Making Sense of Decentralized Finance (DeFi): A Ground-breaking Disruption in The Current Financial System

Crypto assets have been crippling in the past few months, noticeable from a significant decline in crypto prices and market capitalization, along with the declaration of bankruptcy by some avant-garde entities. However, the blockchain technology that underlies cryptocurrencies remains crucial, as blockchain has grown to be one of the imperative pillars supporting the emergence of Decentralized Finance (DeFi). Enabling through blockchain-based smart contracts, DeFi creates a crypto-economy environment similar to the traditional financial system. DeFi allows everyone in any location to access financial services – such as lending, insurance, and investment – based on digital assets (Gudgeon et al., 2020). Amidst the waning popularity of cryptocurrencies, DeFi is growing steadily, with more than USD 10 billion daily transactions processed (Banerjee et al., 2022). This article aims to address the concern on the disruptive potential behind the emergence of DeFi and the risks that come from its growing existence.

Decentralized Finance: A Disruptive Innovation?

Decentralized Finance’s (DeFi) increasing prevalence is apparent in attracting researchers’ attention, and many scholars refer this phenomenon to other form of terminologies, such as  decentralized autonomous finance and open finance (Eikmanns et al., 2023). Though there is no singular definition of DeFi, its terms are mostly seen through the vantage point of technology and financial affairs. In a general context, DeFi is conceptualized as decentralized financial infrastructures built on a stack of blockchain/DLT and open sources protocols which are enabled via smart contract and allow users to get financial services akin to those offered by traditional financial system (Eikmanns et al., 2023; Popescu, 2020). DeFi’s designated purpose is to extend or even move the financial services presented by the existing system to a digital environment where people can conduct financial affairs without central intermediaries. The architecture behind DeFi that relies on blockchain-based smart contracts allows the transactions to be processed in a secure and verifiable way, enforced by computation coding only, and stored in public ledgers (Deloitte, 2022; Schär, 2021). As a result, DeFi has the capacity to produce a perpetual and open financial system with unparalleled transparency and grant the equal right of access to users.

DeFi protocol is not only mimicking traditional financial systems that provide core banking services such as saving, lending, and investing. As blockchain technology undergoes rapid development, DeFi is reincarnated to be one of the financial infrastructures which is growing at unprecedented speed, offering numerous new and updated applications. With the current pace of development, this ground-breaking innovation is considered a disruption.

DeFi comes with the idea of decentralization – a vision to liberate people from constricting financial systems that depend on trust.  Current traditional financial systems rely solely on the existence of intermediaries – such as commercial banks, insurance companies, or mutual funds – to perform transaction settlement. Consequently, these intermediaries can hold significant power over the users, which leads to inherent fragility and systemic risk when core intermediaries become corrupted (Makarov & Schoar, 2022) However, individuals have no other choice to get financial services but trust these intermediaries, along with the risk of corrupted institutions. Instead of trust, DeFi offered a computation coding to process the transactions, eliminating the need for trusted third parties altogether. Relevant to this, there are at least three prominent features: intermediation, interoperability, and inclusion of DeFi technology that have  considerable potential to reshape the current monetary structure (Eikmanns et al., 2023).

First, DeFi is eager to diminish the function of intermediaries. The foundation of the current economic system is centralization, where government, banks, and public financial companies play an authoritative role that people trust to maintain value and order within the system (Abdulhakeem & Hu, 2021). Although working, the immense authority held by these intermediaries is not immune to abuse that could harm the users through the application of excessive transaction fees or the imposition of usage restrictions. By upholding the principles of disintermediation, DeFi removed the importance of government, banks, or other financial entities and utilized smart contracts so people could have direct control over their financial affairs. When a traditional financial system cannot survive without central intermediaries, DeFi offers a mechanism where anyone is a node and can be the center of a financial structure (Abdulhakeem & Hu, 2021).

Second, because the code is open source and nobody holds copyright over every program within the protocol, DeFi is highly interoperable. It creates an extremely competitive environment which leads to the emergence of an infinite innovation cycle (Eikmanns et al., 2023). Consequently, any problem within a DeFi would be easier to address, and the solution employed could be quickly distributed. Interoperability also means that DeFi can adapt to the growing users’ needs faster than the traditional financial system, ensuring that users can get the best DeFi programs and applications. Third, DeFi applications do not rely on identities, and exclusion is out of the question (Schär, 2021). As long as somebody has an internet connection, DeFi would be accessible to them, thus in some points, DeFi could be a solution for economic empowerment by providing easier access for people towards financial services – including the 1.7 million unbanked population globally (Demirguc-Kunt et al., 2018; Popescu, 2020). Though, unequal internet access and the digital literacy gap must firstly be addressed to achieve financial inclusion,  DeFi would still reduce the wealth, status, and location barriers that are also imperative factors preventing people from getting financial services.

Admittedly, this leap in technology challenges the current financial system. DeFi strikes the existing system by offering efficiency, transparency, and accessibility (Abdulhakeem & Hu, 2021) – something people found lacking from centralization. With the ongoing trajectory of digital technology development, it is possible that DeFi could replace the function of governments in providing financial structures in the future. Still, along with its intricacies, DeFi holds a promising ground that can be advantageous for countries to solve the long-standing systemic problem.

As Disruptive Innovation: How Risky Is It?

