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Defining Decentralized Finance (DeFi) - Part 4

Defining Decentralized Finance (DeFi) - Part 4

<style type="text/css"> .title-defi { text-align: center; } .h6-heading { text-align: center; margin-bottom: 30px; font-size: 20px; font-weight: 700; color: #002d9c; margin-top: 15px; } .sub-heading-defi { text-align: center; color: #002d9c; font-size: 26px !important; font-weight: 700 !important; } .sub-heading-defi2 { text-align: center; font-size: 26px; margin-top: 30px; margin-bottom: 35px; font-weight: 700 !important; } .h6-heading { text-align: center; } .defi-img { width: 100%; } .center-defi { display: flex; justify-content: center; margin-bottom: 20px; } .cards-defi { display: flex; flex-wrap: wrap; justify-content: space-around; } .cards-defi img { width: 55px !important; } .cards-defi > div { display: flex; flex-direction: column; justify-content: flex-start; align-items: center; width: 32%; margin-bottom: 40px; background: #eff1f9; padding: 75px 45px; box-sizing: border-box; text-align: center; box-shadow: 25px 20px 20px 0px rgb(0 0 0 / 10%); } .icon-box-defi { flex-direction: column; display: flex; align-items: center; margin-bottom: 40px; box-shadow: 25px 20px 20px 0px rgb(0 0 0 / 10%); background: #f2efe9; padding: 35px 25px; } .icon-box-defi-icon { display: flex; align-items: center; margin-right: auto; margin-bottom: 25px; } .icon-box-defi-icon h4 { color: black; margin-left: 30px; } .icon-box-defi-icon img { padding-right: 20px; } .icon-box-defi-content p { margin-bottom: 0; } .icon-box-defi-content h5 { margin-top: 0; font-weight: 700; margin-bottom: 22px; } .icon-box-defi-content { border-left: unset; padding-left: 20px; } .h5-defi { font-size: 26px; text-align: center; font-weight: 700 !important; margin-top: 80px; margin-bottom: 50px; } .cards-defi p { font-weight: 700; margin-bottom: 0; margin-top: 10px; } h3.conclusion { font-size: 26px; text-align: center; font-weight: 700 !important; margin-bottom: 55px; margin-top: 55px; } .cb p { clear: both; } .content-defi { color: black; font-size: 20px; line-height: 35px; } .cards-defi span, .cards-defi p { color: black; font-size: 20px; line-height: 35px; margin-top: 20px; font-weight: 400; text-align: center; } .icon-box-defi-icon img { width: 100px; } .brand-blue { color: #3761c8 !important; } #custom-code h4 { font-family: 'Aktivgroteskcorp'; font-size: 24px; text-align: center; } .cb img { width: 110px !important; margin-bottom: 30px; } #custom-code p { font-size: 20px !important; line-height: 35px !important; } .prl-20{ position: relative; right: 85px; } @media (max-width:767px) { .prl-20{ position: relative; right: 0px; } } @media (max-width:500px) { .icon-box-defi-icon h4 { color: black; margin-left: 10px; font-size: 20px !important; margin-bottom: 25px; text-align: left !important; } .icon-box-defi-icon img { width: 75px !important; } .cb img { width: 110px !important; margin-bottom: 0px; } #custom-code p { font-size: 16px !important; line-height: 25px !important; } .sub-heading-defi { text-align: center; color: #002d9c; font-size: 18px !important; font-weight: 700 !important; } .sub-heading-defi2 { text-align: center; font-size: 18px; margin-top: 0; margin-bottom: 35px; font-weight: 700 !important; } .icon-box-defi { flex-direction: column; } .icon-box-defi img { margin-bottom: 25px; } .icon-box-defi-content { border-left: 0; padding-left: 0; } .h5-defi { font-size: 18px; } .h6-heading { font-size: 16px; } .cards-defi > div { width: 100% !important; } .cards-defi p { font-weight: 700; text-align: center; } .content-defi { color: black; font-size: 16px; line-height: 25px; } .cards-defi span, .cards-defi p { color: black; font-size: 16px; line-height: 25px; margin-top: 20px; } } </style> <h3 style="margin-bottom:40px;" class="sub-heading-defi prl-20">Part 4</h3><br> <h3 style="color: #000; text-align: center;">Can we really have technological solutions for everything?</h3> <div class="content-defi"> In <a href="https://kristal.ai/post/defining-decentralized-finance-defi-part-3">our last article</a> we explained about some of the real-world application of DeFi. But what about the challenges and roadblocks for the adoption of decentralized finance? We will give a quick explainer on that.<br><br>DeFi is a product of the post-Facebook era. Like every industrial trend born in the 2010s, its birth and maturation has been followed by an intensely polarized debate around its prospects as a disruptor across industries. </div> <h3 style="text-align:center;margin-top: 30px;margin-bottom: 30px;color: black;">Theories about the future of DeFi?</h3> <div class="cards-defi"> <div><img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/6239621450eca64b9028409d_Future_icon_1.png" alt="Icon Image"> <span>There are those who see it as a final manifestation of Tim Berners Lee’s vision for <span class="brand-blue">the internet in the domain of finance</span>, where the decision-making around a transaction’s validity and an asset’s authenticity is intermediated by consensual protocols. </span> </div> <div><img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/62396214e7f5e9535b538b95_Future_icon_2.png" alt="Icon Image"> <span>There are others who view it as a <span class="brand-blue">technocratic solution</span>, emblematic of Silicon Valley’s hubris post the Global Financial Crisis to solve all the human problems through technology and code. </span> </div> <div><img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/62396214f4c057599d3abf21_Future_icon_3.png" alt="Icon Image"> <p>Perhaps a more balanced vision, which sees DeFi as a solution to <span class="brand-blue">reduce the latency in the processes of verification and settlement in financial services</span>, without a wholesale disruption of the importance of financial institutions <span class="brand-blue">is a more likely future.