum, and Dai, a decentralized, unbiased, collateral-backed cryptocurrency soft-pegged to the US dollar so it can be classified as a ‘stablecoin’, or a currency created to hold a relatively stable value.
The organization claims Dai has helped Argentinians hedge against the devaluation of the Argentinian peso and Venezuelans take similar measures in relation to the Venezuelan bolivar, while residents of an island in Vanuatu were awarded 50 Dai to pay local vendors, avoiding high transfer fees. It also claims to deliver considerable benefits spanning savings, cross-border remittances and market stability for traders.
As DeFi evolves, AI and machine learning presents a considerable opportunity to improve the quality and relevance of DeFi services – and many operators and entrepreneurs in the field are already taking advantage. For example, SingularityDAO – announced in 2020 – aims to democratize AI for advanced financial prediction, risk management, arbitrage, and automated market-making, while another organization, BlockBank, aims to combine DeFi and centralized finance through a mobile banking application with an AI-powered assistant, with its own platform incorporating AI to monitor and understand social intelligence, risk mitigation, analytics, batched transactions and smart contracts.
The incumbent finance sector is also taking seriously the impact and opportunities of DeFi on its operations. A survey of financial institutions in Europe, conducted by BCG Platinion – part of Boston Consulting Group – and cryptocurrency firm Crypto.com in late 2020 found 86% were implementing or assessing services built on a DeFi framework, and 58% were concerned they could lose a competitive advantage by ignoring DeFi instruments. Of the businesses assessing or implementing blockchain technology, “42% are pivoting to a more decentralized approach to asset management [and] 38% of companies are using it to facilitate faster, more secure, payment processing services, rising to 61% for the biggest companies,” the researchers said.
In addition, 70% of companies acknowledged restructuring the business model or decoupling decentralized finance would increase the speed and lower the cost for financial transactions, while 67% said it would open up new revenue streams and 61% said they believe smart contracts are an important business driver for considering or adopting DeFi as a way to execute financial services.
However, in an indication of the sector’s comparative immaturity, security continues to present a challenge for DeFi, with the value of the industry making it vulnerable to a range of attack types. Blockchain security firm Certik estimated the user funds lost due to DeFi hacks in 2021 at $1.3 billion – a 2,500% increase over the previous year, but a fall when measured by the proportion of DeFi’s overall market capitalization. BCG Platinion Managing Director Kaj Burchardi, noted that while it was encouraging to find financial institutions seriously and strategically collaborating with the crypto community, “there is still quite some progress to be made in order to bring DeFi into the mainstream, especially in security and compliance.” The types of attacks known to compromise DeFi range from bugs in smart contracts to simple copy and paste errors and faulty dApp logic.
A cloud-based solution such as Alibaba Cloud Blockchain as a Service can help businesses and developers realize the potential of DeFi and other blockchain-powered applications. The service enables organizations to build a secure, stable blockchain environment while reducing the costs of operation and maintenance. Alibaba Cloud BaaS enables rapid deployment, management of smart contracts, application access and supports mainstream open source blockchain technologies Hyperledger Fabric and Enterprise Ethereum – Quorum, as well as proprietary financial-grade blockchain technology Ant Blockchain.
While DeFi remains a long way from full maturity, it does present a powerful opportunity to apply decentralization and disintermediation to transform the finance sector.
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