Much of the financial world participates in a centralized form of finance, meaning that one entity acts as a bank or third party between two others in any transaction.
For example, suppose you’re buying groceries from a store and use debit or credit to purchase the items. In that case, you and the store agree to allow your purchase to occur based on the faith that the store has in the bank, which acts as an intermediary between your account and the store.
Now imagine you’re buying a high-ticket item like a house. When you finance your home purchase, you’re using a lender, often a bank, to loan you the money so that you can close the deal. Unfortunately, between applying, processing, and underwriting, time takes a while, creating a burden on the transaction while you await approval and funding.
With centralized finance, there will be hiccups and delays as it takes time for the third party (the lender) to approve and fund any transaction, which can slow down the deals, leading to some people getting “cold feet” and rescinding their offers.
Because of the delays and the lack of control over the specific transaction, as well as limiting the number of fees and costs associated is why decentralized finance is becoming so popular.
Benefits To A DeFi System
Decentralized finance, or DeFi, is a peer-to-peer system that conducts transactions without a third-party intermediary.
Along the same lines, there are significant benefits to eliminating third parties in transactions, from reducing inefficiencies to expanding access, making finance much more transparent, and granting more control to the two principal parties in the transaction.
Reducing inefficiencies: DeFi eliminates intermediaries that may slow down or deny transactions between two parties. Bypassing intermediaries also eliminate fees that make transactions less affordable to execute. DeFi gives parties direct interactions, making settlement and execution of transactions more accessible and instantaneous.
Expanding Access: Centralized finance comes with plenty of barriers that keep many people out and cause more hurdles for those who can participate than necessary. DeFi eliminates third parties, expanding access for more transactions and increasing access to financing that otherwise may be difficult to obtain.
By expanding access to financing, small businesses will have more funding available to help with projects that can grow and boost economic growth for themselves without the costly fees associated with traditional financing.
Increased Transparency: Too much of the centralized finance market is opaque, meaning it lacks a sense of transparency. DeFi is open-sourced, which means that all parties have access to all the fundamentals, from the coding involved to the liquidity available and other important details that show the overall health of the parties in the transaction that centralized finance leaves out.
More Control: Because you have direct party-to-party transactions taking place, there is more direct control in DeFi than in other systems.
The reason is that with intermediaries, you are relinquishing control over your financial options and transactions, which may make it more difficult to participate for some parties and more challenging to execute deals.
DeFi operates within a blockchain, which is an open-sourced listing of all the transactions that take place, lending verification and authenticity to the transaction. The control over the transaction comes from what is known as distributed ledgers.
Distributed ledger technologies allow users and participants in transactions to verify those transactions and have direct input on recording all data associated with the execution of those transactions. Its control and transparency are wrapped all in one.
With distributed ledgers, there’s much more direct control and authenticity to two-party transactions than centralized finance.
Risks Associated With DeFi
Like all financial transactions, some risks are inherent to the system. When you have three (or more) parties involved in a transaction, such as with traditional finance, the risk of added fees, overcharges, and delays increases dramatically.
With DeFi, you’re conducting financial services without intermediaries, eliminating those hurdles, but that means that there is greater direct exposure to risk in any transaction.
Risks involved in DeFi transactions include;
- Added exposure to risk in Smart Contracts
- Third-party “Oracle” risks
- Unequal scaling risks
- Custody risks
Smart contracts are open-source, making them more vulnerable to being exploited or taken possession of.
Third-party “Oracle” risks related to the interaction between DeFi and third parties acting on behalf of a conventional finance vehicle. Think about stocks.
To be able to buy and sell stocks using digital currency, the blockchain needs real-time data from an outside entity, and if that data is incomplete or wrong, there is an extreme risk on the part of the DeFi side.
Unequal scaling risks are associated with the speed of processing. If you were to compare digital currency rate speeds with more traditional transaction speeds, it’s not even close.
Custody risks are those that come with having to secure and store digital currency in a wallet. If your online security has a slip, it can be exploited, and the entire digital currency platform can be exposed or taken.
The risks that DeFi may bring with more prominent usage can’t be ignored. Because of the growing popularity of digital currency, one security option is implementing AI to look for and solve exposure risks and protect assets during transactions.
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