INSUBCONTINENT EXCLUSIVE:
DeFi comes with a host of risks as well that developers and regulators will need to addressFervent proponents of cryptocurrencies and the
blockchains they run on have promised a lot.To them, these technologies represent salvation from corporate power over the internet,
government intrusions on liberty, poverty and virtually everything else that ails society.But so far, the reality has mostly involved
financial speculation with popular cryptocurrencies like bitcoin and dogecoin, which soar and plunge with alarming regularity.So what are
cryptocurrencies and blockchain good for?As an expert on emerging technologies, I believe that decentralized finance, known as DeFi, is the
first solid answer to that question
DeFi refers to financial services that operate entirely on blockchain networks, rather than through intermediaries like banks.But DeFi comes
with a host of risks as well that developers and regulators will need to address before it can go mainstream.What is DeFi?Traditionally, if
you want to borrow US$10,000, you first need some assets or money already in the bank as collateral.A bank employee reviews your finances,
and the lender sets an interest rate for the repayment of your loan
The bank gives you the money out of its pool of deposits, collects your interest payments and can seize your collateral if you fail to
repay.Everything depends on the bank: It sits in the middle of the process and controls your money.The same is true of stock trading, asset
management, insurance and basically every form of financial services today
Even when a financial technology app such as Chime, Affirm or Robinhood automates the process, banks still occupy the same intermediary role
That raises the cost of credit and limits borrower flexibility.DeFi turns this arrangement on its head by re-conceiving of financial
services as decentralized software applications that operate without ever taking custody of user funds.Want a loan? You can get one
instantly by simply putting cryptocurrency up as collateral
This creates a "smart contract" that finds your money from other people who made a pool of funds available on the blockchain
No bank loan officer necessary.Everything runs on so-called stablecoins, which are currencylike tokens typically pegged to the United States
dollar to avoid the volatility of bitcoin and other cryptocurrencies
And transactions settle automatically on a blockchain - essentially a digital ledger of transactions that is distributed across a network of
computers - rather than through a bank or other middleman taking a cut.The rewardsTransactions made this way can be more efficient,
flexible, secure and automated than in traditional finance.Moreover, DeFi eliminates the distinction between ordinary customers and wealthy
individuals or institutions, who have access to many more financial products
Anyone can join a DeFi loan pool and lend money to others
The risk is greater than with a bond fund or certificate of deposit, but so are the potential returns.And that's just the beginning
Because DeFi services run on open-source software code, they can be combined and modified in almost endless ways
For example, they can automatically switch your funds among different collateral pools based on which currently offers the best returns for
As a result, the rapid innovation seen in e-commerce and social media could become the norm in traditionally staid financial services.These
benefits help explain why DeFi growth has been meteoric
At the recent market peak in May 2021, over $80 billion worth of cryptocurrencies were locked in DeFi contracts, up from less than $1
The total value of the market was $69 billion as of Aug
3, 2021.That's just a drop in the bucket of the $20 trillion global financial sector, which suggests there is plenty of room for more
growth.At the moment, users are mostly experienced cryptocurrency traders, not yet the novice investors who have flocked to platforms like
Even among cryptocurrency holders, just 1% have tried DeFi.The risksWhile I believe the potential of DeFi is exciting, there are also
serious causes for concern.Blockchains can't eliminate the risks inherent in investing, which are the necessary corollary of the potential
In this case, DeFi can magnify the already high volatility of cryptocurrencies
Many DeFi services facilitate leverage, in which investors essentially borrow money to magnify their gains but face greater risk of
losses.Moreover, there isn't any banker or regulator who can send back funds transferred in error
Nor is there necessarily someone to repay investors when hackers find a vulnerability in the smart contracts or other aspects of a DeFi
Almost $300 million has been stolen in the past two years
The primary protection against unexpected losses is the warning "investor beware," which has never proved sufficient in finance.Some DeFi
services appear to violate regulatory obligations in the United States and other jurisdictions, such as not barring transactions by
terrorists, or allowing any member of the general public to invest in restricted assets like derivatives
It's not even clear how some of those requirements even could be enforced in DeFi without traditional intermediaries.Even highly mature,
highly regulated traditional financial markets experience shocks and crashes because of hidden risks, as the world saw in 2008 when the
global economy nearly melted down because of one obscure corner of Wall Street
DeFi makes it easier than ever to create hidden interconnections that have the potential to blow up spectacularly.Regulators in the United
States and elsewhere are increasingly talking about ways to rein in these risks
For example, they are starting to push DeFi services to comply with anti-money laundering requirements and considering regulations governing
stablecoins.But so far they have only begun to scratch the surface of what may be required.From travel agents to car salespeople, the
internet has repeatedly undermined the bottleneck power of intermediaries
DeFi is another example of how software based on open standards can potentially change the game in a dramatic way
However, developers and regulators will both need to up their own performance to realize the potential of this new financial ecosystem.Kevin
Werbach, Professor of Legal Studies and Business Ethics, University of PennsylvaniaThis article is republished from The Conversation under a
Read the original article.
