6 min read · Jul 12, 2022
Decentralized finance has a significant impact on how banks function and introduces changes to the overall financial ecosystem. There are currently numerous different critical perspectives regarding decentralized finance for the right reasons. Some view DeFi as a revolution, whereas others view it as an opportunity, and yet others view it as a swindle.
Therefore, an impartial view of the world of DeFi could provide a comprehensive understanding of their role within the financial system as a whole. Let’s examine the advantages and disadvantages of decentralized finance in the following section. With a thorough examination of the advantages and disadvantages of DeFi, readers might determine the true potential of DeFi.
DeFi is an acronym for decentralized finance, which is what the name means. To put it another way, it’s a collection of blockchain-based applications that provide alternatives to traditional financial services.
The financial sector has been instrumental in promoting a number of prominent blockchain application cases. Online payments and the selling of virtual assets are just two of the many ways that blockchain technology has the potential to revolutionize traditional finance. The use of blockchain in finance has become more prominent since the introduction of DeFi.
Pros and cons of DeFi
As mentioned above, there are several significant competing perspectives surrounding DeFi. It is viewed as a revolution, an opportunity, and occasionally a scam. Currently, there appears to be an increase in the number of skeptics, as the value of bitcoin falls along with the value of many DeFi crypto-tokens. Let’s analyze some of the significant advantages and disadvantages of DeFi.
There is no single organization or group to blame; yet, the world has recently witnessed financial crises due to the central banks and middlemen who continue to regulate the cash flow.
Mismanagement on the part of central banks (CBs) and other third-party intermediaries was largely to blame for the occurrence of financial crises (TPIs). Smart contracts, on the other hand, eliminate the potential for human error in the day-to-day operations of the process; that is unless the contracts themselves were drafted in an unclear manner.
This of course also means that the smart contracts developed in DeFi must be error- and bug-free in order for the protocols to work as intended. Doing extensive software audits and penetration tests to ensure security are crucial in DeFi.
Utilizing encryption in conjunction with consensus techniques such as proof-of-work and proof-of-stake has enabled blockchain to achieve true immutability. Therefore, the benefits and drawbacks of decentralized finance have permitted the genuine advantages of immutability in finance.
What this means is that the records, once they’re in the blockchain, cannot be corrupted. This removes the potential adverse effects of bad actors and human mistakes that are sometimes found in traditional finance.
By virtue of immutability, it is impossible to alter any blockchain network record. In addition to the characteristics of decentralization, immutability provides a potential guarantee of security. Intriguingly, the immutability capabilities of blockchain safeguard the integrity of DeFi systems when conducting financial transactions.
Transparency is one of the most remarkable contributions of DeFi. Besides its immutability, DeFi also provides transparency through the openness of blockchain data, which can be viewed by anyone at any time. Clearly, decentralization involves greater openness, and the distributed ledger contains information about all blockchain network operations and transactions.
The cryptographic principles behind blockchain also ensure that information is only recorded after its validity has been verified. This prevents double-spending and misuse.
The growth of peer-to-peer lending and borrowing solutions has been significantly aided by DeFi, which has been a prominent player in the process. These forms of loan and borrowing solutions offer a considerable number of features that are quite promising for end-users.
Before DeFi, to receive a loan, you had to physically go to a bank, where you would spend a significant amount of time. Even in the middle of the night, if you have DeFi, you can receive a loan with only a few clicks. As long as you have access to the internet, the market is available to you at any time and from any location you choose.
Tokenization is one of the noteworthy concepts that have lately surfaced in the blockchain community. Ethereum delivers extensive capabilities for smart contracts, paving the way for the issuance of crypto tokens. Essentially, crypto tokens function as digital assets available on a blockchain, with varying capabilities and applications. Tokens include utility tokens specific to a particular decentralized application (dApp), real estate tokens, and security tokens, among others.
Tokens are capable of facilitating several functionalities. Real estate tokens could provide fractional ownership of a particular real estate. Alternatively, security tokens could potentially serve as digital shares in particular applications. Most importantly, tokenization could also improve access to other assets, both physical and digital.
Undoubtedly, DeFi projects can facilitate financial inclusion for a larger population. Nonetheless, DeFi initiatives face tremendous challenges with respect to the scalability of the host blockchain.
Notably, the confirmation of DeFi transactions takes up a long time. Concurrently, transactions using DeFi protocols may become prohibitively expensive during periods of congestion.
However, this only applies to certain blockchains such as Ethereum. For instance, Ethereum might demonstrate the ability to perform nearly 13 transactions per second at full capacity whereas the centralized counterparts could allow thousands of transactions throughout the relevant time period.
On the bright side, these disadvantages of Ethereum are changing with the introduction of Ethereum 2.0 and proof-of-stake. We could say that the problems are actively being solved.
Liquidity is another essential component that must be considered for blockchain-based initiatives and protocols. As of June 2022, the total value locked (TVL) of all DeFi projects sits at just over $79.8 billion. Therefore, it should come as no surprise that the market for decentralized finance is not nearly as large as that of conventional financial systems. Thus, placing your confidence in a market that does not have nearly as much liquidity as the conventional financial market might be challenging. However, this issue should improve as DeFi gains more mass adoption.
The fact that users have to share responsibility for maintaining the network is one of the many aspects of DeFi that users find to be problematic. The DeFi projects will not accept responsibility for any errors made by contributors. The only thing they do is get rid of the middlemen, thus it is up to the users to be responsible for their own money and property. As a result, the DeFi space requires the utilization of the right tools that can eliminate the likelihood of errors and blunders caused by humans. DeFi can be powerful and replace many aspects of traditional finance by giving the power back to users, but with great power comes great responsibilities.
Nonetheless, a promising future ahead for DeFi
Decentralized finance’s pros and cons have been the most important factors in deciding its current value. However, the advantages of DeFi outweigh the disadvantages, as can be seen from the comparison of the two sides. The conventional benchmarks of financial services are poised to be transformed by decentralized finance, which has quickly emerged as a promising technology.
DeFi, most importantly, has the potential to encourage the use of blockchain in the financial sector. Scalability can still be an issue for DeFi, despite the benefits of transparency, immutability, and decentralization.
