What Are the Benefits of Decentralized Finance?
The uncertainty posed by the year 2020 has made investors explore beyond traditional investment options. The blockchain and cryptocurrency space have appeared to be quite attractive for investors. Moreover, the cryptocurrency industry seems to have recovered way faster than the traditional investment markets. Decentralized Finance or DeFi is the one industry that has been booming this entire year. While the use cases of blockchain have been explored in the banking and finance domain, with DeFi, they have become even more relevant. Decentralized finance holds promise to bring transformation into the banking and financial system. In this article, we are going to discuss how DeFi differs from centralized finance and what are the benefits of a decentralized financial ecosystem.
Centralized vs Decentralized Finance
A decentralized finance network allows anyone to access its tools irrespective of their citizenship, location, and so on. Centralized finance, on the other hand, allows only verified and credible individuals to participate. Not only the identities of participants are known, but the respective transactions can also be easily audited. Likewise, in the question of centralized vs decentralized access control, DeFi and centralized finance differ with respect to their basic functionalities. A decentralized finance system allows wider access to financial products or services without any intermediary organizations. It promotes financial inclusion and allows the unbanked to get access to services like loans. Moreover, with DeFi, a user remains in control over their financial assets instead of a centralized institution like banks. Decentralized finance incorporates dApps and smart contracts based on blockchain technology. DeFi eliminates limitations of geographical location and time of centralized systems as the financial ecosystem can be accessed through dApps from smartphones.
Understanding Decentralized Finance
As the name suggests, decentralized finance, or DeFi, is the opposite of traditional centralized finance systems. It comprises financial applications operating via decentralized blockchain, primarily Ethereum’s blockchain. The concept of decentralized finance eliminates the need for a middleman that is almost predominant in finance-focused platforms. Cryptocurrencies are an excellent example of how effective a decentralized economic system can be. On-ground application of cryptocurrency suggests the possibility of financial products and services without a centralized controlling authority. DeFi use cases covering lending, borrowing, insurance, asset management, etc. are a perfect example of the capabilities of a decentralized ecosystem.
Benefits of Decentralized Finance
The traditional centralized finance system comes with a variety of barriers. These systems are also restricted by geographical locations and local regulations. These are just some of the drawbacks of centralized finance that have been successfully overcome by decentralized finance, leading to its increasing popularity in recent times. Being highly innovative, DeFi also comes with important benefits as listed below:
Decentralized finance sits on top of the blockchain setup. In other words, the blockchain acts as the ‘infrastructure layer’ for DeFi to function. The dApps in the decentralized financial systems offer the same services but without the complexity of the centralized financial system. Globally, there are nearly 2 billion unbanked people who do not have the access to basic financial services of borrowing. The functionality of DeFi can be leveraged to provide such services without monitoring from a central entity.
One of the core advantages of decentralized finance is that it allows users to preserve the autonomy of their assets and investments. DeFi governance is autonomous as it allows for the disintermediation of finance. It is based on applications that are entirely decentralized. Additionally, unlike the traditional centralized banking systems, decentralized finance does not depend on interventions from institutions like courts for arbitration or banks. Removal of intermediaries and functionality via smart contracts makes the decentralized system highly autonomous. While not everyone may be comfortable working in a decentralized finance environment, the trend is certainly shifting to more autonomous financial platforms.
DeFi enables financial inclusion to the unbanked across the globe. Users from all over the world can participate easily irrespective of their social status or physical location. In this sense, decentralized money trading platforms are also more inclusive incorporating a wider audience. Moreover, participants can gain access to services to financial services such as loans, without the restrictions imposed by centralized financial organizations.
Decentralized finance uses blockchain as its underlying infrastructure. The blockchain technology enables instant transactions between any two parties without limitations on geography and time. This further facilitates efficiency in the process.
In a centralized system, the control of an individual's assets remains in the hands of an intermediary like a bank. Tokens in a decentralized infrastructure are accessed through private keys. Typically, DeFi applications ensure that individuals retain the possession of their keys to increase privacy. This allows individuals to remain in control of their own assets.
Decentralized money is capable of achieving transparency that results in price as well as market efficiency. There is no existence of asymmetric information due to the manner in which decentralized finance is designed. As a result, principal-agent related risks are minimized. The transparent protocol in place ensures that the personal interests of all investors and users are kept intact at all times.
Decentralized Finance Innovation
Blockchain enables technological innovation in the financial ecosystem. The innovative DeFi contracts are capable of handling millions without even a bank account or the involvement of a third-party entity. Moreover, the customer has complete possession of the crypto asset.
Through blockchain, DeFi facilitates the tokenization of real-world assets into their digital counterparts or security tokens. These digital tokens, representing an underlying asset, can be traded on a peer-to-peer network. The ownership of an asset is managed through smart contracts and recorded on a transparent ledger. This further allows extracting liquidity from an illiquid asset.
Challenges In Decentralized Finance
The DeFi space is still very much perceived as being in its experimentation and innovation stage. Additionally, a lack of legal regulations does not allow to access the optimum benefits from a decentralized financial ecosystem. Centralized finance offers higher liquidity in comparison to decentralized finance. For DeFi to overcome this, it needs a wider adoption. Also, it is sometimes difficult to overcome system failures in DeFi as there is no central authority conducting audits. In case of a failure, the decentralized functionality makes it difficult to identify the point of failure. Despite the limitations mentioned above, there are various significant use cases of decentralized finance that have made it one of the most important innovations of modern times. More importantly, DeFi helps in removing the limitations of the traditional finance system to make it more inclusive, accessible, and cost-effective.
The decentralized finance crypto is concerned with establishing the financial services in an entirely different manner from the traditional centralized finance setup. These are more open in their approach. However, like every other system, decentralized finance, too, comes with its own set of challenges and drawbacks that may lead to hesitation in its adoption by the users. For now, the benefits of decentralized banking and finance seem to far outweigh its limitations or drawbacks.