The existence of DeFi looks like a double-edged sword. On one side, DeFi provides the tools and environment needed for reforming centralized financial infrastructures: ensuring the application of low-cost transaction fees, unparalleled transparency, and promising inclusivity. On the other side, the growing existence of DeFi posed a threat not only to the government but also to the users. As an open-sourced environment without central intermediaries, DeFi’s emergence is accompanied by poor governance arrangements that raise some concerns (FSB, 2023), such as: who responsible for what or who can be held accountable in the event of failure. There is a blurry distinction between users, developers, and infrastructure providers, resulting in unclear accountability and responsibility of governance mechanism (Rikken et al., 2019). This could have a negative impact on the stability of the financial system as well as mislead the users about the DeFi’s claims of its promises and safeguards.  

However, the more significant threat posed by DeFi is its capability to undermine the rule of law (Zetzsche et al., 2020) and thus, in this case, governments need to take action toward its growing presence. Zetzsche, Arner, and Buckley (2020), highlighted three different areas where DeFi could compromise the rule of law. First in terms of jurisdiction and applicable law. As the product of Web3, DeFi is operating globally, meaning it has been beyond spatial boundaries. Thus, if there is any conflict between users, it would be difficult to determine which laws and jurisdictions are applicable to settle the matter. Second is the issue of law enforcement. Decentralization upheld by DeFi would make enforcement becoming more challenging. The DeFi environment could be anarchy as no entity could enforce that the game within the structures complies with laws and regulations. As a result, DeFi can be a modicum to conduct illicit actions (OECD, 2022). Lastly are concerns on data protection and privacy. DeFi’s operations rely on cloud and DLT, it indicates that the data of DeFi’s users would be stored in multiple servers instead of an individual server; therefore DeFi’s users are prone to privacy violation. Even if data protection principles are applied, the data generated from a DeFi is ‘decentralized,’ which makes the concept of ‘data ownership’ simply theoretical (Zetzsche et al., 2020).

Given its rapid growth, it is crucial that governments begin to keep track of this development closely to get a better understanding of its mechanism, the benefits it brings, and the underlying risks (OECD, 2022). Simply refusing DeFi will deprive a country of the benefits it offers. That being the case, governments must formulate a strategy to utilize DeFi to its full potential while managing its risks. Combining DeFi with the current traditional financial system can be an option, as both need to work together (Casey, 2022). DeFi could bring innovative solutions to the table for systemic problems the traditional financial system faces: transparency, inclusivity, and efficiency. On the other hand, by combining DeFi with the traditional financial system, its environment no longer needs to be anarchy, as traditional finance could impose some of its regulations to achieve functional stability.

References

Abdulhakeem, S. A., & Hu, Q. (2021). Powered by Blockchain Technology, DeFi (Decentralized Finance) Strives to Increase Financial Inclusion of the Unbanked by Reshaping the World Financial System. Modern Economy, 12(01), 1–16. https://doi.org/10.4236/me.2021.121001

Banerjee, A., Byrne, R., Bode, I. de, & Higginson, M. (2022). Web3 Beyond the Hype. https://www.mckinsey.com/industries/financial-services/our-insights/web3-beyond-the-hype

Casey, M. (2022, September). ‘DeFi’ and ‘TradFi’ Must Work Together. Finance & Development, International Monetary Fund, 24–26.

Deloitte. (2022). DeFi deciphered: Navigating disruption within financial services . https://www2.deloitte.com/content/dam/Deloitte/us/Documents/risk/us-financial-advisory-defi-march-2022.pdf

Demirguc-Kunt, A., Klapper, L., Singer, D., Ansar, S., & Hess, J. (2018). The Global Findex Database 2017: Measuring Financial Inclusion and the Fintech Revolution. Washington, DC: World Bank. https://doi.org/10.1596/978-1-4648-1259-0

Eikmanns, B. C., Mehrwald, P., Sandner, P. G., & Welpe, I. M. (2023). Decentralised finance platform ecosystems: conceptualisation and outlook. Technology Analysis & Strategic Management, 1–13. https://doi.org/10.1080/09537325.2022.2163886

FSB. (2023). The Financial Stability Risks of Decentralised Finance. https://www.fsb.org/wp-content/uploads/P160223.pdf

Gudgeon, L., Werner, S., Perez, D., & Knottenbelt, W. J. (2020). DeFi Protocols for loanable funds: Interest rates, liquidity, and market efficiency. AFT ’20: Proceedings of the 2nd ACM Conference on Advances in Financial Technologies, 92–112.

Makarov, I., & Schoar, A. (2022). Cryptocurrencies and Decentralized Finance (DeFi) (No. 1061; BIS Working Papers). https://www.bis.org/publ/work1061.pdfOECD. (2022). Why Decentralised Finance (DeFi) Matters and the Policy Implications.

Popescu, A.-D. (2020). Decentralized Finance (Defi) – The Lego Of Finance. Social Science and Education Research Review, 7(1), 321–348.

Rikken, O., Janssen, M., & Kwee, Z. (2019). Governance challenges of blockchain and decentralized autonomous organizations. Information Polity, 24(4), 397–417. https://doi.org/10.3233/IP-190154

Schär, F. (2021). Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets. Review, 103(2). https://doi.org/10.20955/r.103.153-74

Zetzsche, D. A., Arner, D. W., & Buckley, R. P. (2020). Decentralized Finance. Journal of Financial Regulation, 6(2), 172–203. https://doi.org/10.1093/jfr/fjaa010