Michael Kodari is the founder and CEO of Kodari Effects (KOSEC), a leading provider of investment services.
The term DeFi, which is short for decentralized finance and purposefully sounds like the word “defy,” was conceived in 2018† Despite only being around for a handful of years, this alternative global financial system built on public blockchains such as Bitcoin and Ethereum has grown tremendously in size and diversity since its inception. Can DeFi transform the existing financial infrastructure as we know it? Let’s break it down.
More than a crypto buzzword
DeFi is emerging as an exciting new financial technology that is taking over the centralized banking and finance industry. Unlike traditional financing, where a company, bank or fund is responsible for your money, with DeFi you are only responsible for you, the investor. It uses a combination of existing blockchain-related technologies such as digital assets, wallets and smart contracts to create a financial ecosystem ready to bypass banks, brokers and exchanges – basically anything or anyone who traditionally operates financial services and incorporated.
For many people this is hugely attractive: by removing the so-called “middlemen”, DeFi ensures a higher degree of efficiency. Simply put, DeFi provides a way to make a profit with a fraction of the investment that would otherwise be required. At the same time, it lends itself to greater transparency for financial transactions, while democratizing access and ownership, reducing the estimated 1.7 billion people worldwide who do not have a bank account.
The Pros and Cons of DeFi
Despite its meteoric rise to fame, DeFi technology is still in its infancy. It has not had years of stress testing on a large scale to solve problems. That means money can be lost or compromised. And DeFi thrives in the absence of rules and regulations, which means there is a lack of consumer protections.
Blockchain ledgers have also raised questions about illegal activities. A DeFi protocol could act as a platform where questionable funding could take place without there being a central authority to counter it. For example, in August 2021, sophisticated hackers exploited the vulnerability of smart contracts, $610 million of the DeFi platform Poly Network. Fortunately, all funds were returned this time, but that may not always be the case.
Besides being the newbie to the scene and the ensuing issues around security and legal compliance, DeFi has a lot going for it. As mentioned before, it is unauthorized and inclusive. Transactions are real-time and transparent. Smart contracts are highly programmable. But despite its many benefits, traditional financial publishers and lenders scoff at the idea of embracing and leveraging DeFi’s blockchain ledger technologies.
With the growing distrust of banks, some are touting DeFi as the ideal solution for the future of finance – one that will ensure that regulatory malpractice can be eradicated. As early as 2020, a Gartner analyst predicted that DeFi would soon go mainstream† While DeFi and legacy financial institutions may seem like opposing forces, I believe that together they can be transformative.
The best of both worlds
Disruption in the financial world will not disappear anytime soon. The rapid pace of technological innovation is having that effect. Navigating this blazing fast pace requires agility and open-mindedness, as well as thinking about the bigger picture. Take blockchain for example. Initially, banks were skeptical about the adoption. Now some big banks investing in crypto and blockchain related companies.
DeFi faces the same scenario. As traditional financial institutions are beginning to realize that DeFi is here to stay, they can go onboard and implement this technology into their existing frameworks. ING bank sets a good example of the potential for collaboration in this space. The Netherlands-based bank recently analyzed DeFi’s risks and opportunities and has written a report titled “Lessons Learned from Decentralized Finance.” After examining the pros and cons, ING Bank concludes that “the best of both worlds is achieved when centralized and decentralized financial services work together”.
What would this collaboration look like? For starters, centralized financial institutions should embrace innovation and move away from their risk-averse mindset. They must proactively contribute to regulatory development so that the core benefits of DeFi are preserved.
At the same time, legacy financial institutions can begin offering DeFi services to those without and under a bank. By providing consumers with greater access to the blockchain ecosystem through their existing banking services, the micro, small and medium-sized enterprises (MSMEs) could be closed financial gap†
As the blockchain principles DeFi relies on merge with the global financial architecture, we could see benefits such as faster international transactions, capabilities to make money work harder, and easier access to loans.
A future-proof opportunity
The modern landscape has shaped a new kind of consumer, and legacy financial institutions must evolve too. Financial institutions need to put the customer first and now lay the groundwork to provide personalized, flexible and simplified offers. For inspiration, they can look to banking giants such as Morgan Stanley and Goldman Sachs who have already started paving the way for this modern, synergistic ecosystem of finance.
DeFi innovation is ripe for opportunity and opens the door to new and better ways to serve customers. Rather than tearing down centralized banking, DeFi may just be the thing that makes it future-proof.