Decentralized finance is a blockchain-based set of applications that, in principle, need no intermediaries to work. These financial products have similar characteristics to traditional services and their boom period could, to some extent, change the financial sector and give rise to both opportunities and challenges.
Interest in cryptocurrencies and decentralized finance (DeFi) increased exponentially during the pandemic, according to the World Economic Forum, which states: "Decentralized finance aims to transform traditional forms of finance by reconstructing and reimagining services." But what precisely is decentralized finance? How does it work? What are its advantages, disadvantages and challenges?
Javier Ibáñez, cofounder of Alastria and director of the FinTech Legal Observatory at Universidad Pontificia de Comillas, explains that decentralized finance consists of "financial agreements (mostly lending and investment) backed or in the form of blockchain and, as such, recorded on an unchangeable block chain. Blockchain is a database of which all users have a copy. In other words, an unchanging ledger that contains the full history of all the transactions executed in the network with a timestamp.
"It's an enormous database shared between a lot of players, secured by encryption and that can apply to any type of transaction," explains Sergi Simón, Risk Management program coordinator at the EALDE management school. This expert further clarifies that decentralized finance means a set of applications aimed at creating "an open, more transparent, more secure financial system that is outside the control of intermediaries."
As defined by the company Finanzas Descentralizadas, DeFi is a "set of systems that enable us to exchange value (tokens) from point A to point B (between wallets), with no intermediaries." No two decentralized finance projects are the same, and each of them offers specific characteristics, risks and opportunities. According to professor Ibáñez, decentralized finance "works with DeFi backing but has the same legal effect as traditional finance contracts."
This type of finance is deployed through decentralized applications developed on public blockchains such as Ethereum. Use cases include lending, currency exchange and interest earning. Programmer Juan Nuvreni gives an example in a video posted on YouTube to help you understand how they work: "On the one side, there is a lender that places their cryptocurrency on a DeFi platform managed by a smart contract and every month gets an interest rate for keeping their currency there." On the other side, there are the borrowers, people who wish to apply for a loan and use the same platform to get cryptocurrency.
"When they want to pay their loan, they also pay interest for using the platform. This means that the lender and the borrower interact with these protocols and earn and pay a variable interest rate without having to negotiate any terms," stresses Nuvreni. He goes on to explain that everything happens with a blockchain algorithm that "handles interest rates and collateral prices."
Ibáñez mentions that the "medium being secure, really quick and very cheap" is one of the advantages of decentralized finance. But there are some disadvantages too. For example, users must have at least some knowledge of this technology and get training, "just like it happened with the internet." "Especially as refers to network access and digital identity, which you need to operate and manage your own investment portfolio. Otherwise, you have to pay more to get someone else to do it for you."
Another challenge is regulation. "While DeFi has the potential to transform the financial system, it lacks a clear policy landscape that could help accelerate benefits and mitigate risks," reads a news release from June by the World Economic Forum. This organization has created a tool kit to guide authorities through creating policies on decentralized finance.
DeFi could change the finance sector to some extent: "There will be fewer intermediaries such as you find today and there will be some more specialized intermediaries arising, such as custodian of the cryptographic keys needed to operate, and platform managers." This type of finance is increasingly common, states Ibáñez: "This is the future and it cannot be changed. We can expect it to have a dominant position in the financial market in a few years because of its advantages."