Cryptocurrencies emerged as a solution to the problem of the 2008 global crisis – inequality and inefficiency of traditional financial institutions. Since the inception of Bitcoin, the adoption of blockchain technology in the world of finance has strengthened its decentralization, creating a new world of decentralized financial services, also known as DeFi.
However, there are some things that keep DeFi from popularizing despite its many benefits. Blockchain technology has brought several new developments to our world, including decentralized finance.
Thanks to the DeFi ecosystems, there are now more decentralized and peer-to-peer networks for financial banking and lending, as well as advanced financial instruments. Despite the notable success of these ecosystems, DeFi is still in its infancy.
DeFi vs. Fintech
FinTech is a trendy area today; over the past few years, dozens of FinTech startups have been created around the world. At the heart of FinTech is the idea of harnessing innovation to improve the delivery of financial services. That is why it is argued that decentralized finance is the same as FinTech.
Yes, both FinTech and DeFi aim to establish financial inclusion, efficiency, and freedom to use technology. As of March 24, 2021, the total blocked value (TVL) is $ 49.70 billion, the adjusted total blocked value is $ 55.93 billion, the number of unique active wallets for 24 hours is 40.59 thousand.
However, one of the exceptionally key differences between FinTech and DeFi is that FinTech solutions are centralized. At the same time, DeFi apps are open-source systems that run autonomously without the support of a centralized authority or company.
DeFi Apps stand out for taking a new approach to open-source finance that allows many services to run on top of the blockchain. The internet is a great example of how DeFi works.
The main benefits of DeFi
One of the main benefits of DeFi is the unlimited funding option. DeFi applications apply practical solutions to countries in the world that do not have a normal banking system. DeFi Apps offer access to financial services in African countries that were previously unavailable.
Banks still rely on IDs and credit ratings to verify customers. With DeFi apps, users don’t need to have a bank ID or credit rating to use financial services.
This provides anyone with the ability to use financial services. In light of the current pandemic, DeFi solutions could be a much more efficient and effective alternative for generating universal basic income from governments. With DeFi, millions of people could get government funding in an instant.
Decentralized Finance (DeFi) Challenges
Decentralized markets have their own advantages and disadvantages. While DeFi offers many potential benefits, the downsides impede mainstream adoption.
All of the issues below are holding the decentralized financial system back from widespread adoption, but some investors don’t care at all. The serious risks of the DeFi ecosystem stem from smart contracts, lack of credit insurance, user error, and asset liquidity.
Vulnerability of smart contracts
Since smart contracts are intermediaries of DeFi systems, their vulnerabilities can affect the functioning of the DeFi ecosystems. Smart contracts are programmable algorithms that are prototypes of traditional (real) contracts.
A smart contract controls the execution of the contract between the two parties after the conditions are entered into it. However, the presence of an error or flaw in the code can lead to the loss of funds locked in the smart contract.
Yes, smart contracts make it very easy for the parties to fulfill the contract, but errors in the code can lead to significant problems. Another significant problem is user error. If the user uses the wrong address to send money, he may not return it back.
The so-called Reentrancy attacks are widespread in the smart contract system, which is also a significant obstacle to the automation of all finances. Besides Reentrancy attacks, DOS attacks are very common. DeFi systems are highly susceptible to DOS attacks.
If a defective smart contract ends up in the DeFi ecosystem, it could result in severe loss of funds and financial data. Another error that can arise from a smart contract vulnerability is user error. Mistakes like these have resulted in people losing millions of their money.
For example, a developer mistakenly took control of hundreds of wallets and destroyed them in an attempt to return them to their owners. It was a long time ago, in 2017, but the story is still popular today.
Another story – the developers tried to fix a bug in the code that led to their hacking and the loss of $ 32 million. These guys unknowingly transferred the ownership of all their assets to one person and could not fix what they had done.
The unpredictability of the DeFi market
Market unpredictability is the second problem that scares off investors and traders very much. Since cryptocurrencies have so much volatility, the DeFi market further encourages this lack of digital coins.
As a consequence, investors can lose a lot of money during the sharp ups and downs in prices, even if everything is technically in order. Due to the volatility and unpredictability of the market, many people are reluctant to accept cryptocurrencies as a stable form of measure of value.
Moreover, the value of each cryptocurrency can vary in different ways, so it is difficult to choose a specific currency for financial transactions. DeFi will only increase market volatility and scare off big investors.
There is no precise regulation of the decentralized financial system in the world. Since governments or central banks have no control over transactions, most people do not trust the system. Moreover, in some countries, local governments may prohibit cryptocurrency without prior notice. This is one of the main problems in the DeFi system.
Due to the lack of regulation, the likelihood of criminal activity is also high. Since the system offers anonymity, anyone can send or receive money without revealing their names, which gives more options to criminals.
The cryptocurrency world is filled with thousands of digital currencies, which creates additional difficulties when it comes to cash out. Difficulties may also arise when exchanging cryptocurrencies due to low liquidity.
As a result, you may not receive money on time, which is a big problem in a decentralized financial system. While many digital currency proponents argue that cryptocurrencies are highly liquid assets, this only applies to a few digital assets. As a result, you cannot freely exchange your assets, which makes the financial system ineffective.
Due to the high volatility of cryptocurrencies, obtaining loans is difficult. In most cases, lenders are ready to offer loans, but they ask for very high collateral for this. This puts the borrower in a difficult position when obtaining a loan. Another problem is the lack of credit insurance.
DeFi ecosystems have not been able to eliminate this danger. The availability of urgent loans is a big problem. Attackers can get hundreds of thousands of US dollars using a loan. With no intermediaries for any lending, DeFi ecosystems put investors at risk of losing money from untrustworthy clients.
There are other markets and systemic factors that affect the adoption of DeFi systems. DeFi is not a fully decentralized system, as it is more or less controlled by developers. It is they who are tasked with developing and fixing all the problems related to DeFi.
Developers who are central providers of DeFi solutions make it difficult to decentralize the system and make funding difficult. Another issue with DeFi’s dependency on developers is that they can be dishonest and misappropriate customer funds.
Many are trying to find possible solutions to all of the above risks and problems. Smart contract vulnerabilities and errors are gradually being addressed. Governments can issue regulations that will govern digital assets. It may be more important now to focus on providing
better liquidity and volatility.
Atomic swaps are also the solution to DeFi’s problems. They allow the direct transfer of liquidity from one blockchain to another. Some might argue that the obvious way to tackle the problem of decentralized finance is through DeFi collaboration.
The approach is quite reasonable, but not without its drawbacks.
Thus, tokens within such a “confederation” of projects continue to compete for user attention and, accordingly, staking in DeFi. That is, the problem of flooding the market with a shaft of highly specialized tokens is not being solved, as well as the problem of overloading parent blockchains.
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