Michael Kodari is the Founder and CEO of Kodari Securities (KOSEC), a leading provider of investment services.
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The term DeFi, which is short for decentralized finance and purposefully sounds like the word “defy,” was coined in 2018. Despite being around for only a handful of years, this alternative global financial system built on public blockchains like Bitcoin and Ethereum has ballooned in size and diversity since its inception. Could DeFi transform legacy 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 taking on the centralized banking and finance sector. Unlike traditional finance, where a company, bank or fund is responsible for your money, with DeFi, only you, the investor, are responsible. It uses a combination of existing blockchain-related technologies like digital assets, wallets and smart contracts to create a financial ecosystem primed to bypass banks, brokers and exchanges—basically, anybody or anything that traditionally manages and processes financial services.
For many people, this is hugely appealing: By removing the so-called “middlemen,” DeFi bestows a higher degree of efficiency. Put simply, DeFi offers a way to earn profits with a fraction of the investment that would otherwise be needed. At the same time, it lends itself to greater transparency for financial transacting while democratizing access and ownership, helping the estimated 1.7 billion people globally who are unbanked.
DeFi’s Pros And Cons
Despite its swift rise to fame, DeFi technology is still in its infancy. It hasn’t had years of stress-testing at scale to sort out issues. That means funds could be lost or put at risk. And DeFi has been thriving in the absence of rules and regulations, which means there’s a lack of consumer protection.
Blockchain ledgers have also raised questions about illegal activity. A DeFi protocol could present as a platform where dubious financing could occur with no central authority to vet against it. For example, in August 2021, sophisticated hackers exploited smart contract vulnerability, nabbing $610 million from the DeFi platform Poly Network. Fortunately, all funds were returned this time, but that might not always be the case.
Apart from being the new kid on the block and the resulting issues surrounding security and legal compliance, DeFi has a lot going for it. As stated previously, it’s permissionless and inclusive. Transactions are in real time, and they’re transparent. Smart contracts are highly programmable. Yet despite its numerous benefits, traditional finance issuers 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 to the future of finance—one that ensures regulatory malpractice can be rooted out. A Gartner analyst predicted back in 2020 that DeFi would soon go mainstream. While DeFi and legacy financial institutions might seem like opposing forces, I believe that together, they can be transformative.
The Best Of Both Worlds
Disruption in the world of finance isn’t going away anytime soon. The fast pace of technological innovation has that effect. Navigating this breakneck pace takes agility and open-mindedness, as well as big-picture thinking. Take blockchain, for instance. Initially, banks were skeptical to adopt. Now, a number of major banks are investing in crypto and blockchain-related companies.
DeFi faces this same scenario. As traditional financial institutions begin to realize that DeFi is here to stay, they can get on board, implementing this technology into their existing frameworks. ING Bank presents a great example of the potential for collaboration in this space. The Netherlands-based bank recently analyzed the risks and opportunities associated with DeFi, penning a report called, “Lessons Learned from Decentralized Finance.” After researching the pros and cons, ING Bank concludes that the “best of both worlds is achieved if centralized and decentralized financial services cooperate.”
What would this cooperation look like? For one thing, centralized financial institutions should embrace innovation and move away from their risk-averse mindsets. They must proactively contribute to developing regulations, ensuring DeFi’s key advantages are maintained.
At the same time, legacy financial institutions can begin offering DeFi services to the unbanked and underbanked. Providing consumers greater access to the blockchain ecosystem through their existing banking services could help close the Micro, Small and Medium Enterprises (MSMEs) finance gap.
If the blockchain principles that DeFi relies on become fused within the global financial architecture, we might see benefits like faster international transactions, opportunities to make money work harder and simpler access to lending.
A Future-Proofing Opportunity
The modern landscape has shaped a new kind of consumer, and legacy financial institutions must evolve as well. Financial institutions must put the customer at the forefront, laying the groundwork now to provide personalized, flexible, and simplified offerings. For inspiration, they can look to banking giants like Morgan Stanley and Goldman Sachs who have already begun paving the way for this modern, synergistic ecosystem of finance.
DeFi innovation is ripe for opportunity, opening the door to new and better ways to serve customers. Instead of taking down centralized banking, DeFi might very well be the thing that future-proofs it.
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