Advantages & Disadvantages of DeFi

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Alex Lielacher

Before discussing the advantages and disadvantages of Decentralized Finance (DeFi), let’s take a look at the history of traditional finance and how we‘ve come to realise the need to create a system that is not based on powerful intermediaries.

Finance has come a long way and reviewing this short history will help us better understand why we like the idea of adding the concept of “Decentralized” to “Finance” in as many places as possible.

At the very beginning of human history, finance had no place. Human needs were summed up in hunting for survival and finding shelter. As the population increased, humans had the need to interact with each other.

Trading was an important part of this interaction.

The most basic form of trading was the direct exchange of one good for another. You had more meat than you needed, so you had to exchange the extra amount with a neighbor for something like their wheat.

But to what ratio should this exchange take place? 1:1, 2:1, something else?

There was no clear criterion for determining the value of goods.

Another problem with this method of trading was that you may not be able to find someone who is willing to exchange his own product with yours or it may take a long time and your goods may be wasted by then.

With the expansion of goods and products, the need for a criterion and index for the valuation of goods grew. This led to the invention of money systems and the first generations of finance emerged. The first money in the form of coins, was made of electrum (an alloy of gold and silver) appeared around 600 B.C.

A new way to trade

Now people could easily exchange their goods for money and vice versa.

With the advent of industry, different types of money and assets became popular. This new generation of finance emerged with the advent of banks and third party organisations to co-ordinate human economic behavior.

But hold on!

  1. Were all the problems solved?

  2. Who was controlling money? People or governments?

  3. Was the distribution of money fair and equitable?

  4. Is all the money spending on the welfare of the people and solving their problems?

  5. Is it possible to keep money transactions safe despite having intermediaries?

As you may have guessed when money is under the control of a particular entity (like government), we meet a big problem:

Unrestricted Printing of Money

Governments took the right to print money and introduced themselves as intermediaries between two parties of trade through the creation of central banks.

As you may know, printing more money make goods more expensive, but does not change the quantity or quality of goods. If everything is more expensive, you are not any better off, even if your wages increase.

On the flip side, rare assets like gold, rare art and these days Bitcoin become more valuable.

Easy monetary policy and high inflation are two of the leading causes of money depreciation.

There is no need to accuse a specific organization or group however, due to negligence of duty or maladministration of the central banks and intermediaries who continue to control money, the world has recently experienced severe financial crises. Factories and companies went bankrupt and many people were fired and lost their jobs.

Financial crises have caused people to lose confidence in traditional financial systems. People are waking up to the benefits of an unmediated financial system.

The invention of Bitcoin was one of the first step towards achieving this goal.

With the advent of Bitcoin and cryptocurrencies, finance has entered a new phase. There have been some dramatic changes however, it still cannot be considered as a decentralized finance. Most crypto financial transactions and services are made through centralized exchanges.

What’s the difference between a bank and a centralized crypto exchange?

To some extent, not much; decentralization can quickly lose its meaning when an intermediary organization plays a large role in a decentralized finance system.

Anyway, let’s say we have a completely decentralized financial system (DeFi). Could this system meet all our needs?

DeFi is a fast-growing sector of the cryptocurrency industry, it consists of thousands of projects on several different blockchains. Most traditional financial services, can be facilitated through DeFi but without the interference of a third party like Banks or any other non-banking financial institutions. Eliminating intermediaries is the most prominent feature of DeFi.

This is the new generation of financing.

Many believe DeFi is the future of finance and that investing in DeFi could lead to substantial returns. But are these investments risk-free?

Since it’s difficult for newcomers to separate the good aspects of DeFi from the bad, It would be useful to discuss the pros and cons of DeFi.

Where DeFi shines

As mentioned above most traditional financial services are potentially catered for within the DeFi space:

1. Decentralized exchanges (DEX)

Online trading services based on smart contracts. DEXes enable users to perform token exchanges and trading without intermediaries.

2. Automated Market Maker (AMM)

AMMs are the same as DEXes with an important difference. DEX platforms use order books (which contains P2P orders) for pricing, while an AMM platform uses a special mathematical formula to price assets, and the liquidity comes from liquidity providers, who usually earn tokens as a reward, rather than needing people to be on both sides of each trade.

3. Lending

The crypto loan business is definitely an attractive alternative for many people. Lenders receive interest payments while borrowers gain access to capital. With DeFi, borrowers can use their funds as collateral and borrow without a credit score.

4. Staking

Some blockchains are based on proof-of-work (PoW) like Bitcoin and some other are based on proof of stake(PoS). Staking is a type of activity in which you are rewarded by locking your assets in a PoS based network, in exchanged for providing security and confirming the transactions of a blockchain network.

5. Non-Fungible Token (NFT)

NFTs are a new phenomenon in the crypto space which has many uses like identification, arts(digital ownership),gaming, collectibles, sports, media & entertainments, real estate, etc.

