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Decoding Pros & Cons Of Defi Ecosystem
By Laxmikant Khanvilkar
These emerging technologies have the potential to shake up the financial services industry, leading to decentralized finance (DeFi).
Loans, insurance, derivatives trading, and exchange are all facilitated by DeFi without the need for intermediaries.
Technological innovations have necessitated significant improvements in the financial industry as the markets undergo unprecedented changes. Therefore, it is imperative that the financial industry improve a great deal following technological innovations. Although these advancements imply more convenience and accessibility, there are still overall social costs of centralized platforms arising from traditional issues of finance such as opaqueness and moral hazard frictions.
As such, it is important to understand how the Defi ecosystem is eliminating these shortcomings and the associated frictions. We’ll look at how smart contracts, which initiate DeFi transactions, work, focusing on the smart contracts that provide loans and token exchange services that form the basis for this review.
We may begin by defining the pros and cons of an innovative decentralized governance model that is driven by the possession of governance tokens. Although the DeFi infrastructure has great promise, there are five main kinds of operational hazards that users must be aware of: protocol consensus, Oracle, frontrunning, and systemic risks.
Future research should focus on the scalability of existing blockchain systems, improved interoperability and design of the Defi protocols, and stringent audits of smart contracts.
Centralized platforms have traditionally offered financial services. Prominent examples are the world’s two most significant payment processors, Visa and Mastercard; the world’s largest stock exchange, Nasdaq; Vanguard and Blackrock, known for their investment and brokerage services; and JP Morgan Chase, a provider of the full spectrum of banking services. Although it is crucial for the provision of intermediation services to the real economy, the centralized financial system might also be exclusive and expensive to users. Take credit card companies as an example: they charge processing fees that are between 2 and 4.35 percentage points of the transaction value.
Furthermore, commercial banks often charge significant service fees and loan interest rates but provide users with low interest on deposits. Financing becomes too expensive for some small borrowers who cannot obtain loans or mortgages and have no other option but to use credit cards that have higher-than-normal borrowing rates. The availability of simple financial services, such as payments, also remains dubious, especially in the underdeveloped areas, where a vast part of the population is unbanked.
Technological advancements in finance have led to the emergence of alternative service providers, which help address some of these problems. New payment platforms such as Square and Venmo use smart phones and internet technology to develop cost-effective and easily accessible payment options. An average consumer on the street and a small entrepreneur can use these services as access to financial systems dramatically increases.
Technological advances within the industry have facilitated the financial intermediation processes through the development of peer-to-peer lending platforms such as Prosper and LendingClub. Provided by platform lenders, which originate mostly from institutional investors, fund loans also represent an alternative to traditional sources of credit. Fintech brokerage platforms like Robinhood allow users to make commission-free trades on stocks, ETS, and even cryptocurrencies using mobile apps.
Although they serve as an important improvement for the fintech space in terms of convenience, inclusiveness, and cost advantages, these financial technology innovations inherit many features of centralized finance (CeFi). To start with, building up these fintech applications in the current financial infrastructure does not automatically lead to reduced costs of transacting and improving execution velocity. For example, if you get a payment from Venmo and cash it in through your bank, you have to initiate a bank transfer. This kind of transfer can take from one to three working days to get processed. Despite the availability of an option for an instant transfer, choosing it remains costly due to a 1.75% fee being charged.
However, it is the case that the majority of the currently operating fintech platforms continue to act like centralized institutions interested in pursuing profit-free margins and thus tend to result in moral hazard issues and costs to society. Accusations have been made that some of these platforms prioritize gaining money over customer interest. Robinhood Markets, a platform that offered fee-free trading investment services, sought to make profits for itself rather than from its traders by redirecting customer order flows to high-frequency trading firms rather than stock exchanges.
In the same manner, the opaqueness of the credit assessment methodologies employed by certain peer-to-peer (P2P) lending systems can result in defaults and consequent losses to the lenders. Since P2P companies are profit-making entities, they seek to increase their profits. As a result, although lenders’ interest is to avoid people with high risk, P2P may attract borrowers to take more loans by quoting low rates and ignoring the credit risk. Many P2P lending companies fail because of the moral hazard puzzle, especially in China.
Given that most centralized financial platforms failed to address some of the challenges highlighted in this essay despite adopting fintech innovation, the introduction of distributed ledger technologies offers a clear chance to permanently resolve these challenges for any financial institution that applies these fintech enhancement tools. Such technologies may cause even more disturbance to the financial service industry, enabling the shift toward the decentralized trade space, also known as decentralized finance (DeFi).
DeFi allows it to deliver services like exchange, borrowing, derivatives trading, and insurance without the use of centralized intermediaries.
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