The financial system had evolved to become more efficient through different Innovations. In its current form, almost every aspect of our financial system is centralized through government and banks, and even within the crypto financial system, many services are still centralized. This centralized system has been much more efficient than its previous forms, but it has inherent problems according to Harvey et al. (2021) such as the inefficiency from intermediaries, opacity, centralized control, limited access, and lack of interoperability1.
Using blockchain technology, DeFi (Decentralized Finance) challenges the existing traditional finance and tries to solve its inherent problems, while providing similar or even newer services. DeFi decentralizes the financial sector by putting self-executing smart contracts in place of existing financial institutions, and blockchain in place of centralized ledgers, increasing efficiency and transparency. However, as DeFi is a new and evolving sector, risks stemming from lack of regulations and security issues, among other, are still very much present.
1. Traditional And Centralized Finance
Traditional Finance (TradFi) is the existing financial system, which is based on fiat currency2. Over time, TradFi has developed to become more efficient through innovations. From the inefficiency of the barter system, to various forms of currencies3. The speed innovation has accelerated in the last century, from credit cards, ATM, telephone and internet banking, and others1.
As further innovations are created, fintech and all of its forms emerge. Fintech uses technology to improve financial inclusion, reduce costs, decrease inefficiency, improve productivity, and connect the real and financial sector, among other benefits4. As Fintech is defined as technology which is used to support or enable financial services, CeFi (Centralized Finance) and DeFi (Decentralized Finance) comes under this sector.
CeFi is a term used for crypto financial products which are centralized. Therefore, CeFi is similar to TradFi, but uses digital assets or stablecoins, and generally has more integration with other providers2. CeFi has multiple kinds of financial services including lending, exchange, payment, insurance, and asset management2.
CeFi exchanges are the first crypto financial service to launch in 2010, and therefore are larger than its newer decentralized counterpart5. Binance is the largest existing Crypto exchange with a peak daily trading value of US$76 billion, and has facilitated US$ 7,7 trillion of crypto exchange in 2021, according to Business of Apps. Many CeFi exchanges use a matchmaking algorithm to connect supply with demand, and an orderbook system to record and validate transaction6.
2. Decentralized Finance
According to Wharton, DeFi are decentralized applications based on blockchain which provides financial services7. Therefore, DeFi possesses all the decentralized and transparent characteristics of blockchain and cryptocurrency, where the overall ecosystem is unaffected by intermediation or goverment influence. Transparency would also be a plus as all transactions are recorded on the blockchain8.
DeFi are mainly based on public blockchain like Ethereum that facilitate smart contracts9. Smart contracts are automated contracts in the form of codes that self-execute with certain conditions and are immutable once deployed10. This improves efficiency and decreases the need for third parties, especially in monitoring agreement performance. Smart contract automation would also improve trust and reduce potential costs such as operational, fraud, and legal risk costs.
A crucial aspect in DeFi practice are stablecoins, which replaces most cryptocurrency which are too volatile to be a reliable unit of account. Stablecoins are assets that peg its market value to an external reference, such as gold or the US Dollar using complex algorithms or legal relationships, creating a stable digital asset9. The development of CBDCs (Central Bank Digital Currency), the digital form of central bank money issued by central banks, can also become a further source of stable value for DeFi11, 12.
DeFi, which are blockchain-based, can connect with the outside world through data sources called oracles, which can supply data such as stock values, currency values, or weather data1. This developing function is crucial for DeFi to create utility outside of its ecosystem. All the applications and organization in the DeFi ecosystems are decentralized. Meaning that the applications can be used by anyone and have no controlling body; while the organizations has its operational rules in a smart contract, and is governed by governance token holders1, 13.
DeFi is currently still in the early adoption stage, and therefore are much smaller compared to CeFi, but it has grown significantly over the last few years. According to Defipulse14, DeFi has more than US$100 billion deposited in November 2021, a 700% growth from around US$12,5 billion in November 2020. The largest DeFi platform, Maker, has locked over US$18 billion in value, while DeFi tokens have reached over US$175 billion in market cap.
3. How DeFi Can Improve TradFi And CeFi
Both TradFi run by banks, and to a lesser extent CeFi, have several issues which are solvable by the DeFi ecosystem3,1. Traditional finance has centralized control and governance by banks and large institutions, or crypto finance companies in CeFi, while DeFi uses open protocols, smart contracts and governance tokens to decentralize governance. The lack of access to traditional finance, such as towards unbanked members of the society, can potentially be improved through DeFi. Using technology, DeFi can improve financial inclusion by reaching unbanked societies and allowing any user to access financial infrastructure regardless of location or wealth.
