In the previous article, we learned about some of the features of DeFi. In this article, Coincu will help you clarify some of the other characteristics and challenges facing the field.
*(Continued in the section characteristics and advantages of DeFi)
- Modern infrastructure, improved market efficiency, and robustness
Ideally, capital should flow as seamlessly as information in the internet age. In particular, the settlement should be instant, transaction costs should be minimal, and service should be available 24 hours a day, 7 days a week, 365 days a year. And our global financial system only operates from 9 to 5 (except weekends and holidays), which is not efficient.
There is a clear underlying demand for modern settlement infrastructure, as Ethereum settled $1.5 trillion last quarter, up from $31 billion in Q1 2019. We’ve also recently seen potential market dislocation due to lack of instant settlement: online brokerage Robinhood was at one point forced to suspend GameStop (GME) buy orders due to difficulty meeting capital needs, which itself was T+2 settlement (T+2 settlement is an industry-standard, and transactions typically take two days to clear).
Efficient markets also require robust infrastructure. The distributed nature of blockchains makes them incredibly resilient: in the 6 years since Ethereum launched, the network (and the applications built on it) have had 100% uptime. But that’s not the case with centralized analogs. Even when centralized, established, and/or regulated, these centralized entities (whether exchanges or payment networks) can exhibit unreliability, especially during times of high volatility.
The impact on users is very real. Take Robinhood’s sudden suspension of GME stock trading in March 2020 as an example, which caused some users to suffer losses and sue Robinhood for this.
- Global access, unified market
In essence, the international market has a larger liquidity pool, which can greatly reduce the transaction costs of all market participants.
Today, decentralized exchanges (DEXs) can offer better exchange rates for certain assets than siled centralized exchanges or service providers. In the stock market, financial instruments like American Depositary Receipts (ADRs) provide a bridge into the foreign exchange market but often suffer from large premiums and thin liquidity.
It can also lead to greater financial equity when the market is accessible globally. Currently, some developing countries are often excluded from financial services due to the high cost of establishing a local business relative to demand, lack of infrastructure, etc. But decentralized financial services can serve marginalized populations, offering insurance, international payments, and dollar-denominated savings accounts and credit.
- Real-time data
One of the benefits of building financial services on a transparent shared database, the distributed ledger of the blockchain, is that all relevant transaction data is publicly available in real-time.
For example, in the Uniswap protocol, yields generated by Liquidity Providers (LPs) can be tracked at a per-second granularity. Investors can use this data to decide how to allocate funds, providing more efficient price discovery and resource allocation, while regulators can monitor real-time transaction data to identify rogue user activity.
This is very different from traditional capital markets. Traditional capital markets keep investors in the dark until companies release quarterly earnings reports. The situation is even worse in the private market, where companies routinely falsify their accounting metrics (if they decide to publish them).
It’s hard to imagine investors making rational decisions when faced with out-of-date data! Regulators are also struggling with the current system and can wait years to discover wrongdoing, often too late, as the bankruptcy of Greensill Capital and the fake accounts at Wirecard are just two recent examples. Research.
- Eliminate counterparty/credit risk and reduce compliance fees
By definition, DeFi platforms are “self-custodial”: users never trust their assets to a centralized operator. While DeFi may seem daunting to some at first, the self-custodial nature of DeFi helps eliminate counterparty and credit risk, which in traditional finance is associated with a party in a financial transaction defaulting or failing to meet its transaction or loan obligations.
Analysts estimate that since 2011, more than $7 billion in total cryptocurrency value has been lost through centralized exchanges (CEXs), from hacks to operators deliberately absconding with user funds. DeFi is a paradigm shift from “don’t be evil” to “can’t be evil.”
Self-custody is also beneficial to DeFi application operators, who can avoid unnecessary liabilities and compliance management fees: for example, the cryptocurrency guidelines issued by the US FinCen (Financial Crimes Enforcement Network) require companies that host user funds to obtain a currency transfer license, This is often a difficult process, and those DeFi applications that interact with self-custodial wallets can operate without a license.
Centralized Finance vs. Decentralized Finance
DeFi is distinct from typical centralized banking and financial organizations.
In centralized finance, banks and other third parties hold the funds and enable the transfer of funds between parties; each party charges a fee for its use. An acquiring bank receives the card information from the merchant and passes it on to the credit card network to complete the credit card transaction.
The network authorizes the charge and asks the bank for payment. Because retailers typically have to pay for the usage of credit and debit cards, each link in the chain is paid for the services it provides.
Centralized finance oversees all financial activities, including loan applications and local bank services.
By enabling individuals, businesses, and merchants to perform financial transactions through new technologies, decentralized finance eliminates middlemen. DeFi makes use of the connection, software, hardware, security protocols, and peer-to-peer financial networks.
People can lend, trade, and borrow using software that logs and validates financial transactions in distributed financial databases from anywhere there is an internet connection. A distributed database collects and aggregates data from all users and utilizes a consensus process to verify it, making it available from different locations.
By enabling anyone to utilize financial services wherever they are, regardless of who they are or where they are located, decentralized finance eliminates the necessity for a centralized finance model. Through individual-focused trade services and personal wallets, DeFi applications provide consumers with more control over their finances.
Early skeptics had said that no one would use Bitcoin or think it had value; yet in just over a decade, it has become a $1 trillion asset, rivaling gold, and the balance sheets of several public companies are held.
Likewise, critics argued that Ethereum wouldn’t work and was too slow and expensive; today, Ethereum powers thousands of permissionless applications, complete trillions of dollars worth of transactions, provides the infrastructure for traditional financial giants, and makes great contributions to cutting-edge cryptography research.
Even when the ICO craze failed, many token sales funded very important technological developments, including decentralized storage (the longtime holy grail of computing), network interoperability, manipulation-resistant data feeds, and decentralization calculations.
DeFi won’t spell the end of existing financial services, as some hardcore believers might think (just as the internet didn’t kill print entirely). However, for traditional financial services and other companies, the DeFi opportunity will allow them to focus on their core structural strengths—custodial products, prime brokerage, fiat on-ramp, customer service, and more—while gaining direct access to decentralized acquire liquidity and products in the protocol.
As with any evolving new technology, DeFi has its challenges. It’s not unlike the early days of the internet when slow connections and expensive hardware limited even the brightest innovators to supporting the images or videos that are now widely used in online socializing.
DeFi exists and will always exist. Some skeptics see it as an idealistic movement doomed forever to be cast in the shadow of the internet.
But because of its innovations around settlement efficiency, risk management, and accessibility, DeFi is likely to become a core part of financial infrastructure, not just for cryptocurrencies, but probably for all other categories of markets: in the near future, people will be using DeFi protocols to sell tickets, Apple shares, pork futures, socks, etc., most likely through portals that provide access to this infrastructure, with separate governance regimes and business activities.
*The article references the source from a16z content site Future.
DISCLAIMER: The Information on this website is provided as general market commentary and does not constitute investment advice. We encourage you to do your own research before investing.
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