Decentralized finance: Redefining financial transactions in the digital economy

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  • DeFi incorporates blockchain technology, cryptocurrencies, smart contracts, oracles, stablecoins, and decentralized apps.
  • Enterprises from emerging economies whose demands fail on the regular banking system also add value to DeFi.
  • Exploiting the current DeFi ecosystem and infrastructure creates revenue potential, including new services and products and operational efficiencies.

Understanding decentralized finance (DeFi)

DeFi refers to a new type of financial intermediation that eliminates the need for central intermediaries in financial transactions. Decentralized apps (DApps) are programs or protocols developed on public blockchain infrastructure to support this new kind of intermediation. DeFi initiatives are primarily open-source, interoperable, internet-based protocol stacks supporting financial services. These initiatives leverage smart contracts developed on public blockchains like Ethereum.

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DeFi relies heavily on smart contracts that run on public blockchains. Smart contracts are pieces of code stored on a blockchain platform. The codes conduct a series of specified activities autonomously, often by the conditions of an agreement, without the need for an intermediary. These smart contracts are immutable once deployed. The source code and transactions facilitated by the smart contract are logged on the blockchain for anyone to see.

A smart contract, for example, may be configured to swap a given amount of cash for another between two counterparties. Suppose the smart contract code confirms that each counterparty has delivered the requisite currency. In that case, it will complete the transaction, removing the requirement for third parties to support the trade. A set of smart contracts can interact to perform various duties. Applications frequently rely on numerous connected smart contracts.

Most DeFi services remain modelled around current services in the tiered financial system. However, this has not always been practical. Other than speculative trading, cryptocurrencies were initially too volatile to support financial transactions. The solution emerged in the creation of “stablecoins”.  Stablecoins use either complicated algorithms or legal ties with a trustworthy centralized institution to tie their market value to an external reference. Additionally, stablecoins easily imitate the qualities of traditional money and interoperability with DeFi apps. Therefore, stablecoins can serve as a fundamental component for supporting more sophisticated assets, similar to how the present financial system works.

Evolution and growth of decentralized finance

The digital assets and crypto markets have evolved rapidly in recent years. Organizations now facilitate the buying and selling of cryptocurrencies. Institutions also provide custody services while also exploring methods to participate in decentralized finance (DeFi). Cryptocurrencies such as Bitcoin and Ethereum continue gaining acceptance as payment methods. Innovators have shown a strong interest in applying non-fiat assets that may retain their worth in the face of future depreciation.

Simultaneously, the blockchain technology that underpins bitcoin and its accompanying financial infrastructure is on its way to providing a system of financial railways that runs parallel to – and linked to – existing financial infrastructure. DeFi incorporates blockchain technology, cryptocurrencies, smart contracts, oracles, stablecoins, and decentralized apps. This combination yields enormous financial power.

DeFi also finds value in enterprises from emerging economies whose demands fail on the regular banking system. Some enterprises, for instance, use payment firms such as BitPesa in Africa. The leading DeFi platforms remain valuable in making direct payments or converting payment amounts to USD-backed stablecoin for cross-border remittance.

Digital native enterprises, venture investors, and people are driving the current boom in DeFi. The participation of traditional financial institutions in DeFi represents a significant turning point in the industry’s development and progress toward universal acceptance. DeFi has ramifications for the more extensive financial system and existing types of financial intermediation.

DeFi aims to change the world’s centralized financial infrastructure by adopting an internet-based decentralized architecture that depends on open-source protocols rather than traditional financial intermediaries. Consequently, traditional financial institutions have a batch of development options that can improve existing operations and services while posing a threat to today’s financial services and core business model. Institutions’ responses to this new kind of decentralized financial intermediation will have long-term consequences for their position in the growing digital economy.

DeFi creating solutions through blockchain technology.
DeFi creating solutions through blockchain technology.[Photo/business2community]

Decentralized finance value addition to financial transactions

Decentralized peer-to-peer lending, such as collateralized lending, interest-bearing deposits, or investment portfolio management, can considerably influence the current global financial system and its intermediaries if used worldwide.

