Decentralized, peer-to-peer, and borderless, digital assets and open networks offer a promising alternative to the way money and value has traditionally been transacted — but what is the true economic relevance of decentralized finance (DeFi), and how can it shape the future of global finance?
In many ways, DeFi could provide us with an early window into what the future of global finance should look like. As the total value of assets locked in DeFi platforms surpasses USD 40bn, it seems more and more users are now buying into the unique features of DeFi: high yield, liquidity, flexibility, and transparency.
Shaping the future of finance in the new normal
While some may refer to the income earned via yield farming or liquidity mining as passive income, I prefer the term ‘coded income’, since DeFi income is hard-coded into smart contracts. Although DeFi yields are paid out in highly volatile tokens, its returns are generally significantly higher than those earned from centralized finance products.
Interoperability is the core philosophy of the DeFi space. The flexibility of DeFi platforms comes from the technology stack composability in which new DeFi services are developed using previous tools as building blocks. Reminiscent of the popular childhood toy, these ‘money Legos’ allow the ecosystem to benefit from individual progress, encouraging the steady development of new protocols and platforms within the space. Furthermore, as DeFi smart contract codes are open source, the mechanics of the tools are available for all to see — this boost in transparency is a major improvement over the traditional black-box style that many centralized financial services adopt.
Global finance has certainly been affected by new technologies and data-driven apps, which enable millions of investors to trade more easily than ever before. Thanks to the leap in digitalization brought on by the COVID-19 pandemic, this is growing more apparent than ever. Although the trading volume in DeFi still represents a small, albeit fast-growing, fraction compared to the volume traded in global credit and financial markets, its major impact lies in making new products and strategies accessible to all.
Most DeFi tools replicate financial models that have been available for years but in practice they were mainly reserved for hedge funds that had access to both capital and technology. With the help of DeFi, retail investors now have direct, unencumbered access to sophisticated trading strategies they could never have experienced before. Similar to how Bitcoin (BTC) revolutionized the centuries-old legacy financial system, once this door has been opened, it becomes impossible to close.
Confined by code: the challenges and limitations of DeFi
The majority of modern era computer scientists and world-changing tech entrepreneurs are still alive today. In this regard, despite the fact that software has become omnipresent in our lives, programming is still considered a recently acquired skill for humanity. The fast-moving, ever-evolving nature of software also means code can quickly become obsolete, or worse, unsafe.
This is a flaw which applies to smart contract codes, and by extension in DeFi, since smart contracts that have been deployed on a blockchain cannot be altered or easily modified. Instead, new versions of the DeFi tools have to be created to replace previous iterations, and users will need to be aware of any changes or vulnerabilities since their funds may be at risk. Although decentralized insurance solutions exist to mitigate such instances, the risks and limitations of smart contract code and the blockchain infrastructure remain the central challenge to the expansion of DeFi.
Beyond experimentation: DeFi going mainstream
Another barrier to the mainstream adoption of DeFi is the education it takes to actually be able to partake in the space. DeFi market participants need a solid foundation in finance or at least a basic understanding of smart contracts if they want to navigate the intricacies of DeFi’s offerings. Although traders and investors often have a limited understanding of how the financial instruments they invest in function, this is a more sensitive issue for DeFi as investors need to directly interact with the instrument without any risk-insulating centralized guardrails. As a believer in the benefits of decentralization and the motivational power of high returns, I am confident that these issues can be overcome. However, the cost of hard lessons learned by new users is precisely what regulators mean to avoid.
Moreover, the flexibility and superfluidity of DeFi assets can be attributed to reduced friction due to the general absence of KYC/AML throughout the space. Connecting to a browser crypto wallet is sufficient to onboard, use and switch between a large number of DeFi platforms which will automatically recognize your wallet’s crypto assets. Adding a KYC/AML layer to these platforms would certainly affect the speed of transactions and the overall efficiency of DeFi-based trading strategies.
However, the US Securities and Exchange Commission and Commodity Futures Trading Commission actions in the US and the proposed Markets in Crypto-Assets (MiCA) regulations in the EU are just a few examples indicating that governments do not intend for the future of global finance to be unregulated. In that sense, I expect a regulated DeFi ecosystem to eventually emerge, one that is likely to be run by established, licensed companies and used by accredited investors— a marked difference from the current open models.