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The Emergence Of Decentralised Finance (DeFi) And The Potential Impact On Traditional Banking And Financial Services
BFSI Blockchain Decentralised Finance

The Emergence Of Decentralised Finance (DeFi) And The Potential Impact On Traditional Banking And Financial Services

By Priyobroto April 24, 2023 - 90 views

Decentralised finance (DeFi) has made a huge splash worldwide, with its potential for traditional banking disruption. It is a rapidly growing financial technology that uses secured and distributed ledgers, based on blockchain and smart contracts, just like cryptocurrencies.

But how is it contributing towards disruption or financial services innovation? In the U.S., for instance, the SEC (Securities and Exchange Commission) and Federal Reserve have clearly outlined the regulations for centralised financial entities such as brokerages and banks that customers depend on accessing financial services and capital directly.

DeFi poses a challenge to this centralised financial setup through empowering people with peer-to-peer digital transfers/exchanges. It also contributes towards the elimination of fees charged by financial institutions and banks for the usage of specific services. Those holding their money in secure digital wallets can instantly transfer funds, while anyone with internet can make use of DeFi.

What is centralised finance?

For understanding decentralised finance, one should first have an idea of what centralised finance is all about. Here are some core points worth noting in this regard: 

  • Centralised finance has the money held by the banks and third parties. They are the ones who enable money transfers across multiple parties, each of them charging fees for the usage of services. 
  • Networks clear charges and request payments from banks. Every chain entity gets payments for services provided. 
  • All transactions are supervised in this system, right from local banking services to applying for loans.

How does decentralised finance (DeFi) work?

Decentralised finance (DeFi) has huge potential for traditional banking disruption. Here are some points worth noting: 

  • This system does away with intermediaries by enabling merchants, individuals, and businesses to take care of financial transactions with new and emerging technologies. 
  • DeFi makes use of security protocols, software, connectivity, and hardware advancements via peer-to-peer financial networks. 
  • Individuals can easily trade, lend, or borrow funds whenever they get an internet connection, using software for verifying and recording financial transactions throughout financial databases that are distributed. 
  • Distributed databases are those which are readily accessible throughout multiple locations, gathering and aggregating data across users and leveraging a consensus-based mechanism for verification. 
  • Decentralised finance (DeFi) does away with the need for any centralised financing model, through enabling any individual to make use of financial services almost anywhere, irrespective of their identity or location. DeFi applications enable higher control over funds for users via personal wallets and trading solutions catering to individuals. 
  • Decentralised finance does not ensure complete anonymity. Transactions, while not having individual names, can be traced throughout all entities with access, including the law and Governments. 
  • DeFi makes use of blockchain technology as used by cryptocurrencies. The blockchain is the secured and distributed ledger/database. Transactions get recorded through blocks and verified by users. Once verifiers agree to transactions, the blocks are closed and then encrypted.

Another block is made with data on the earlier block within the same. The blocks are conjoined through data in every proceeding block, which gives it the blockchain moniker. Information in earlier blocks cannot be modified without any effect on the following ones. Hence, there is no way to change a blockchain. 

How DeFi is being used in the financial sector

Decentralised finance (DeFi) is being used widely in the financial sector, with the following being the major take-aways:  

  • P2P (peer-to-peer) financial transactions, right from payments through applications and issuing loans. 
  • DeFi is enabling direct interest rate negotiation between two parties and lending through its networks, equating to lower fees. 
  • Anyone with internet can access DeFi platforms and there are no locational limitations on transactions. 
  • Smart contracts on blockchain and records of competed transactions can be easily reviewed and are immutable. 
  • Income-generation and capital transfer abilities for investors with high security.

Here’s how it is disrupting traditional protocols:

  1. DeFi is enabling lending/borrowing at scale between unknown parties and minus intermediaries with automatic setting of interest rates, based on demand and supply. Loans are secured through over-collateralisation, with loan access anywhere and anytime. 
  2. DeFi is also enabling the de-centralised trading and development of derivatives for various assets like commodities, stocks, and even currencies. Decentralised asset management for cryptocurrency is another growing trend. 
  3. Decentralised exchange concepts have come up, with cryptocurrency holders no longer needing to leave the arena for token swapping. DEX has several smart contracts with reserves of liquidity, operating as per pre-defined mechanisms of pricing. 
  4. Decentralised insurance is also available, covering bugs for smart contracts in this entirely new space. This is a major risk area for DeFi users, and is covered by these plans. 

As can be seen, crypto-based decentralised finance has already reached an advanced stage in terms of its evolution. It is steadily taking care of all the necessary functions of a financial system as a result. DeFi could well be the next big thing in global finance, provided it can navigate security threats successfully. 

FAQs

What is decentralised finance (DeFi) and how does it differ from traditional finance?

Decentralised finance is where distributed and secured ledgers are used with blockchain technology like cryptocurrencies. It means peer-to-peer transfers without higher fees for transactions as charged by all the entities in a traditional transaction chain. It can enable anytime and anywhere transactions between unknown parties, with automatic conditions and smart contracts, eliminating intermediaries. 


How does DeFi work and what are the key components of DeFi platforms? 

The main components include specific hardware, software, stablecoins, and so on. The infrastructure is continually evolving, and the system works through an independent yet secured and highly traceable network on the blockchain. Transactions are recorded, stored, and are verifiable easily. At the same time, there are no intermediaries and resultant charges. Parties can directly engage in transactions with automatic setting of interest rates or other crucial parameters. 


What are the potential advantages of DeFi over traditional finance? 

DeFi is a transparent and open system as compared to the closed and centralised system followed by traditional financial institutions. Transactions are public and may be viewed by any individual. They are readily traceable as well. At the same time, there is no need for intermediaries and no constraints on the location or time. Fees and charges are also lower as a result. 


What are the risks associated with DeFi and how can they be mitigated?

The major risks include financial mismanagement of platforms, issues pertaining to smart contracts, and bugs. There is of course, decentralised insurance that is steadily coming into play for covering these bugs in smart contracts along with other software malfunctions. Better regulatory and privacy mechanisms are necessary for keeping these security threats at bay.

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