A portmanteau of “decentralized” and “finance,” DeFi has become a common term within the world of blockchain and web3. Bitcoin and the alternative blockchains that succeeded it aim to decentralize currency (via cryptocurrency). DeFi is aiming to go beyond decentralizing mere currency by doing the same for borrowing, lending, trading, remittances, and other services customarily found in the traditional finance (TradFi) realm of credit unions, banks, and other legacy institutions.
Not to be confused with financial technology (FinTech) apps (Venmo, Revolut, Paypal, Robinhood) that are more closely related to TradFi than DeFi, decentralized apps (dApps) take these same services and decentralize them via blockchain protocols. We’ll be focusing on decentralization (the “De” in “DeFi”) as this is the core distinction between these financial worlds. First, let’s take a look at some of DeFi’s benefits.
Advantages of DeFi over TradFi and FinTech
For many, a key advantage of DeFi is that it is permissionless; this allows you to engage with DeFi without having to ask for permission to send a remittance, get a loan, or send an online payment. With a bank or the FinTech apps mentioned above, you need permission from them to use or access their services. Depending on the needs you have, you may have to provide personal information, go through rigorous Know-Your-Customer (KYC) procedures, or provide evidence that your finances and credit history can satisfy the requirements to receive a loan.
On the contrary, nearly anyone can access DeFi alternatives to these services with only an internet connection, a crypto wallet, and a smartphone (or computer). This allows you to send permissionless payments via a variety of blockchain protocols to anyone in the world. These payments can be big or small (buying a coffee or a house), local or international, and are often much cheaper than remittances and other legacy alternatives.
From the capital controls in Iran—to the banning of USD in Venezuela—to the debanking of Canadian protesters (and many more examples), this permissionless doesn’t seem important until your permissions have been revoked. For those who are victims of financial censorship, having a DeFi alternative has been a pecuniary lifeline for those who have been constrained or banned by the traditional financial system.
Further, this permissionless extends to both borrowing and lending. If you have crypto, you don’t need a bank to get a loan. You can deposit your crypto to immediately get a crypto-collateralized loan through a DeFi protocol that can be paid to you in stablecoins (which can be exchanged for fiat currency if needed). Once the loan is repaid, you get your crypto back automatically. And should you desire, you can also lend out your crypto to get a return on it — allowing you to act as a banking alternative for others. These DeFi rates are often much higher than the rates one would receive from a standard savings account (1-10%+ vs. 0.01-1%, respectively).
Lastly, you can trade your crypto for other crypto and stablecoins via a decentralized exchange (DEX) in a permissionless fashion. In stark contrast, the permissioned FinTech app Robinhood ended up removing your ability to buy Gamestop shares during the GME short squeeze of 2021. This action led many to explore blockchain and DeFi alternatives.
DeFi allows for anonymous or pseudonymous online financial transactions. For proponents, having online financial privacy is a key human right. As an alternative to fiat and legacy payment networks, DeFi allows individuals to be in full control of their finances. Oftentimes, DeFi protocols allow for faster and cheaper payments (and better lending and borrowing rates). While a standard remittance can take days, a crypto payment typically takes from mere seconds to just a few minutes.
This permissionless enables a related feature: censorship resistance. As permission from a third party isn’t required, in concert with the optional privacy, financial censorship measures are largely diminished and less enforceable. As a workaround to restrictive laws and oftentimes burdensome financial sanctions, DeFi is allowing for the free flow of capital around the world. Beyond what some would say are malicious restraints by financial entities or governments, the censorship resistance of DeFi also allows for robust payment networks with little-to-no downtime (depending on the blockchain). Even major credit card networks have intermittent outages that can wreak havoc on developed areas and economies that need online payment functionality or eschew physical cash payments.
The last key benefit of DeFi is trustlessness — meaning you don’t need to trust an individual or financial entity to safeguard your finances. This is made possible via the blockchain. To start, verified crypto transactions are immutable (irreversible and unchangeable) so merchants don’t have to worry about a customer reversing or suspending a payment. More importantly, DeFi protocols allow you to fully control your assets so there is no need to trust an intermediary, third party, or a financial custodian. This removes the counterparty risk that has plagued both TradFi (Bernie Madoff Ponzi scheme, Cyprus bank account levy) and centralized crypto exchanges (CEXs) and services (FTX, BlockFi, Gemini Earn). This third-party risk is why the phrase “not your (private) keys, not your coins” has become a mantra for crypto natives. With DeFi, “If you have your keys, you have your coins.” This means that you maintain full control of your crypto funds—nobody else can touch them.
To reiterate some of the pros above, DeFi typically allows for financial transactions and agreements that are faster, cheaper, permissionless, trustless, more private (anonymous/pseudonymous), and censorship resistant.
Helping the Unbanked — and Unbanking the Banked
Another notable benefit of the DeFi ecosystem is how it is opening up access to key financial services for those in underserved regions or developing countries. A shortage of banking infrastructure—or the proximity to it— n developing countries is one reason why millions around the world still live in largely cash-only economies. Others may lack the financial capital minimums required to open a bank account or are fearful of using them for a variety of other reasons.
