Beyond banks and brokers: All about decentralized finance (DeFi)

Open full sized image

Peer-to-peer finance bypasses the traditional outlets.

© Andrii Yalanskyi—iStock/Getty Images

If you can imagine sending money, making a payment, or buying a financial asset without the assistance of a bank, brokerage, or other official intermediary, then you’ve grasped the essence of decentralized finance.

Decentralized finance—or DeFi for short—is an emerging digital ecosystem that allows people to send, purchase, and exchange financial assets without relying on banks, brokerages, or exchanges. DeFi sidesteps the traditional pathways to making financial transactions.

DeFi’s emergence may be quite significant. It doesn’t merely point to a new form of financial tech on the horizon; it promises a new financial horizon altogether.

As a potential investor, you probably have lots of questions:

If you’re considering jumping in, you’ll need some basic insight into this emerging space.

Decentralized finance may not add much that’s new in the way of financial products. But if it takes off, it could revolutionize the way we exchange financial products. Still, why fix a system that’s already efficient and functionally safe—in other words, why fix what ain’t broke?

Banks and financial institutions can help you transfer funds from one place to another, but the route isn’t direct. There’s often a chain of third-party service providers assisting in a single transaction. Not only might this chain slow down a given transaction, but each provider also charges service fees. And because you’re relying on third-party services (each one subject to human error, technological glitches, hardware malfunctions, and security breaches), none of them is 100% secure.

Individuals and businesses are always looking for a faster, safer, and more economical way to make peer-to-peer (P2P) financial transactions. What DeFi has to offer goes well beyond an incremental improvement (as opposed to, say, the advent of the automated teller machine or direct deposit). It promises innovation that’s unachievable using traditional systems and technologies.

By building a financial system on a blockchain-based network, and eliminating the go-betweens, transactions can be more direct; service fees can be largely eliminated; and asset transfers and exchanges can be made virtually tamper proof.

Blockchains are digital ledgers that are shared and updated by all participating computers (aka nodes). All transactions that go into a blockchain are verified by select nodes participating in the network. All blocks are encrypted, and once they’re closed, the contents of the block are permanently sealed and cannot be changed. Any attempt at altering the contents of a block will alert all computers on the network (which can number in the high thousands). This is what makes a blockchain virtually impenetrable and safe.

Comparing this to today’s financial system, even the most efficient, price-competitive, and secure banking processes can’t offer these benefits at the level that a blockchain network can—or so say blockchain proponents.

DeFi can do one better. Because it utilizes the blockchain, individuals and businesses can transact other asset types that aren’t accessible through traditional financial means, such as smart contracts and non-fungible tokens.

Overall, DeFi offers users more control over their money. Financial assets can be transferred or purchased in a matter of seconds or minutes. Service fees would largely be abolished, as there would be no third-party companies assisting with transactions. Your money would be converted to a “fiat-backed stablecoin” and made accessible via digital wallet so you wouldn’t have to deposit funds into a bank. And because bank accounts will no longer be necessary, almost anyone with an Internet connection can have access to the same financial goods and services.

The biggest risk is that DeFi is unregulated. There is no FDIC backing (nor that of any other regulatory entity) to protect your funds should a major glitch, error, or cyber hack make your funds unavailable or cause them to disappear.

Also, the technology is so new that there’s no unified or comprehensive way to determine whether any part of a DeFi system is operating at optimal capacity or is free from scams. In theory, each technological component in a DeFi ecosystem should operate in a fast, efficient, and secure manner. In practice, however, it’s still untested.

The easiest and safest route would be to invest in stocks of companies that are involved in DeFi development. However, many of these companies are new and operate in the cryptocurrency space, making them quite a bit more speculative and volatile than better-established companies in mature industries.

Investors can also stake cryptocurrency to invest in a DeFi operation’s blockchain ecosystem. Staking allows crypto holders to support a coin’s blockchain network by locking up coins to validate new blocks for a transaction. If your stake is chosen in the validation process, you can earn income in the form of more cryptocurrency. A more advanced version of this type of investing is called yield farming, which involves lending cryptocurrency to a DeFi platform or operation in exchange for interest or additional cryptocurrency.

The biggest risk in the DeFi space, again, is the absence of regulations to protect your money. This leaves you vulnerable to scams and theft. Because DeFi is an emerging industry, you run the risk of investing in a project that could fail. Plus, the cryptocurrency markets are highly volatile and complex, making it difficult to gauge both the market and industry. In addition, technology glitches, high energy consumption, hardware malfunctions, and even system maintenance and upgrades all contribute to DeFi’s risk factors.

In this regard, DeFi is similar to the bond market. Bonds with the highest risks offer higher rates of return as compensation for that added risk. But if the issuer defaults, you could lose your money.

When it comes to emerging industries, early investment can often bring outsize returns. But it’s important to understand the risks, which can equal or outweigh the potential returns. Decentralized finance may one day disrupt banking as we know it. But if and until it does, the DeFi space will be rife with uncertainty and speculation. Proceed with caution.