The rise of decentralised finance (DeFi): opportunities and challenges
DeFi has been one of the most exciting and revolutionary innovations in recent years within the blockchain and cryptocurrency ecosystem.
DeFi is well-positioned to disrupt traditional finance in a number of ways
It leverages blockchain technology to disrupt the conventional path of financial systems without the need for intermediaries, giving out financial services that are much more transparent, accessible, and efficient.
Being in the financial ecosystem, I look at the rise of DeFi not just as an evolutionary step, but as a force capable of transforming the way we will set up our interaction with money, investments, and governance.
But where great opportunities lie, there are also great challenges, especially around regulation and security.
What is DeFi?
DeFi is a broad category of financial applications and protocols on blockchain networks. Unlike traditional finance, where banks and other financial institutions act as middlemen in providing services to customers, DeFi applications depend on smart contracts, which represent self-executed agreements coded right into the blockchain. These will grant users access to a wide range of financial services, including lending, borrowing, insurance, and even savings accounts, without any middlemen.
The DeFi ecosystem operates peer-to-peer, setting up a very inclusive environment for financial services where any person connected to the internet can access. This will break down the barriers that have traditionally excluded billions from participating in the global financial system.
DeFi opportunities
1. Financial inclusion
One of the advantages of DeFi is its ability to provide services to individuals who are not served by traditional banks or have limited access to banking services due to identification requirements or branch location constraints in rural or underserved areas. DeFi eliminates these barriers effectively and enables people in such regions to engage in saving money, borrowing funds, and investing in various opportunities.
2. The middlemen are removed
DeFi has no need for centralised middlemen. It reduces fees by raising efficiency. Traditional finance will often have several touch points in the chain of transaction. In direct contrast, DeFi’s peer-to-peer model lets users interact with financial services directly, often at a fraction of the cost.
3. Transparency
All DeFi transactions are recorded on the blockchain, which is open and, by nature, a tamper-proof ledger. This is an open invitation to reduce fraud and corruption since one can audit all the transactions and smart contracts.
4. Programmability and automation
Smart contracts will automatically perform in DeFi when specific conditions are met. As such, it offers a wide avenue for new forms of financial instruments which will be fully automated, including but not limited to the following: AMMs, yield farming, and decentralised insurance.
The challenges facing DeFi
Although DeFi is an extremely promising sector, it still has several major challenges to be solved for mass use. The main areas of concern are regulation, security, scalability, and user experience.
1. Regulation
By institutional nature, the decentralised and borderless nature of DeFi creates a rather difficult environment for setting regulation. To this date, financial regulators worldwide struggle to categorise and oversee assorted arrays of DeFi protocols, and not many investors will be willing to join this market without regulatory clarity. Clear regulatory guidelines are needed, and it needs a proper balance: the regulators must balance between consumer protection and enabling innovation. Too much regulation will kill the growth of DeFi, while too little opens up DeFi to potential frauds and abuses.
2. Security risks
Security is the biggest concern in DeFi. The openness of the ecosystem and the complexity of smart contracts leave room for hackers to look for potential susceptibilities to exploit. Within recent years, there have been a number of high-profile hacks in DeFi, by means of which millions of dollars in users’ money has been lost. While auditing smart contracts is getting better, security will be one of the top challenges as the ecosystem continues to grow.
3. Scalability
As DeFi adoption increases, the demand for more advanced underlying infrastructures able to support more transactions is also on the rise. A number of Layer-2 scaling solutions are active in that direction, but a lot remains to be done.
4. User experience
In my opinion, DeFi platforms are anything but user-friendly, especially to the layman who struggles with advanced technology. The learning curve is very steep, from how to use a DEX to managing private keys. For wider diffusion of DeFi, an improved user interface and experience will be important. Innovation in wallet development, UX design, and more user-friendly protocols has started to arrive, but is far from universal.
DeFi’s disruptive promise
Despite those challenges, DeFi is well-positioned to disrupt traditional finance in a number of important ways, including:
1. Banking and lending
Some DeFi protocols enable users to lend and borrow assets directly without having to be intermediated by a bank. Without question, this will put additional pressure on traditional lending institutions, especially within developing markets.
2. Payments and remittances
Stablecoins pegged to the value of fiat currencies are being used more and more for payments and remittances. I believe DeFi can achieve much quicker and more affordable cross-border payments compared with the traditional banking system.
3. Insurance
Decentralised insurance platforms are another new method for managing risk. They offer a way for people to pool resources to build insurance products without traditional insurers.
Final thoughts
The rise of DeFi marks the beginning of a fundamental shift in how we think about and interact with financial systems. It brings tremendous opportunities for financial inclusion, efficiency, and innovation, though each comes with its challenges. Now that the ecosystem is starting to mature, we should be addressing concerns in regard to regulation, security, and scalability for continued growth.
The question isn’t whether DeFi will disrupt traditional finance, but how fast and in what ways it’ll reshape the financial landscape. To the rest of us onlookers, it is pretty clear: this is no fringe movement. It is a paradigm shift that is gathering momentum at light speed. No nascent technology goes without its bumps along the way, but the financial and social payoffs are immense.
About the author
Hesham Zreik has been ranked #39 out of the top 50 investors (Forbes 2018) based on investment and successful exits. Hesham has invested in +100 start-ups and has co-founded more than 40 start-ups. He has a passion for building innovative start-ups around the principle of developing simple solutions to challenging problems. Hesham is the founder and CEO of FasterCapital an online incubator and accelerator that helps start-ups in raising capital.
