DeFi has the potential to grow so much bigger, considering that any traditional financial service can be decentralized. Traditional finance is a behemoth of epic proportions, with the global banking sector estimated to be worth nearly $8 trillion.
What is Decentralized Finance?
Decentralized finance is an umbrella term for a collection of different financial products that are built on top of blockchain technology. It includes cryptocurrencies, tokens, and smart contracts that allow people to issue their own crypto-collectibles and NFTs (like Next Earth), replace fiat systems (like MakerDAO), or trade assets without using a third party (like Uniswap).
DeFi is an alternative to the traditional financial system, which is built on a foundation of debt and trust. Decentralized finance works by building systems that are more transparent, efficient, and fair.
As transactions get verified by a network of computers and recorded on the blockchain, they become “trustless”—no middlemen required. This is why many people see DeFi as a potential replacement for traditional banking services like loans or credit cards; it’s simply cheaper and faster to do transactions that are automatically verified in a trustless manner, than to use a centralized bank or FinTech firm.
But DeFi isn’t just about digital currencies; it also includes tools that let people raise capital for their projects without having to go through venture capitalists or banks altogether.
The Origins of DeFi
It was only with the Industrial Revolution that we saw an explosion in wealth creation as millions of people were able to work together to produce goods they couldn’t have produced individually. This is when money became a tool for global trade rather than a privilege of birth.
However, the playing field was by no means equal. Banks emerged as the intermediaries in this process, lending and transacting money for their customers and charging high fees for doing so.
In the last century, we’ve seen a massive amount of wealth creation as productivity has increased exponentially. In the early days, it was only industrialists that could benefit from these productivity gains. The middlemen were the banks who used their position to make money by charging fees on all transactions.
But now, with blockchain technology, we are seeing an opportunity for democratization in finance and wealth creation on a mass scale. DeFi is bringing about democratization in finance due to technological advancements like smart contracts and zero-knowledge proofs.
Not all DeFi apps are created equal — it’s important to note that not all DApps are built on top of open-source protocols like Ethereum; many DApps operate on private permissioned blockchains like R3 Corda or Hyperledger Fabric.
And even when they do operate on public permissionless blockchains like Ethereum, they often run into scaling issues due to limitations in the underlying codebases — all this is to say, there are many opportunities for DeFi to improve, expand, and take over more and more of the traditional financial world.
As DeFi continues to grow in popularity, there are some interesting questions that arise about its potential impact on the financial world as we know it today, including:
- Who controls DeFi?
- What about custody wallets?
- How does KYC work?
These are important questions to consider for the future of DeFi, so let’s explore each of them.
Who controls DeFi?
Decentralized finance is largely built by developers who build applications on top of blockchains like Ethereum or EOS; however, these developers often don’t ensure compliance with regulatory requirements around consumer protection or anti-money laundering.
Many decentralized finance applications don’t currently offer any form of investor protection at all — this could change in the future, but until then, consumers need to be aware that they may not be protected if something goes wrong during an investment.
What about custody wallets?
Some applications require users to store their assets inside an application’s custody wallet instead of keeping them on their own personal hardware wallets like Ledger or Trezor.
This is often required for security purposes, but also means that users give up control over their assets, since these apps control where those assets are stored in addition to what happens with them (i.e. they can be sent elsewhere without permission).
How does KYC work?
KYC stands for “Know Your Customer” and is generally required by regulators before allowing individuals/businesses access to financial products such as lending platforms or investing platforms.
Investors must submit identification documents such as proof-of-identity documents, like passports and utility bills.
Many in the DeFi space believe that custody and KYC requirements go against the ethos of decentralization, and that regulators are getting in the way of building trustless applications. These problems have yet to be sorted out, but they’re also an indication that there’s a lot of opportunity for people entering the space today.
In the end, there’s no doubt that DeFi has an enormous impact on the financial world, with already over $100 billion worth of capital having been decentralized.