What is DeFi and Why Does It Matter?

The term “decentralized finance” and, more commonly, its abbreviated form – DeFi – is seemingly everywhere these days. But the name doesn’t do a particularly good job of describing what the DeFi ecosystem is comprised of or what it can do.

At its core, DeFi seeks to replace many of the functions performed by traditional institutions with software known as a “smart contract” that operates on a blockchain network (today, most DeFi is powered by Ethereum). 

For example, instead of depositing money in a bank account that the bank can then lend out to other parties based on its own proprietary rules, in DeFi, crypto can be staked in a liquidity pool that fuels other transactions. DeFi smart contracts can facilitate lending, trading, risk management, derivatives creation, payment solutions, and more.

DeFi goes further than financial services, however. Smart contract mechanisms are used for Decentralized Applications (dApps), Decentralized Autonomous Organizations (DAOs), and Non-Fungible Tokens (NFTs), all of which are used for purposes that don’t necessarily involve the facilitation of financial transactions.

What Makes DeFi Disruptive?

In many ways, DeFi has the potential to upend the entire financial system as it is currently known. By removing gatekeepers, simplifying infrastructure needs, and dramatically reducing overhead, DeFi allows more entrepreneurs to build more ways for more people to make more money – without arbitrary barriers.

Higher Yields

Because DeFi protocols are open-source software instead of a complex institution, and aren’t subject to governance like Federal Reserve interest rates, returns for staking can exceed returns on bank account deposits by orders of magnitude.

There are also multiple opportunities for arbitrage that can drive alpha for institutions, including liquidity pool swaps, cross-platform trading, and fluctuations in Miner Extractable Value (MEV). 

Transparency

Because all DeFi transactions are recorded to the blockchain, anyone can view transaction history. The significant barrier is gaining the technical know-how to access the blockchain and analyze the data. This transparency gives market participants the theoretical ability to fully understand the ecosystem, making it possible to identify additional money-making opportunities and, more precisely, gauge risk. Of course, when you need to access many blockchains, as well as, many markets for price, getting access to and normalizing this data can get incredibly expensive and complex, which is why Amberdata exists.

More Equitable Financial Services

One benefit of the anonymous and deregulated nature of DeFi is that it makes financial services more equitable by minimizing the possibility of discrimination while allowing returns-on-capital that are impossible for the average person to access through traditional finance. It also promises to bring financial services to people that don’t have access to banks, particularly in developing countries. This was one of the driving factors behind El Salvador’s adoption of Bitcoin as legal tender in 2021. Down the line, participation in DeFi could help institutions raise their ESG scores, especially once emissions concerns related to crypto are addressed.

What are the Challenges of DeFi?

While DeFi’s disruptive impact on financial services creates many opportunities and provides many benefits, it’s not without challenges and risks, chief among them being risk of loss due to theft or fraud and an unclear regulatory environment.

Lack of Recourse in Case of Theft and Fraud

The same lack of a central authority and regulations that makes transactions fast and discrimination nearly impossible also eliminates most avenues for recourse in the case of fraud or theft. If your credit card is stolen and used to make fraudulent transactions, you can contact your issuer to get the transactions reversed and you will not be held liable for them. If your bank goes out of business, the federal government guarantees at least some of your money (up to $250,000 per depositor, per insured bank, for each account ownership category). With DeFi, there’s no safety net if a platform is hacked, an application turns out to be a scam, or you fall victim to phishing. 

For institutions seeking to enter DeFi, this means that they need to be extremely diligent when it comes to choosing DeFi protocols to participate in, have strong security policies and procedures in place, and ensure that all employees are well-trained on those security policies and know how to spot potential phishing or other scam attempts.

Lack of Regulatory Clarity

While most states and countries have yet to implement crypto-specific regulations (though that will change sooner than later as adoption of crypto keeps growing), institutions seeking to enter DeFi have to do so while remaining compliant with broader fiduciary regulations.

The main compliance challenge with DeFi is KYC/AML. While crypto is designed for anonymity, some steps can be taken to protect your institution from involvement with wallets known to be associated with bad actors. Projects can keep these wallets out by either using a blacklist of such wallets or operations on a whitelist-only basis and using an identity verification process before granting access.

However, many DeFi projects do not take these measures. While institutions can mitigate this risk by simply staying away from such projects, regardless of potential returns, they should also maintain their own blacklists as an additional safeguard. 

How Can Institutions Manage These Challenges?

In addition to implementing robust vetting and due diligence procedures, institutions entering DeFi need to have comprehensive, granular data to power decision making. Given the fast-changing nature of the ecosystem, the deep domain knowledge required to know where to look, and the inherent challenges of blockchain data, institutions should not attempt to access this data on their own. 

Instead, institutions seeking to enter DeFi will best serve their clients by working with a digital asset data provider that already has the necessary expertise to analyze blockchain data and provide actionable insights about the ecosystem.

The Amberdata platform provides blockchain data from the most active cryptocurrency networks and protocols (as well as market data from the most important crypto exchanges). We’ve built our data sets with institutional use cases in mind, providing the easy to consume formats and reliability you receive with traditional asset classes.

Download our eBook to learn about the challenges in accessing digital asset data, what data you'll need to be successful, and how partnering with a data provider enables institutions to take advantage of the opportunities available in the DeFi space, while effectively managing the potential risks.