June 6, 2023
Decentralized Finance (DeFi) refers to financial services offered on blockchains. With DeFi, you can perform transactions supported by traditional financial institutions—borrow, lend, earn interest, buy insurance, and trade assets—but without having to depend on the honesty, solvency, competence, or back-office accounting of a third-party intermediary.
This is because DeFi platforms are decentralized, meaning that no central organization, such as a bank or brokerage firm, controls the activity. Typically, these platforms operate via smart contracts, agreements created and memorialized via computer code that automatically execute when all parties fulfill their obligations.
DeFi is highly favored by consumers who believe the world’s traditional financial infrastructures are out-of-date, opaque, untrustworthy, or too concentrated. What is the future of DeFi, particularly in relation to TradFi?
Has DeFi disrupted TradFi?
DeFi has disrupted TradFi in a number of ways, creating a real possibility for transforming current financial services. Some of these ways include:
Geographic democratization
DeFi has opened up financial services to a global audience by removing geographic barriers that are often present in traditional finance. For instance, it is difficult for foreigners to directly trade in U. S. markets, just as it is difficult for U. S. citizens to directly trade in foreign markets. DeFi changes that. Local regulations permitting, anyone with an internet connection and a digital wallet can access DeFi services, which in a very real sense don’t exist in just a single nation.
Currency exchange risk
Because DeFi platforms exist on decentralized blockchains, and transactions are priced in currencies native to these blockchains (like Bitcoin or Ether), there is no risk associated with currency exchange fluctuations. While this is somewhat important to retail transactors, it can be enormously important to corporate and institutional transactors.
Disintermediation
DeFi eliminates the need for intermediaries like banks, brokers, and other financial institutions, reducing fees and inefficiencies. Transactions are conducted directly between parties on blockchains.
Transparency
DeFi platforms are built on public blockchains, which provide open access to information about transactions, protocols, and assets. As an example, you can see how Amberdata collects data on every decentralized exchange on Ethereum. This increased transparency allows users to make more informed financial decisions than those that take place within TradFi systems that are often opaque, particularly to retail users. It also allows Amberdata to provide enterprises with blockchain data built for application-specific blockchain use cases in finance.
Programmable money
DeFi platforms enable the creation of programmable money through smart contracts, which can automate transactions and execute predefined actions based on specific conditions. This feature enables complex financial instruments and products with much less friction and the possibility of human error than TradFi transactions.
Your keys, your coins
DeFi platforms generally do not hold users' assets, allowing users to retain direct control over their funds. This reduces the risk of loss due to insolvency, fraud, or mismanagement of centralized banks.
Virtual money never sleeps
DeFi platforms operate 24/7, allowing users to access financial services anytime, anywhere, without being restricted by traditional banking hours.
Can/should DeFi replace TradFi?
DeFi offers numerous advantages over TradFi, and has the potential to transform the financial landscape, but whether it can or should fully replace TradFi doesn’t have a simple answer.
This is why:
Limited adoption
DeFi is still fairly new, and only a relatively small percentage of people use it. In order to replace TradFi, DeFi must reach a critical mass of adoption and understanding.
Regulatory confusion
DeFi operates in a largely unregulated space, but recently regulators and government officials, particularly in the U.S., have begun to call for stricter regulatory regimes. While many founders and users believe that clear DeFi regulation will ultimately spur DeFi adoption; in the short term, this uncertainty can create risk and fear among users.
Security
DeFi platforms face unique security risks, such as smart contract vulnerabilities and other potential bad actor exploits. To replace TradFi, DeFi platforms must achieve a level of security that at least matches that of TradFi.
Transaction speed and cost
Many DeFi platforms have scalability issues. Transaction fees and network congestion can be significant problems, especially during periods of highdemand. For DeFi to replace traditional finance, it must develop solutions to ensure transactions that are as fast, efficient, and inexpensive as current electronic transactions.
Interoperability
Transferring assets between DeFi platforms and between TradFi institutions is in some cases still difficult. This is changing and must continue to do so.
Ease of use
Much of DeFi is still a bit clunky, and demands browser add-ons or the creation of wallets, which can be daunting to the non-tech savvy. Greater adoption will demand simpler user interfaces.
Should DeFi complement TradFi?
DeFi and TradFi are not mutually exclusive. Instead, they can coexist, with DeFi platforms complementing and augmenting traditional financial services. DeFi offers innovation, efficiency, and greater access to financial services, while traditional finance offers stability, security, and regulatory oversight. Many believe that the future of finance could be a combination of the best aspects of each.
Why does DeFi exist at all?
DeFi emerged in response to the limitations and inefficiencies of traditional financial systems and to leverage the power of blockchain technology in finance. Several factors contributed to its development and growth:
Reaction to the 2008 financial crisis
The global financial meltdown of 2008 exposed flaws in the financial system, leading many to lose faith in centralized banks and brokerages. DeFi emerged as an alternative that its proponents claim is more stable, transparent, and inclusive. (Decentralized finance platforms don't rely on a single point of control and are thus more resilient to attacks or failures. This reduces the risk of the sort of systemic failures of centralized financial systems that occurred in 2008.)
