“DeFi is one of the most exciting developments in crypto and has the potential to revolutionize the financial system as we know it.” - Brian Armstrong

Since its popular use in 2018, there has been rampant discussion in finance and tech circles about the potential to replace the traditional centralised finance ecosystem (CeFi) with decentralised finance (DeFi). Let us begin by understanding what decentralised finance is.

What is DeFi

DeFi (short for decentralised finance), is the umbrella term for financial services on public blockchains, usually Ethereum. DeFi allows you to avail most of the financial services that banks and other conventional financial institutions provide - borrow, lend, earn interest income, buy insurance, trade derivatives, and assets, and much more, only with the added advantage of eliminating middlemen and paperwork and increasing the speed of financial transactions. Just like crypto in general, DeFi is global, peer-to-peer (connects the 2 concerned parties in a financial transaction directly, devoid of any centralised financial system/middleman), pseudonymous, and open to just anyone with a smartphone, an internet connection, and rudimentary knowledge about crypto. DeFi takes the basic premise of cryptocurrencies like bitcoin -  digitisation of currencies - and expands on it to create what many crypto and tech enthusiasts call “an alternative to Wall Street”. DeFi as a concept is believed to have been incubated in an August 2018 Telegram chat between Ethereum developers and entrepreneurs discussing what to call the movement of open financial applications being built on Ethereum. 

Blockchain and cryptocurrencies are the core technologies that enable DeFi to function as an alternative to centralised finance and provide similar services in terms of payments, trading securities, insurance, decentralised exchanges to trade cryptocurrency, NFTs, and flash loans.

The concept of flash loans is particularly fascinating. These are loans denominated in a particular cryptocurrency (usually stablecoins), wherein borrowing and repay in the same transaction. At first sight, this may sound absurd. However, there is a simple logic to it. Say a student wants to engage in arbitrage in the cryptocurrency markets, but the limitations on capital lead to minimimal margins. . If they wish to engage in arbitrage and make a side income that is good enough to cover their residential expenses. A considerable amount of capital would be required, which could be procured from a flash loan. , They would essentially be borrowing the sum of money by entering into a contract encoded on the Ethereum blockchain, without the need for any paperwork or collateral. They could even bank on arbitrage without using a rupee of their own capital! They would only have to repay the loan as part of the same transaction. If the transaction can’t be executed or is lost, the funds automatically go back to the lender. Any profit made can be pocketed, deducting any interest charges or fees. DeFi is powered by several decentralised apps, more popularly known as ‘dapps’, which run primarily on the Ethereum blockchain. Funds (denominated in a particular cryptocurrency) are stored in ‘e-wallets’.  The currency used within DeFi is stablecoins, which is the term for cryptocurrencies that are pegged to the value of a real-world asset, like the US Dollar, to bring more stability into the system. While most of us consider Bitcoin as the most popular cryptocurrency, Ethereum has more use cases in DeFi because it’s adaptable to a wider variety of uses. Just like we measure the size of a stock market using its equity market capitalization, the size of the DeFi market is measured by a metric called ‘total locked value’, i.e. the amount of capital currently employed in various DeFi protocols. This figure in 2023 stood at around INR 3 trillion, as per Forbes, and is estimated to grow at an even faster pace in the coming years.

The Black

A common apprehension held by detractors is the ostensible lack of sufficient safeguards for investor security within DeFi, as compared to CeFi wherein authorities like the RBI enforce standards such as minimum reserve requirements to maintain stability in the financial and banking system. Meanwhile, DeFi remains unrestricted by the gamut of rules and oversight controlling traditional finance. Critics argue that this relegation of regulatory duties to mathematics and software is a threat to consumer protection. Moreover, they also argue that it has made money laundering and fraud easier by allowing the use of anonymous or pseudonymous transactions on decentralised platforms, which can make it difficult to trace the origin of funds. Furthermore, DeFi projects often leverage smart contracts which, while offering enhanced automation and efficiency, are also subject to risks such as bugs and exploits. If a smart contract is poorly written or contains a bug, it can be exploited by malicious actors leading to significant losses. Such vulnerabilities have led to numerous DeFi hacks and security breaches in the past, underscoring the inherent risks in this nascent industry. For example, TinyMan, a popular Algorand DEX, was exploited for roughly $3 million worth of cryptocurrency in January 2022. Ethereum-based DEXs offer decentralized trading freedom, but active users face potentially high transaction costs due to fluctuations in Ethereum exchange rates. Users of DeFi services such as DEXs also require a certain amount of technical expertise and knowledge about blockchain and the cryptocurrency ecosystem, without which they would be susceptible to errors, potentially leading to massive financial losses. 

The White 

DeFi has revolutionised financial services by removing the need for a central authority/ intermediary to provide the same. By facilitating transactions through ‘smart contracts’, it has democratized the financial system - anyone with an internet connection can access financial products, regardless of geographical barriers and the traditional financial exclusion techniques that conventional banks employ while offering loans. Globally, nearly 1.7 billion people lack access to a bank account. DeFi can provide them with access to financial services such as savings and credit, which can improve their economic opportunities and play a role in furthering the cause of global economic equality. Additionally, , DeFi’s blockchain tech base means that transactions are transparent and can be audited by anyone with access to the decentralised ledgers, reducing the probability of fraud. Blockchain technology also employs several inbuilt security mechanisms that provide sufficient protection from hackers. Privacy is another benefit, given that users are pseudonymous and have control over their assets and personal information, unlike CeFi, where this control is relinquished to banks and other financial institutions. Furthermore, DeFi speeds up the rate of transactions and other financial processes by eliminating intermediaries and lengthy verification processes such as KYC. This is especially beneficial for people who frequently engage in cross-border transactions like remittances. While a remittance typically takes days to process using CeFi, a crypto payment just takes a few seconds or minutes. Through services such as flash loans, users can avail credit at more competitive rates, since intermediary commissions are non-existent in the DeFi system. 

The Grey

DeFi has the potential to bring about groundbreaking changes in the way we avail everyday financial services such as loans. It can disrupt the existing CeFi ecosystem that is dominated by banks and other financial intermediaries and lower the cost of access to finance for the common man and woman on the groun. However, DeFi is still in its nascent stages and has been subject to problems like hacking and volatility. It is highly advisable that users of DeFi invest only small amounts in DeFi services like DEXs, after assessing their risk appetite, atleast until the technology reaches a stage where most of the problems mentioned above are adequately addressed. Users should only invest in DeFi instruments after learning about the associated processes and technologies to reduce the risk of loss. 

With that said, the success of DeFi projects like Aave (a successful lending platform that allows users to earn interest on deposits and borrow assets, flash loans without collateral) indicates a bright future for DeFi. Many experts believe that developments in DeFi will enable a democratisation of the finance industry and greater financial security and privacy of data for users. However, there is still a long way to go. 

By Aditya V. Gulavani