Advantages and Risks Associated with Decentralized Finance (DeFi)
Decentralized Finance has completely taken over the financial and banking sector, as the world shifts towards innovation and technology. The DeFi system bridges the gap and helps in overcoming the limitations of the traditional financial system. Besides peer-to-peer transactions DeFi also has use cases like lending, borrowing yield farming, and more.
The emergence of blockchain-based decentralised finance has led to the disruption of the traditional financial system. In fact, the number of DeFi users in 2022 was around 4.8 million, which is quite a fascinating number. Investment firms invested $2.7 billion in the DeFi project last year, which was a 190% increase from the previous year. It won’t be wrong to say decentralized finance has a lot of potential, and most businesses are started with DeFi development to explore the potential.
Notably, decentralized finance has greatly affected the way banks and other financial institutions work. And also led to changes in the financial ecosystem. Currently, there are different points of view on DeFi for different reasons. While some consider decentralised finance as an evolution, few consider it as a moment, and then there are certain who consider it as a hoax or deception.
So, before you make an opinion on decentralised finance, understanding the advantages and risks associated with decentralized finance is important. So here is an unbiased opinion on DeFi based on what we know. So let’s start with the discussion.
What is Decentralised Finance (DeFi) All About?
Before understanding the benefits of DeFi and the risk associated, it is important to have a brief discussion on what exactly DeFi is about.
Decentralized Finance is a blockchain-based architecture which utilises digital assets, digital wallets, smart contracts and oracles to create a financial ecosystem that is free from centralised authorised, middlemen, or intermediaries, unlike the traditional financial system. Thus blockchain-based applications can provide a peer-to-peer option to carry out usual financial services.
The concept of DeFi is still at an early stage of its development, and still businesses are sceptical about adopting DeFi as a mainstream financial service. However, with an increased digital impression, wider acceptance of blockchain development solutions, and increased investments in DeFi projects, decentralised finance has started gaining a lot of traction over recent times. These are also the reasons it can generate good volumes of assets or resources.
So, what exactly should you do? Should you invest in DeFi or skip it for a while? To understand this you need to know how DeFi works first.
How Does DeFi Work?
The decentralized finance ecosystem works on standard protocols which depend upon preset open-source codes called smart contracts. With smart contract development you can set preconditions for the DeFi system which are necessary for carrying out smooth transactions. These codes are written on a blockchain network, thus anyone can access and review them. Moreover, everyone can use smart contracts through digital wallets. Thus the platform allows users to transfer and lend funds, or any other DeFi services offered by the platform.
One of the biggest perks of the defi ecosystem is the zero involvement of middlemen, intermediaries, or central authorities. As a result, the process of getting entry and credit is quicker, easier, and is also less expensive. DeFi platforms are secure, and once the information is stored in the blockchain it cannot be modified or changed. Besides, all of the transactions are transparent.
As a result, the DeFi system has made it possible to carry out cross-border payments, DEX, and peer-to-peer lending, which was earlier not possible with traditional finance.
Advantages of Using Decentralized Finance (DeFi)
The DeFi ecosystem has led to a movement, especially in the financial sector. Indeed the financial system aims to benefit the users as well as the investors in different ways. Besides, the DeFi ecosystem is constantly improving to create better financial opportunities. Here are some of the most prominent benefits of using decentralized finance.
Decentralized finance runs on the blockchain which uses cryptography and consensus algorithms such as Proof-of-Work making it immutable. The immutable nature of decentralized finance practically makes it impossible to alter or modify the data recorded on the blockchain.
One of the best things about the DeFi system is that it is easy to access. Anyone with a crypto wallet and internet connection can access the system. The users can carry out transactions, run trade, and lend or borrow funds without having to do any paperwork or meet-ups.
Blockchain-run financial systems do not just offer high security but also transparency to the users. The decentralized network leads to enhanced transparency, while the distributed ledger system shows information about all the activities being run on the network.
Easy Access to Financial Services
One of the main perks of using the DeFi system is that it provides easy access to every individual to use financial services. Thus individuals who are otherwise refrained from traditional finance can also use the DeFi system.
The DeFi system does not require any third-party involvement of the intermediaries. Thus it reduces the cost as you do not have to pay any fees to the middlemen. Thus in the end the users have more funds left to themselves.
Better Control Over Funds
The DeFi network allows users to have better control over their funds. Since there is no centralized body involved the users do not have to depend upon them to manage the funds and assets.
As compared to the traditional financial system, the transactions on the DeFi platforms are smooth and happen quickly. Thus users can get access to their money without having to wait.
Greater Privacy and Security
All of the transactions on the DeFi system are stored on a public blockchain network. Thus it provides a higher level of security and transparency to the users. Also because of the pseudonymous nature of blockchain user privacy is also not compromised.
Geographical location is not a barrier to decentralised finance. As long as you have access to the internet you can access any DeFi services at any given time. This makes it easier for anyone to access the financial system.
Risks Associated With Decentralised Finance
Most of the risks related to the DeFi system are because of the technologies related to it.
Here are some of the major risks related to decentralized finance.
Although the defi network is decentralised there are high chances of some sort of centralization in the system. Besides, defi is an unregulated space which increases the chances of users coming across financial instability and risk in this unregulated market.
Highly Volatile Market
There is constant fluctuation in the value of cryptocurrencies due to the highly volatile market. As a result, digital assets are constantly a risk. Thus investors may experience loss and must be aware of all the transactions and investments they are making.
Since it is a decentralized network, there is no one person to be held accountable for mistakes or concerns. Since there are no intermediaries, the users need to take responsibility for everything including managing their funds and assets.
The decentralized financial system has certainly brought in new possibilities for users across the globe. In fact, the DeFi system is widely used by individuals to carry out financial transactions. Finally, decentralization is bridging the gap between the users and the financial system.
However, it does come with possible risks, uncertainty being one of the major risks associated with the DeFi system. The decentralised financial system needs tools that can minimise human errors and technical risks.
Having said that, DeFi is definitely boosting applications of blockchain in the fintech and banking sectors. And it will be interesting to watch how DeFi and its applications further change the financial system.