DeFi solutions are enabling the unbanked to access crypto payments, crypto savings accounts, collateralized loans, and other DeFi products. These revolutionary solutions allow the unbanked to skip the intermediary step of banking and go from strictly “cash economies” to “DeFi economies” in much the same way that many went from “no phone” to “mobile phone” without the need for an intermediary landline—and the related infrastructure.
For the developed world and banked populations, DeFi is merely an alternative or option that opens up your financial choices. This may allow you to take advantage of the DeFi pros mentioned above—or incentivize the TradFi and FinTech ecosystems to offer better rates, lower fees, and better service to stay competitive and retain customers.
For these individuals, they are “unbanking” themselves by replacing these services (in part or in totality) with DeFi alternatives. For many with pre-existing FinTech apps, checking accounts, and stock market access, DeFi is simply a supplemental paradigm that can be used in concert with TradFi and FinTech offerings.
The Disadvantages of DeFi
There are two sides to every crypto coin (and 6 sides to every block); some see things differently and counter that some of the aforementioned advantages are actually disadvantages. While DeFi allows you to be largely in control of your finances, it comes with issues, risks, and the need for more personal responsibility.
Some lament the ease of use and/or the need for technical crypto knowledge to engage with DeFi. While this has continued to improve, DeFi often lacks dApps that can match the intuitive user interfaces (UIs) and the simple user experience (UX) of FinTech apps and other financial products. This can create a barrier to entry that discourages newcomers from using DeFi products.
The immutability and irreversibility of transactions can create problems — and financial losses. If you were to send a transaction to the wrong address, it is likely that you could lose the crypto contained within that transaction (unless the receiver chose to voluntarily return the crypto). On the contrary, you can often get your bank, credit union, or financial app to reverse a faulty or fraudulent transaction. This lack of a financial backstop for mistakes is one reason many are reluctant to engage with DeFi.
DeFi allows for the possibility of crypto losses through self-custody errors. While “not your keys, not your coins” means your crypto can be safely stored on your personal crypto wallet(s), the flip side of this is “lose your keys, lose your coins.” If you don’t have recovery measures in place (a secondary wallet backup or a recovery phrase) and you lose your wallet or forget its access password, you will lose all the crypto stored on the wallet. Accidentally misdirected transactions and unrecoverable crypto wallets can result in heavy financial losses and have created horror stories for those affected. It is much harder (if nearly impossible) to lose permanent access to your stock portfolio- or bank-related accounts.
The identification of financial parties and their transactions can prevent illegal activities. While some praise the permissionless of DeFi, others are concerned about the lack of KYC and Anti-Money-Laundering (AML) procedures within parts of the DeFi world. This could result in illegal activities that could otherwise be prevented — ranging from tax evasion to human trafficking. DeFi proponents counter that TradFi-enabled fiat payments still account for the majority of these illicit activities.
The last risk is the chance of a hack or smart contract exploit within a dApp or DeFi protocol. Even if you don’t make an errant transaction or lose your crypto wallet (and its holdings), there is still the possibility that you could lose crypto via DeFi. If you send crypto from your wallet to a DeFi project, crypto could be stolen through a black hat hacker exploiting a vulnerability in a protocol, cross-chain bridge, or some other DeFi exploit. Noteworthy examples include The DAO hack, the Ronin bridge exploit, and the Wormhole incident. For those that use DeFi, it’s recommended to use DeFi products that are well established and have been around for some time as the chance of a hack being successfully executed generally tends to diminish over time.
Determine if DeFi is Right for You
If you’d like to experiment in this emergent sector, you could start by using a DEX like Uniswap, Ox Protocol, or QuickSwap. Following that, you could consider exploring more feature-rich DeFi options such as Lido, Aave, Curve, or Compound. They allow you to experiment with lending, borrowing, and staking options within DeFi.
While most would agree that there are both pros and cons to DeFi, opinions can be divided— argely based on one’s philosophical or political leanings. Many that are more traditional or come from the TradFi world would opine about the importance and merits of KYC, AML, trusted financial institutions, and having some sort of recourse in the event of a financially related hack, scam, or other issue. For the crypto native crowd, DeFi is the solution to counterparty risk, financial intermediaries, unbanked populations, the desire to be anonymous, financial censorship, and the financial friction and delays in traditional banking. For those reasons, the decision to stay planted in TradFi, explore DeFi, or use a combination of these distinct financial worlds is generally best left up to the individual, their unique circumstances, and their overall perspective.
Cheat Sheet
DeFi Pros:
DeFi allows for permissionless, trustless, and censorship-resistant transactions.
DeFi enables online financial privacy.
DeFi financial transactions and processes are typically faster and cheaper.
DeFi provides financial services to the unbanked.
DeFi can “unbank the banked” by giving them an alternative way to manage their finances.
DeFi Cons:
DeFi options can be more difficult to use due to the less than optimal UI/UX and/or the need for crypto knowledge.
Accidentally misdirected transactions and unrecoverable crypto wallets can result in lost funds that can’t be recovered.
Hackers have stolen large amounts of crypto by exploiting bugs and vulnerabilities in DeFi protocols; this can result in your funds being stolen.
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Source: https://decrypt.co/resources/what-are-the-pros-and-cons-of-defi-learn