In contrast to the traditional financial system, DeFi gives individuals greater control over their assets and the ability to choose how to invest them without relying on an intermediary. Traditional financial institutions won’t go away, but how people and organizations interact with each other in the financial system and make financial decisions might change dramatically.

Business-to-business relationships will be impacted by DeFi as well. Decentralized apps based on smart contracts have the potential to become intermediaries between institutions as blockchain use grows and tokenization of financial assets like derivatives and securities continues to evolve. Institutions might use smart contracts to instantly trade tokenized securities in an open internet marketplace instead of going via the Depository Trust & Clearing Corporation (DTCC).

Tokenization of real-world assets on public blockchains will also be a source of transition in financial transactions. A public blockchain will record non-tradable assets like commercial real estate, allowing their representation as tradable fractionalized tokens.

Afterwards, these tokens can serve as collateral or part of investment pools on the DeFi protocols. A more open smart contract marketplace where businesses trade using privacy-preserving technologies on a public blockchain and pricing relies on market circumstances also applies to existing supply chains.

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Risks posed by DeFi to financial transactions

Challenges exist in every new technology or invention, DeFi included. Primary concerns exist on legislative ambiguity, scalability, security and technological hazards, and decentralized app governance.

The most significant uncertainty in DeFi is the current lack of anti-money laundering/know your customer (AML/KYC) guidelines. Various industry players continue exploring information to clarify institutional working with DeFi apps regarding AML/KYC rules. However, vital elements still need clarification. Given the unique and sophisticated services provided by DeFi, regulatory clarity will take time to develop.

Another critical concern is cybersecurity. Most cryptocurrency hacks result from either a flaw in the smart contract code base exploited by a hostile actor, a fundamental design characteristic enabling individuals to syphon or withdraw user funds at their convenience, or the misuse of private keys.

A comprehensive assessment of the smart contracts and protocol would eliminate a significant percentage of the dangers in smart contract-related issues. General wallet, essential management education, and established recovery and security mechanisms might help mitigate the risk of critical loss or theft.

Broader issues of governance also need consideration. DApps design goes well with decentralized community governance, the process of implementing modifications, and updates. Therefore, strategic decisions are being polished and tested across many protocols.

A shared governance approach comprises the usage of a decentralized autonomous organization (DAO) and a governance token to allow token holders to vote on changes. Decentralized or community governance is still in its early stages, and communities and methods will adapt as the business evolves.

Private firms, policymakers, developers, and government officials continually attempt to address these issues and hazards. Still, given the depth and breadth of DeFi, regulatory clarity will take time to emerge. Institutions have a plethora of knowledge and experience to offer these players. The institutions also need to collaborate with these organizations to bridge the gap between traditional and decentralized finance.

There are various challenges to overcome with every new technology or invention, and DeFi is no exception.
There are various challenges to overcome with every new technology or invention, and DeFi is no exception. [Photo/]

The prospects of DeFi in financial transactions

DeFi is still in its early phases of development, and institutions will play an essential role in shaping the ecosystem. Exploiting the current DeFi ecosystem and infrastructure creates revenue potential, including new services and products and operational efficiencies. As this new financial ecosystem evolves, institutions that can adapt and embrace these developments will have tremendous growth prospects.

DeFi is one of the most recent and arguably most significant developments in the growth of internet-based digital assets and finance. Over time, this decentralized ecosystem and its players will converge with established institutions that serve as the old financial system’s trusted gatekeepers. Institutional attitude toward this new technology and kind of intermediation will significantly influence how they function and how long they will be successful in the coming digital economy.

Institutional interest in DeFi will continue to grow as the number of participants and cash invested in these protocols grows. Based on their risk appetite and current capabilities, institutions will adopt diverse approaches to how and to what extent they engage with DeFi applications. Still, no financial institution can decide to disregard the new digital economy entirely.

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