Inclusion
Traditional financial systems exclude hundreds of millions around the world who are without access to banking services. For instance, in many developing nations one must travel tens of miles to reach a bank branch. With DeFi, all you need is an internet connection and a digital wallet.
Disintermediation
Again, DeFi eliminates the need for intermediaries by enabling peer-to-peer transactions through smart contracts on blockchain networks, resulting in lower fees and faster transactions.
Transparency and Trust: Traditional financial systems can be opaque, with limited access to information for users. DeFi platforms, on the other hand, operate on public blockchains, with much greater transparency. More transparency enables users to make better decisions about their finances.
Would a DeFi/TradFi bridge help with mass adoption?
The short answer to this question is “Yes.” The longer answer is that a bridge between DeFi and TradFi could significantly contribute to mass adoption of DeFi, but it's important to note that it wouldn’t be the only factor. Creating seamless integration between the two systems would lessen some of the current challenges and entry barriers that we’ve discussed above.
More importantly, the process of integrating the two would solve some of the thorniest adoption issues, issues that get to the heart of what DeFi is. Two of these we haven’t mentioned yet are anonymity and transaction irreversibility.
Anonymity lies at the center of cryptocurrency and DeFi transactions. From Day 1, anonymity has been considered one or even the prominent design feature for developers and users. For governments, though, it's a bug. Granted, the breathless scare stories about crypto’s role in financing bad actors are overblown, and crypto itself isn’t as anonymous as people think. Nonetheless, DeFi anonymity will likely have to give way to better Anti-Money Laundering and Know Your Client procedures before TradFi can fully adopt it. This is already beginning to happen.
Transaction irreversibility is a bit thornier - One of the great benefits of DeFi transactions is that they are instantaneous. Press a key and Boom! Your transaction is complete. Easy as sending an email. No long clearance delays or multiple intermediaries adding time and fees to your transaction. What’s not to like? The only downside is that if you mess up transaction details, like a counterparty's, your money can be gone in a flash with no recourse. This is a big downside. Developers are currently creating solutions to transaction irreversibility, but there are as yet no standards in place.
Most people in the DeFi space agree that DeFi/TradFi bridges will be beneficial for mass DeFi adoption, but worry that DeFi may become too much like the outmoded systems it was created to disrupt. Ultimately, the market and users will decide.
How DeFi and TradFi can help each other
TradFi and DeFi can help each other. How?
Very simply: DeFi can modernize TradFi, while TradFi can make DeFi more acceptable to a wider user base. DeFi for institutions can help modernize TradFi by introducing innovative solutions, leveraging blockchain technology, and addressing some of the limitations of the current financial system and institutional markets. TradFi can provide the comfort of institutional size and familiarity.
Six areas of mutual benefit are: innovation, inclusion, speed/efficiency/cost, transparency, borrowing & lending, and asset tokenization.
Innovation
It is clear that not only is most of the innovation in finance being done in the DeFi space, but it’s also happening at warp speed. DeFi's programmable money enables rapid development and deployment of new financial products and services. By adopting these capabilities, TradFi can foster innovation and stay competitive in an increasingly digital world. Not all innovations will pan out, but many will, and DeFi is already prompting stodgy traditional firms to try to keep up.
Inclusion
DeFi clearly can remove geographic and socio-economic barriers, helping banks reach new unbanked domestic and foreign customers, and brokerages more easily access foreign customers. TradFi can give these users confidence that their transactions are properly regulated.
Speed/efficiency/cost
Without question, DeFi has raised the bar on transaction speed, efficiency, and costs. They can bring these benefits to TradFi, while TradFi represents reduced volatility compared to DeFi.
Transparency
By incorporating DeFi’s increased transparency features, TradFi institutions can increase trust, reduce corruption, and empower their customers. Amberdata provides digital asset data and infrastructure for both DeFi platforms and TradFi institutions, as well as data for crypto native firms and fintech product developers.
Decentralized borrowing & lending
Much of DeFi is crypto banking, decentralized lending platforms, lending protocols, and borrowing services. DeFi lending rates and DeFi interest rates are often more competitive than traditional financial institutions and DeFi lending often has more flexible terms. Incorporating these models into TradFi can provide users with more options and better access to credit.
Asset tokenization
DeFi has popularized the concept of tokenization, representing real-world assets like stocks, real estate, and commodities on the blockchain. Integrating tokenization into TradFi can provide increased liquidity, fractional ownership, and more accessible investment opportunities, for its customers. For TradFi, this makes accessible millions of investors and $trillions of tokenizable assets.
What does the future hold?
The integration of DeFi principles and technologies into TradFi will likely be a gradual process, facing challenges such as regulatory compliance, technological limitations, and people’s resistance to change. However, by embracing DeFi innovations, TradFi can evolve to better serve the needs of a digital and interconnected global economy.
Amberdata is your lens into the entire crypto economy. We deliver comprehensive digital asset data and insights into blockchain networks, crypto markets, and decentralized finance, empowering financial institutions with critical market or DeFi data for research, trading and analytics, risk management, derivatives analytics, and compliance.
Contact us to book a demo and learn more about how Amberdata products can help your business navigate the future of DeFi.
