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Decentralized Finance (DeFi) Challenges Traditional Operating Models

The reliance on central institutions has been a cornerstone of western civilization. As the role of government increased in western democracies, people were able to increasingly outsource trust from individuals over to central institutions that operate under the rule of law. Traditional Finance has been no exception as societies have given monopoly over the control of money and financial services to central banks and its intermediaries. However, new technological innovations are transforming the traditionally rigid financial sector.

The change began with the FinTech (Financial Technology) revolution, when private companies such as PayPal entered the market and changed the traditional dominance of the financial sector by offering faster and cheaper options to consumers.

However, in the wake of cryptocurrencies, an even more revolutionary reform is now coming; DeFi .

DeFi , Decentralized Finance , is another revolution in the financial sector . With the rise of cryptocurrencies, especially with Ethereum, new types of financial services, decentralized financing services, have also rocketed in recent years.

The combined market value of the various DeFi protocols has risen to hundreds of billions of dollars in a couple of years, meaning we are no longer just talking about weekend projects for hobbyists.

In practice, DeFi’s history can be considered to have begun with bitcoin . But because the financial world is much more than just transferring currency from one party to another, a different kind of blockchain innovation was needed that would allow for more complex financial transactions.

Ethereum enters the stage in 2014. Ethereum was the world’s first blockchain platform supporting intelligent contracts, on which it was possible to build various distributed applications. After the creation of Ethereum, innovators began to think about what could be built with this new technology.

One of the first areas to experience the impact of decentralization was the financial sector . Innovators began to build, among other things, decentralized stock exchanges, loan services, derivatives, stable currencies, betting platforms, crowdfunding protocols and even insurance services. Open source protocols accelerated innovation, as each problem only needs to be solved once.

DeFi is driven by a few technological innovations that have emerged with the rise of cryptocurrencies. The most important of these are the block chain as well as intelligent contracts.

Block chain: A block chain is a block of data that, as the name implies, is concatenated to each other so that it is not possible to change the data within the chain without changing other blocks in the chain. The blockchain is an innovation behind cryptocurrencies that enables secure transactions that work without the need for intermediaries, that is, directly from one party to another.

Intelligent Contracts: The term intelligent contract is a bit confusing as it is not actually a contract, or an intelligent one. Simply put, an intelligent contract is a piece of code that is executed under certain circumstances or rules. Intelligent contracts allow for complex transactions that take place automatically.

What these new technological innovations bring are, for example, decentralization, openness, transparency and universal functionality.

Decentralization removes individual vulnerabilities from the system and reduces the control and monopolies of individual actors. DeFi protocols are open to everyone to use, as well as open to participate in development, as they are based on open source code.

Transactions in the block chain are open to everyone, which increases transparency in the system. Transparency makes scams more difficult when, in principle, all activity in the block chain is open to anyone to see.

Overall functionality is also often seen as a strength of DeFi. Universal functionality allows for a smooth flow of value from one protocol to another.

DeFi’s problems are basically the same problems with blockchains and intelligent contracts in general.

Scalability is one of the ultimate problems that must be solved before DeFi and cryptocurrencies can compete with traditional financial services. Regulation in the field is also a big threshold issue, as regulation is ideologically somewhat against DeFi‚Äôs values, but may be necessary to prevent various scams and improve the user experience.

The finality of blockchain transactions can be seen as an advantage in terms of security, but on the flip side, in problem situations, transactions cannot be canceled and no help can be obtained.

Proponents of the most ideal DeFi see its protocols as crippling to traditional central banks and financial institutions and see the financial sector of the future as fully decentralized, free and open. There is still a long way to go to this utopia, but the explosive development of DeFi and cryptocurrencies has also been taken seriously by traditional financial giants.

DeFi has grown rapidly in recent years and the largest protocols are already comparable to traditional banks in terms of market value and volume.

DeFi’s development is also logically tied to the underlying cryptocurrencies and their development. If the trend continues, traditional financial service providers may soon have to rethink their own strategies if, in practice, fully automated DeFi protocols begin to compete against their human capital-intensive companies.

DeFi’s benefits are undeniable, but in order to replace traditional financial institutions, it still needs to address a number of fundamental issues, such as scalability, user experience and regulation.

Chris Crespo
Chris Crespo
Chris is a Co-founder and Chief Editor at Nordic Fintech Magazine, where he simplifies complex financial concepts through jargon-free content, making it easy for anyone to understand. With extensive experience in financial services, including working with some of Europe's largest banks, he brings a wealth of knowledge and insight into the industry. As the former Chief Futurist of the largest bank in the Nordics, Chris has a deep understanding of the Future of Financial Services, the Future of Money, Disruption, and Ethical AI in Finance. He is also a guest lecturer at Stanford University, where he shares his expertise on these topics. As a Behavioural Economist, Chris is passionate about exploring the connections between human behaviour and decision-making under risk, as well as uncovering and communicating the links between psychology, leadership, and technology in financial services.