decentralized finance

In 2008, Bitcoin’s release initiated a financial movement, whose present form is Decentralized Finance or DeFi. Over the years, DeFi has steadily made its mark globally, with the promise of upending traditional financial systems.

The response, of course, has been genuinely overwhelming. DeFi’s positive impact in mitigating conventional economic pain points has also been significant. Yet, scrutiny of the bigger picture reveals something grave, a problem that we must overcome to transform finance.

Speculations, trends, and hype have been significant growth drivers since the early days of the blockchain-cryptocurrency domain. The so-called “ICO Craze” of 2017 was among the worst-possible manifestations of this scenario, resulting in losses worth millions. Presently, as we stand at the frontiers of a new financial paradigm, we must learn from past mistakes.

Decentralized Finance Needs Feasible Solutions

The DeFi boom is nothing like ICOs; mere white papers drove the latter, while to a great extent, delivered results are fuelling the former. Despite that, new trends emerge at regular intervals, and innovators jump on the bandwagon without much vision.

In all of this, the tendency has been to completely disregard and oppose the founding principles of Centralized Finance (CeFi). This approach is dogmatic and short-sighted, with the potential to hamper our long-term interests as stakeholders of new finance.

CeFi has problems, no doubt, but there’s also quite a lot that we can learn from legacy financial systems.

This article lets us discuss how we can transform finance through pragmatic and comprehensive solutions rather than trendy ones. How, in the longer run, can we innovate systems that cohere with the broader needs of consumers and enterprises? That is, precisely, the question we must try to answer.

Centralized Finance: The Good and The Bad

A cool-headed approach cannot possibly deny the impact of CeFi in our day-to-day transactions. For one, the domain has evolved through decades of experience; there’s a deep knowledge pool that we must not ignore.

Most financial services that we experience today — deposits, lending, borrowing, and so on — have emanated out of developments in CeFi.

Elaborate credit rating systems, for instance, have been of great use across sectors, facilitating cross-border lending, microfinance, and so on. Innovations in Fintech, as well, began within CeFi.

Everything seems excellent with CeFi. Where did it go wrong?

Why, if at all, do we need new financial systems? Because of three significant aspects, centralization can be very harmful: governance, record maintenance, and risk management.

To exemplify the point, consider the regular lending procedure, where a central authority is in complete control. From background check to interest rate determination, this entity governs every aspect of the process.

A few decide for the many, which may not always be advisable or even acceptable. Consumers, on their part, have little or no say in the process that involves their funds and futures.

The distribution of risk is highly concentrated.

The banks involved are usually the sole bearer of the defaulting risks. Banks charge hefty interests to compensate for high risks, which is ultimately detrimental to financial inclusion. As a whole, the distribution of value and risk in CeFi is highly inequitable, affecting every stakeholder somehow.

Centralized record-keeping and data storage is another aspect of concern with CeFi, as it dramatically hampers security.

Centrally located servers represent single-points-of-failure, becoming easy targets for hackers. Apart from that, censorship, espionage, manipulation, and fraud are some of the other persistent problems of CeFi.

Additionally, monolithic systems imply high costs for implementation, maintenance, and upkeep; this inflates the cost of the end-product or service.

Decentralized Finance: The Alternative to CeFi?

DeFi has the potential to resolve financial pain points, no doubt. It is still too early, though, to make sweeping claims about how it will completely replace CeFi. Although DeFi is treading with long strides, there’s still much ground to cover before it reaches where CeFi is today. This is true in terms of usability and applicability, at least. Nevertheless, DeFi has been transformative in more ways than one.

Consider — a distributed community governs the lending procedures.

As opposed to CeFi, considering the previous example, a distributed community governs the lending procedure, involving an automated consensus protocol.

The determination of interest rates is also algorithmic, ensuring a fair rate structure for everyone.

Above all, there’s a horizontal distribution of risk across lenders, and no single entity carries the entire burden of default. Furthermore, distributed record-keeping and data storage mitigates the risks of hacks; the absence of centralized governance prevents censorship, monitoring, and manipulation.

The immutability of distributed ledgers, such as blockchain, ensures optimal transparency and data security.

However, DeFi is not without shortcomings, especially concerning legal risks and low accountability. Open financial systems uphold the individual’s right to autonomy, but this results in adverse outcomes under specific scenarios.

What about the loosening of the regulatory controls — for profit?

For instance, enterprises can misuse the loosening of regulatory control to maximize profit and bypass obligations towards consumers. Wash trading, price manipulation by sharks, and scam are among the most prominent negativities arising from open finance.

Often, platforms that do not comply with KYC/AML requirements serve as breeding grounds for black markets and money laundering.

Low scalability and interoperability obstruct the realization of DeFi’s fullest potential.

Unlike conventional financial services, DeFi, by and large, is still unable to facilitate day-to-day economic interactions. Solutions in this domain must be able to interoperate, not just amongst themselves but also with the existing financial infrastructure. Only when DeFi and CeFi work in tandem shall we have the comprehensive financial that befits the future.

Semi-Decentralized Finance: Combining the Best of Both Worlds

DeFi and CeFi, as we have seen, both have their upsides and downsides. Presently, we are unable to have fully decentralized financial systems without compromising their functionality or robustness.

The need of the hour, then, is to find ways to leverage the strengths of both CeFi and DeFi. Semi-Decentralization—the middle-way, of sorts—is the most feasible and pragmatic approach to finance, at least for now.

Connecting compiled credit reports.

In lending, decentralized platforms can collaborate with centralized credit unions, aggregating credit scores for prospective borrowers. By connecting compiled credit reports with users’ on-chain wallets, it’s possible to liberate them from overcollateralized loans. The determination and standardization of interest rates shall remain decentralized, thereby ensuring optimal fairness.

Semi-Decentralization fares better with risk management as well.

Borrowers can still get loans from liquidity pools rather than from individual lenders. But legal integration with conventional finance provides a way to recover funds in the case of default. The process is swift and cost-optimized, as the arbitration occurs in bulks. In most cases, we can recover in this manner; if not, then liquidity providers bear the loss in proportion to their staked liquidity.

Globally, the financial community has started the future.

Innovators within the global financial community have already embarked on this journey towards the future. A significant number of upcoming projects are adopting the semi-decentralization approach.

Ripple and XinFin, for instance, are famous names in this regard, innovating with centralized and decentralized technologies in unison. Centaur is another hybrid solution, leveraging CeFi’s efficiency with DeFi’s distributed management.

In projects like Centaur, the flexibility and robustness of conventional finance augment the potential for immutable and transparent data storage and enhanced security.

The direct outcome of this combination is an unprecedented broadening of the scope for use-cases in new finance. By integrating financial licenses with blockchain’s backward-compatible interoperability, semi-decentralized innovations lay the foundations for the seamless financial experience.

Image Credit: burst; pexels; thank you!

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