</span></p> </div> </div> <br><br> <p class="content-defi">That said, even the maturation of DeFi hasn’t answered <span class="brand-blue">four major problems, which could potentially hinder its widespread industrial adoption.</span></p> <div style="margin:30px 0;"> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"> <img src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/6239621401ba985b8e66cd3a_Scalability_Icon.png" alt="Icon Image" /> <h4>Scalability of DeFi:</h4> </div> <div class="icon-box-defi-content"> <!-- <h5>How does DeFi solves the problem of authorization?</h5> --> <div> <p>The first major challenge is that the scalability of DeFi to entirely replace the traditional financial system remains in doubt. As we have mentioned earlier, <span class="brand-blue">the total value locked (TVL) for DeFi has grown from literally nothing pre-Covid to USD 95 billion towards the end of 2021.</span> In the past few weeks, given the way DeFi TVL has sharply crashed from its high of USD 111 bn, with the rising expectations of paring back of liquidity by major global central banks and a rise in global risk aversion. In these circumstances it remains to be seen how much value DeFi platforms are able to substitute away from the value intermediated by traditional, centralized financial platforms (exchanges, payment networks, banks).<br><br>Furthermore, <span class="brand-blue">DeFi applications are relatively new</span>, when measured on the scale of business cycles. They <span class="brand-blue">have not yet been tested by a sharp drawdown</span> in global financial markets, <span class="brand-blue">geopolitical tensions</span> or a <span class="brand-blue">major financial institution failure.</span> A bigger philosophical question here is – if Ethereum-based DeFi platforms became systemically important and a lot of savers and retail customers began to depend on them to exchange financial assets, how would they react to a GFC or a Eurozone crisis? <span class="brand-blue">Will they depend on global central banks to provide liquidity assistance and become a buyer of last resort for DeFi coins to keep a floor on the value of their assets?</span> What if a stablecoin issuer sees a run on its assets with all holders of the coin demanding conversion into USD? If this makes a stablecoin issuer sound like a money market fund at the eve of the Global Financial Crisis, then it is history repeating itself, in a different form, but with the same flavor. </p> </div> </div> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"> <img style="padding-right: 10px;width: 125px;" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/623962194c97842b1e683eb8_Fraud_Icon.png" alt="Icon Image" /> <h4>Probability of fraud</h4> </div> <div class="icon-box-defi-content"> <!-- <h5>How does DeFi solves the problem of interchange?</h5> --> <p>The fundamental argument of DeFi being more resilient to fraud and corrupt practices relies on a <span class="brand-blue">simplistic assumption that the code in which smart contracts are written is transparent and easily accessible.</span> It betrays a deeper misunderstanding of law on three counts.<br><br>The code underlying a DeFi protocol may be transparent, but it also requires a <span class="brand-blue">sophisticated understanding</span> of computer programming to interpret. Within the larger business world, where people are not programmers, it would be <span class="brand-blue">hard to predict widespread adoption of a solution</span> that relies so heavily on specific programming skill sets.<br><br>DeFi’s attempt to trade-off decentralized speed for centralized resilience, in rare cases can have a significant impact on the <span class="brand-blue">confidence of people in the decentralized finance</span> as an alternative to the traditional financial system. As per a report by the security firm Atlas VPN, <span class="brand-blue">76% of hacking incidents until Q3 2021 were concentrated on the DeFi ecosystem.</span> And this was before the fraud perpetrated in the name of DeFi by operators launching a coin based on Squid Games and the very recent heist of USD 120 million from the DeFi platform Badger DAO, which branded itself as “one of the most security minded teams in DeFi”. While we talk about the infallibility of code, we shouldn’t forget the infamous DAO incident of 2016, when an insider led attack focused on one of Ethereum’s vulnerabilities led to a loss of 3.6 million ether, irreparably damaging the reputation of world’s first and largest decentralized venture capital platforms. <span class="brand-blue">The upshot is – mistakes happen. But in a decentralized world, spotting a bug and preventing it</span> from running amok is <span class="brand-blue">much harder</span> as there is no centralized node from where one could neutralize it. Furthermore, for people who lose money in such breaches, the decentralized nature of the system creates an additional pain in <span class="brand-blue">seeking redress</span> for their loss – as the <span class="brand-blue">current DeFi platforms lack a centralized agency</span> to hear them out and sue the defaulting counterparties. </p> </div> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"> <img style="padding-right: 10px;width: 100px;" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/62396213155a4b01b098da85_Collateral_Icon.png" alt="Icon Image" /> <h4>Collateralization</h4> </div> <div class="icon-box-defi-content"> <!