The lack of intermediation in DeFi would improve efficiency and reduce transaction costs, making payments cheap and almost instant15. The transparency and accountability of the financial system would also be improved through blockchain records, especially compared to the opacity of banks1. The aforementioned smart contracts can reduce or even eliminate costs such as settlement and monitoring costs, and using smart contracts in conjunction with collaterals can mitigate default risks10, 15. Innovation in DeFi are also flourishing in comparison to TradFi, as it is permissionless and the DeFi market has much lower barrier to entry15.
However, as with all new innovations in its early stages, DeFi and the whole crypto ecosystem which includes CeFi faces many risks. One of the main challenge is regulatory uncertainty. Cryptocurrency, as the face of the decentralized economy, is regulated very differently between countries, ranging from legal tender to outright bans16, 17. As DeFi and the crypto ecosystem works on a global scale, it would be difficult to apply national legal requirements to enforce laws on DeFi-based financial crimes, fraud, or regulatory evasion13. Furthermore, the lack of AML/KYC framework in DeFi is also a significant concern9. In comparison, CeFi has similar legal risks, but has a better KYC framework.
Keberlanjutan blockchain juga merupakan risiko yang signifikan karena blockchain ethereum, yang berfungsi sebagai blockchain DeFi utama, membutuhkan sejumlah besar energi untuk beroperasi18. Ethereum juga memiliki masalah skalabilitas karena peserta harus membayar biaya transaksi yang sangat fluktuatif tergantung pada volume transaksi9. Selanjutnya, masalah keamanan dalam DeFi sangat signifikan karena pada tahun 2021, penipuan dan pencurian di DeFi telah menyebabkan kerugian sebesar US$10 miliar, naik tujuh kali lipat dari tahun 202019. Semua risiko ini juga berlaku untuk CeFi sampai titik tertentu, karena keduanya didasarkan pada blockchain dan menghadapi masalah keamanan.
The sustainability of blockchain is also a significant risk as the ethereum blockchain, which serves as the main DeFi blockchain, requires a large amount of energy to operate18. Ethereum also has scalability issues as participants have to pay transaction fees which are very volatile depending on the volume of transactions9. Furthermore, The security issues of DeFi are significant as in 2021, fraud and theft in DeFi has caused a loss of US$10 billion, a sevenfold rise from 202019. All these risks also apply to CeFi to a certain extent, as both are based on blockchain and face security issues.
4. Current Practices Of Defi
DeFi has currently provided many of the existing financial services, includimg, savings, lending, exchanges, wealth management, payment networks, and even insurance and derivatives. There are also non-financial institution projects such as betting, KYC, analyics, and asset tokenization. However, according to The Economist, the current DeFi has no real economy to service, with many users using it to facilitate or leverage betting on speculative tokens15.
Lending in DeFi, which lends crypto assets for collateral currently has reached almost US$25 billion in outstanding debt14. The leading protocols, AAVE and Compound, currently give a lending and borrowing rate of around 2,5% and 3,8%, respectively. As the process is decentralized, the process is permissionless and every function occurs automatically using smart contracts1.
A unique innovation of DeFi lending is flash loans, an instant, unsecured loan that has to be repaid within the same transaction. This loan is primarily used for exploiting arbitrage opportunities between exchanges, or refinancing loan without collateral1. Flash loans can be both interest-based or free, as they are instantaneous with very little default risk. Flash loans have been a popular DeFi product, but also carries risks as it has been the subject of cyber attacks.
Another prominent form of DeFi is Decentralized Exchanges (DEX), which allows users to trade between digital assets7. As DEX replaces a central authority with smart contracts, it is faster, cheaper, and more anonymous. Instead of using order books which are used by TradFi and CeFi, many DEXes use AMM (automated market method), which creates an automated trading market using a liquidity pool from users who receive passive income for each transaction. This method enhances market liquidity and removes the potential of market manipulation.
After basic financial services, DeFi has also developed margin trading and derivative protocols. One of these companies is dYdX, which allows investors to take a long or short position using margin collateral with a certain leverage1. Their main derivative product is a bitcoin-based perpetual futures contract, which is similar to traditional futures but without a settlement date. This product allows the investor to bet on the future price of bitcoin based on an index price.
The evolution of finance has led us to TradFi, and by adding cryptocurrency, CeFi develops. More recently DeFi has also developed, creating decentralization by using blockchain and smart contracts. The decentralization of DeFi seems to be able to improve the inefficiency of TradFi and Cefi. However, both the existing cryptocurrency risks shared with CeFi, and DeFi’s inherent risks must be managed in order to create a safer and trustworthy financial system. Beyond that, a worrying aspect of DeFi growth is its tendency to facilitate speculative transactions and its lack of connection with the real sector. This is important to monitor as these trends may lead to larger systemic risks as the sector grows.