Examining Decentralised Finance (DeFI) as an Alternative Financial System (Part III)
The Good, the Bad and the Ugly of Decentralised Finance
Since the global financial crisis of 2007/2008 where investors were left with investments that had lost significant value and rising debt, faith in traditional financial institutions has been shaken. Citizens of countries with declining economies, like Venezuela and Zimbabwe, also hold their monetary authorities responsible for the monetary policies they have implemented which they believe are not economically viable. These are one of the many reasons why cryptocurrency enthusiasts and retail investors believe decentralised finance is the future of finance by decentring central authorities such as central banks and middlemen such as banks and other financial institutions, and empowering everyday people via peer-to-peer exchanges.
Advantages of Decentralised Finance
Some of the advantages include:
Speed: DeFi protocols and products are processed quickly; for example, loan requests are processed timeously considering the promptness of blockchain-based transactions. This is in contrast to bank loans which may take days or even weeks for approval.
Accessible and permissionless: DeFi products offered on blockchain technology fosters access to finance as users are not limited by location or credit history. Retail investors can access financial products or services through DeFi, provided they meet the terms of the Smart Contract. There are also no limits on the value that may be available to users as opposed to traditional financial institutions which are subject to regulatory limits. For example, the Banks and Other Financial Institutions Act 2020 provides that a commercial bank cannot, without the prior written approval of the Central Bank of Nigeria (“CBN”), grant to any person any loan or credit facility such that the total value of the liability in respect of that person exceeds 20% of the bank’s shareholders’ funds unimpaired by losses.
Transparency: blockchain transactions are transparent as you can trace the wallet IDs of contract parties, and the execution and completion times of transactions are recorded on the network. In addition, transactions conducted on them are permanent and cannot be altered. Once a financial transaction or Smart Contract has been recorded onto a blockchain, its terms are visible to participants on the blockchain network and become immutable. This creates some form of security with DeFi financial products as assets or transaction records cannot be altered or fraudulently manipulated. In addition, as the terms of the Smart Contract are written as codes on the blockchain, this limits disputes on the interpretation of contract terms.
As seen above, DeFi has great benefits but there are also inherent risks.
“DeFi has great benefits but there are also inherent risks”
Disadvantages of Decentralised Finance
Hackers: Hackers are a major security risk for a blockchain technology network. While it is hard to hack blockchain technology, it is not impossible. Since 2011, over USD$11,000,000,000 (Eleven Billion Dollars) worth of cryptocurrency has been stolen from crypto wallets that were hacked.
Strict Terms: the financial terms of Smart Contracts are typically stringent as a scale against the limited requirements. Take De-Fi loans where the collateral required is typically set to be equal in value (or more) to the loan requested. Such stringent financial terms are limiting with respect to persons who can realistically access the DeFi products.
Fakes: There have been instances where scammers have used popular Dapps to list fake cryptocurrencies labelled as tokens that can be used to access DeFi protocols. Investors have to be careful in choosing the digital assets they decide to invest in and retail investors may not appreciate the due diligence required.
Investor Protection: DeFi services, products, and technology are by their very nature, typically outside regulatory oversight. Thus, the investor protection provisions that regulated financial institutions are subject to may not apply to Dapps, DeFi protocols or issuers. Without these investor protection requirements, consumers and their investments are subject to the whims of the issuers of these financial products. As highlighted earlier, there is a conspicuous counterparty risk with De-Fi products. For example, if an issuer pulls the plug on a Dapp or blockchain technology, that could put investors’ funds or any collateral that has been deposited in peril.
There are definite pros and cons to De-Fi that requires serious consideration for anyone looking to explore De-Fi products or services. Cryptocurrency enthusiasts are ever optimistic about decentralised finance as the future of finance in terms of delivering financial products and services and the different innovative solutions that may result from blockchain technology.
Is Decentralised Finance the Future of Finance?
According to Benedikt Christian Eikmanns (Senior Consultant at the strategy consultancy Roland Berger and doctoral candidate (PhD) at the Technical University of Munich), Prof. Dr Isabell Welpe, (full professor (W3) at the Technical University of Munich, head of the Chair for Strategy and Organization, co-founder of the TUM blockchain center), and Prof. Dr Philipp Sandner (founder of the Frankfurt School Blockchain Center (FSBC));
“For the first time in history, a financial system is developing without intermediaries at a large scale. So far, DeFi applications cannot compete in terms of security, speed, and ease of use with traditional finance solutions yet. But DeFi has produced real, working applications that have already managed to attract billions of capital. Those resources will be used to develop more competitive and user-friendly applications in the future.”
This is a succinct view of the widely held position on the future of DeFi – the future is bright! In Nigeria today, platforms like Xend Finance are leveraging on DeFi to offer financial products to credit unions, trade unions and individuals. Credit unions provide capital and invest on the Xend Finance platform. The unions are given the $XEND token to hold and their capital is invested in other DeFi pools. At the end of the savings period, the returns on their investment are given to a member of the credit union for that month or period.
In terms of the future of DeFi in Nigeria, it is important to recognise that there are currently discordant approaches from regulators in the financial sector regarding cryptocurrency, which may impact the ease of operating Dapps and accessing DeFi products. On the one hand, the CBN has prohibited banks and other financial institutions from dealing in cryptocurrency and providing payment services to cryptocurrency exchanges and further directed financial institutions to close the accounts of customers who operate cryptocurrency exchanges within their system. On the other hand, Nigeria’s Securities and Exchange Commission (“SEC”) in 2020, released its ‘Statement on Digital Assets, their Classification and Treatment’, which set out how SEC would regulate crypto assets – signifying SEC’s acceptance of cryptocurrency.
While exchanges have found a workaround for these regulatory limits by facilitating peer-to-peer trades, this fragmented approach by the Nigerian regulators may leave investors wary of investing funds in a financial product whose infrastructure is based on blockchain and cryptocurrency.
Though DeFi is still a developing area of finance, one cannot underestimate its attractiveness to investors, whether institutional, high-net-worth or retail, especially with respect to the different innovative solutions on offer. We also opine that it will be complementary to traditional financial services as innovation challenges the way traditional banks and financial institutions operate and offer their services.
As more money is being invested into the development of Dapps and De-Fi protocols, DeFi will become more efficient, easier to use and offer various iterations of financial products which will financially assist individuals and even countries. The future of finance is decentralised and DeFi will only continue to grow.