It is beyond doubt that a new financial ecosystem has entered the mainstream in the last few years. This rise of decentralized finance has forced the traditional financial industry and its regulators to accelerate their understanding of and responses to its opportunities. In the future, they will need to bring their considerable resources to bear to stay on top of the gathering wave of financial industry disruption. Here we mention some of the different perks of decentralized finance and things to be on the lookout for.
According to CoinGecko, decentralized finance has only 5% of the crypto space, but it has seen massive growth recently. It is regarded as a powerful sub-sector capable of leveraging technological innovations to launch applications, generate value, and shape the competitive landscape. As financial policies and regulations adapt, DeFi is set to massively expand.
Decentralized finance, or DeFi for short, refers to financial applications and services built on blockchain technology that operate without the use of intermediaries such as banks or other financial institutions. The transactions are executed automatically via smart contracts on the blockchain, which include the deal’s agreement. In simple words, DeFi relies on blockchain technology to decentralize the financial system, allowing for decentralized financial services and new business models. It creates a financial system that is creative, open, global, and transparent. All of this implies that DeFi offers enormous prospects. Moreover, it improves financial intermediation by boosting efficiency and stability without the requirement for a central body and the associated manpower and operational costs. The increased competition that results from DeFi providers entering the markets currently inhabited by traditional financial institutions has also positive effects. The decentralized, non-custodial applications can replace intermediaries by automatically labeling them as “valid” and making it possible to obtain loans, make investments, or trade financial products. Another big benefit, of course, is that DeFi can potentially reduce the costs of financial intermediation by bypassing and shortening the intermediation chain.
When traditional financial institutions are compared against DeFi, it becomes clear that the marginal cost of DeFi is significantly lower than that of other banks and nonbanks in both developed and developing market economies. DeFi is a low-cost financing solution, to put it simply. The automated and unregulated operation of the DeFi platforms accounts for their low marginal costs. DeFi platforms do not have the same manpower or operating expenses as traditional financial institutions do because the entire lending process is already automated with the help of algorithms and interest rate models. In comparison to the rest, DeFi’s margins are quite thin. To attract borrowers and depositors, DeFi charges far lower margins than traditional financial institutions, offering attractive rates to borrowers and high deposit rates to savers.
Also, the estimated (average) expected losses of DeFi platforms are compared with those of banks. As research suggests, the DeFi margins are excessively small when compared to the same risk exposure. Alternatively, DeFi may be grossly undercharging for its risks. According to a report on cryptocurrency and DeFi by the National Bureau of Economic Research, these lower marginal costs might be counterbalanced by higher upfront expenditures. The contract must be finalized ex-ante because smart contracts do not permit ex-post renegotiation or cancellation, as stated in the paper. Therefore, it necessitates greater up-front expenses for negotiating and defining the precise parameters of an agreement in all conceivable global contexts.
When compared to traditional finance, DeFi presents regulators with new and unique challenges, and international standard-setting organizations, including the Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures, and the International Organization of Securities Commissions, are now debating this issue. As DeFi has no centralized body, the other centralized entities in the crypto ecosystem that have enabled the development of DeFi could be the focus of regulation in the future. For example, according to the IMF, stablecoin issuers could be the main regulatory target, given the importance of stablecoins to DeFi.
While DeFi has the potential to revolutionize the financial industry, it is important to note that there are still some open points. One of the main tasks to strenghten security features, as DeFi platforms are still relatively new. Closing the current regulatory gaps would help to ensure that the DeFi risks are minimized while still allowing borrowers to reap the benefits that these decentralized financial services have to offer. Additionally, the volatile nature of cryptocurrency means that individuals should educate themselves before diving into decentralized finance.