Cryptocurrency, from concept to application, has changed how people think of finance, giving rise to new financial innovations within the space. Paired with both retail and institutional investors seeking ways to maximise returns in a low-interest rate environment, decentralised finance (DeFi) has come to the fore.
From lending to borrowing and trading with smart contracts, commercial use cases have proven the potential of DeFi in disrupting the financial services landscape globally.
In April, DeFi became a US$100 billion sector, and though recent price corrections have seen declines in the total asset value committed to the DeFi ecosystem — now standing at approx. US$106.5 billion as of June 3 — it’s apparent that confidence in the space is only growing.
But much like the initial crypto hype of 2017, DeFi itself has seen its share of scepticism — especially when it comes to how decentralised DeFi actually is. In reality, decentralisation shouldn’t be seen in absolute terms but rather, as a continuum.
Firstly, DeFi protocols are open-source and auditable by anybody. All transaction records are stored on the blockchain and remain immutable and publicly available, thereby enabling a more transparent model of finance.
On top of that, DeFi has become the beacon for financial inclusion and accessibility, as transactions are permissionless, meaning that anyone with internet access can trade on DeFi applications regardless of identification, geographical location or the amount of funds available in their crypto wallets.
Furthermore, users can trade on decentralised exchanges (DEXs) 24 hours a day, seven days a week with no downtime. Earlier this month when the market experienced what can only be determined as a “black swan event”, centralised exchanges like Binance and even Coinbase couldn’t keep up with the drastic price fluctuations and as a result, users were unable to access and exchange their holdings without experiencing limitations and restrictions.
On the other hand, many DEX’s, like that on DeFiChain, encountered no such issue.
Unlike traditional exchanges, DEXs are non-custodial by design, meaning users have sole control of their funds rather than having to deposit them with the exchange directly.
This protects them from hacks that can easily exploit single points of failure on centralised platforms, such as the infamous Bitfinex hack back in 2016 which saw US$623 million worth of bitcoin stolen, or the Mt. Gox saga, which eventually resulted in the Tokyo-based exchange filing for bankruptcy.
CeFi: the OG
Similar to traditional finance, all trade orders and funds on CeFi platforms are handled by a centralised exchange. They also act as custodians, meaning the exchanges control the private keys to your assets. As such, traders will need to trust that the custodians will hold your funds securely and allow you to withdraw them whenever needed.
In addition, centralised exchanges are also subject to the relevant regulations in the markets in which they operate. They include know-your-customer (KYC) data collection practices and anti-money laundering (AML) frameworks, which can vary not only from country to country but also in countries like the US, at a state versus federal level.
Along the decentralisation spectrum
Ultimately, decentralisation is determined by governance. DeFi projects have governance mechanisms in place to make crucial decisions about protocol updates, recruitments or even changing the governance structure.
Most DeFi platforms adopt on-chain governance mechanisms, where individual stakeholders can vote on these decisions directly on the blockchain. It’s also worth noting that for most projects, the governance of DeFi platforms is independent of blockchain governance, which usually aims to achieve two potentially distinct goals.
While some DeFi projects are designed to be as participative and decentralised as possible, some gravitate towards the end of the spectrum over time by relinquishing control of their holdings to the community entirely— something DeFiChain is working towards.
One way this can be achieved is through a Decentralised Autonomous Organisation (DAO) which allows decisions and transactions to be fully automated based on rules that are completely determined by its participants. Participants vote on proposals that can impact anything from the trajectory of the development of a platform or even vote to dissolve a DAO entirely.
At the code level, all source codes for open source DeFi protocols, platforms and projects should be distributed in a highly permissive open source license, and be managed in an open manner by the developers involved in the project.
Bridging the CeFi-DeFi gap
DeFi’s merits lie in the fact that it can mitigate the vulnerabilities of CeFi systems, with transparency, accessibility, censorship-resistance, and security as the most common benefits cited by advocates. However, like any form of innovation, DeFi still has an uphill climb to make before it can truly reach a meaningful form of mass adoption.
Whether we like it or not, the traditional financial services ecosystem — as it exists today and always has — has set a precedent for what most consumers have come to expect, such as convenience and ease of use. That being said, participants of the traditional financial services sector have also been innovating across its verticals, from payments to lending, insurance, and investments.
With bulge bracket banks such as JPMorgan becoming more confident in blockchain technology as an enabler of fast payments, it shows that disruptions in the space such as mobile payments and insurtech have served as a stepping stone to a more digitally-powered financial ecosystem.
While CeFi will always have a role to play, it’s important for financial service providers to strike a balance between centralisation and decentralisation in order to reap the best of both worlds.
Recent crypto projects have managed to combine the advantages of both systems with CeFi’s flexibility to perform fiat-crypto transactions and integration with third-party DeFi platforms via liquidity (or farming) pools or lending.
Instead of deeming DeFi a threat, traditional centralised institutions such as banks would do well to capitalise on the technology to boost business outcomes and address the inefficiencies in their systems.
Once a sweet spot between CeFi-DeFi is identified, these models will be able to deliver a higher level of trust, compliance, and convenience while still staying true to the mission of DeFi that is making finance inclusive for all.