6. No-Loss Games and Lotteries:

Games and lotteries are another attractive service that are a part of the DeFi space. So called, ‘No-loss’ lotteries seem to be risk-free. In this type of lottery participants get their money back and one lucky participant wins all the profit that has accrued in the shared pot and all these processes are done without intermediaries, just using smart contracts in DeFi space.

Where does DeFi have an Advantage?

1. Bye-Bye to human error and mismanagement

We have already mentioned that financial crises occurred due to the mismanagement of central banks(CBs) and third party intermediaries (TPIs). But thanks to smart contracts, human error on a day-to-day basis are removed from the process; unless the contracts themselves were poorly written.

2. Quick and permanent access

Before DeFi, if you needed to get a loan, you would have to go to bank and a lot of time will be wasted. With DeFi, you can get a loan with just one click, even in the middle of the night. You can access the market from anywhere and anytime as long as you have an internet connection.

3. A Healthier System

Covid-19 has shown that traditional financial systems (CeFi) are very vulnerable to global shocks. This is because centralized financial systems are based on direct contact between individuals.

COVID-19 has caused an economic shock three times worse than the 2008 financial crisis — economist Nariman Behravesh

The level of physical contact needed to support decentralized financial systems (DeFi) could drop to zero; and cryptocurrency prices and companies have been going from strength to strength in the current health crisis.

4. Permissionless Operations:

In the traditional financial system, you have to get permission from an intermediary to carry out almost any financial operation.

To withdraw a penny from your account, you must wait for bank approval, while DeFi users can interact with financial services without permission

A wide range of services could be imagined in DeFi space, that not all of them could be mentioned in this discussion. You can read up on a few more DeFi terms in this other DApp Journey DeFi article.

But are all of these services and platforms risk-free?

Undoubtedly, the answer is “No”. Just like an apple that may contain a worm, a DeFi products have their own problems and risks.

What are the challenges facing DeFi projects?

Many of the problems and risks facing a DeFi project are related to the technology they are built upon; blockchains themselves. Since over 90% of DeFi projects are based on Ethereum blockchain, we will consider the challenges for Ethereum challenges as DeFi challenges:

1. Uncertaintity

If the blockchain that hosts a DeFi project is unstable, the project spontaneously inherits this instability from the host blockchain. The Ethereum blockchain is still undergoing plenty of changes, for example mistakes made when moving from PoW to new Eth 2.0 PoS system could introduce new risks to DeFi projects.

2. Scalability

Another big problem with DeFi projects is scalability of the host blockchain.

Two major problems arise from the scalability problem:

a) transactions take a long time to be confirmed b) transaction are extremely expensive at times of congestion

Ethereum at full capacity, can process about 13 transactions per second, while centralized counterparts can process thousands and thousands of transactions.

3. Smart Contract Problems

Smart contract vulnerability is a major source of issues for many DeFi projects. If there is the slightest flaw in the code of a smart contract, it can lead to loss of funds.

4. Low Liquidity

Liquidity can be considered as one of the most important factors for DeFi token-based projects and blockchain protocols. The total value locked in DeFi is over $12.5 billion by october 2020. This is a drop in the ocean when compared to the traditional financial systems.

5. Over-collateralization

As we previuosly said the crypto loan business is an attractive service in DeFi. But this business suffers from over-collateralization and it occurs when the value of the staked asset (by borrower) is prohibitively high when compared to the loan amount itself. DeFi projects have high collateralization in order to counter the removal of obstacles such as credit ratings.

6. Low Interoperability

There are different types of blockchains such as Bitcoin, Ethereum, Binance Smart Chain, each with its own DeFi ecosystem and community. Interoperability enables DeFi platforms, tools, DApps and smart contracts on different blockchains to interact with each other. Until this becomes simpler, many projects are siloed.

7. Lack of Insurance

Insurance protects investors in the event of a hacks or other fraudulent activities. Insurance plays a very important role in centralized finance while it is much more rare in DeFi.

8. Centralization

Creating a decentralized finance is the main purpose of creating bitcoin and blockchain, but sometimes decentralized finance isn’t as decentralized as it should be. Decentralization greatly reduces the possibility of scam.

“Sushiswap” was a DeFi project. The anonymous founder of Sushiswap has rug pulled the project converting all of his Sushi tokens to ETH on September 5, 2020. The price of SUSHI token went up in value to $10 after forked from the Uniswap protocol, and dropped to 0.6$ (at the time of writing this article) after founder converted his tokens. This was an example of how a single point of failure is possible even within DeFi.

9. Your Responsibility

Assuming that DeFi is free of risks and issues, it’s still not responsible for your mistakes. DeFi transfers responsibility from intermediaries to users. If you lose your funds by mistake no one will be responsible, hence, creating some tools to prevent human errors and mistakes is strongly needed in the DeFi space. With freedom comes a lot of responsibility, and many users are not used to having to take care of themselves in this way; which can lead to them losing funds or being scammed.

DeFi is new and experimental and has some issues and problems, especially in terms of security. Developers and fans of decentralized finance hope that these problems will eventually be solved.

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