-- <h5>How does DeFi solves the problem of interchange?</h5> --> <p>The <span class="brand-blue">claim</span> that DeFi lending platforms can disrupt and create an <span class="brand-blue">alternative financial system for the unbanked,</span> without going through traditional banking channels needs to be taken with a pinch of salt. So far, all the DeFi based crypto-lending platforms are <span class="brand-blue">either over collateralized</span> or fully collateralized. That is, if you want to get USD 1000 in cash loan, you either have to deposit USD 1000 or more worth of collateral in cryptocurrency to secure it. In the strictest sense, this looks more like <span class="brand-blue">asset transformation than credit creation.</span> You simply exchange one kind of asset for another because your local bank would not give you a crypto-collateralized loan. This is unlike the fractional reserve banking that has underpinned the global credit system and the economy in the industrial age. Currently, when you go to borrow USD 1000 in cash, the bank simply creates a credit worth USD 1000 in your name, only a fraction of whose value is backed by the deposits. The reason why this USD 1000 credit is considered as good as USD 1000 in cash is because the bank is regulated by a centralized authority (Central Bank), which periodically tests it for its ability to meet its obligations. Once again, the decentralized aspect of DeFi prevents it from enabling credit expansion at scale – the strengths turn into weaknesses.</p> </div> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"> <img style="padding-right: 10px;width: 100px;" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/6239621401ba98df8966cd3b_Security_Icon.png" alt="Icon Image" /> <h4>Security</h4> </div> <div class="icon-box-defi-content"> <!-- <h5>How does DeFi solves the problem of interchange?</h5> --> <p>If you have watched the HBO comedy Silicon Valley, you are perhaps familiar with the “51% attack” where a group of malevolent actors combine their efforts to <span class="brand-blue">take over 50% of a blockchain’s hashing power</span> (like the <span class="brand-blue">voting power in a company</span>), and therefore re-write their own version of transaction history by reversing transactions, or by <span class="brand-blue">modifying smart-contract protocols.</span> In the early days of cryptocurrency, this was not easily done – because the ownership of nodes that validate each transaction was diffused. However, today crypto mining has become a commercial activity and as a result about 50% of bitcoin’s hashing power is owned by four mining pools – indicating a dangerous concentration of power.<br><br>Even moving from a mining-based proof of work system to an alternate proof-of-stake system, as Ethereum plans to do next year, might not prevent the oligopolies to form that control the transaction validation in a direct or indirect manner. That is because as the complexity of operations on Ethereum blockchain increases, only a handful of entities will have the operational expertise to validate transactions in a cost-effective manner. </p> </div> </div><br> <img class="card-icon-defi" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/62396215ebd50801a930d92e_Illustration.png" alt="Icon Image"><br><br> <p class="content-defi">To conclude, while DeFi’s innovation of smart contracts <span class="brand-blue">allows financial market participants to execute transactions on-chain in a cost-effective manner</span> by reducing duplication of functions and processes and increases the yield on tech infrastructure for large companies willing to experiment with them, <span class="brand-blue">it cannot do away with all the benefits that centralized finance brings.</span> That is because when people decide to transact with one another, they are not simply looking for laws and rules in a literal sense. They are also looking for institutions that enforce those laws, which decide what is unfair and fair – a concept that changes with time and social context. <span class="brand-blue">Distributed Ledger Technology may yet prove to be the biggest innovation in digitization of banking infrastructure and inclusive finance.</span> The DeFi paradigm does validly offer a way out of the cumbersome, and somewhat unfair (due to the high costs of intermediation) system of financial intermediation prevalent today, as we have discussed in earlier parts of this article. But its best aspects are realized only as a tool of <span class="brand-blue">integration</span> and <span class="brand-blue">transformation of mainstream finance,</span> rather than an exaggerated poster-child of anarchist fantasy.<br><br><b>To get a complete insight on this topic, read our <a href="https://kristal.ai/post/defining-decentralized-finance-defi-part-1">previous articles.</a></b></p>

By

Shailesh Jha

March 23, 2022

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