What Are the Pros and Cons of DeFi?
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…
DeFi is a combination of "decentralized" and "finance," and has become a popular term in the world of blockchain technology and web3. Bitcoin and other blockchains that followed it seek to decentralize currencies (via cryptocurrency). DeFi aims to do more than decentralizing currency. It will also provide services such as lending, trading and borrowing.
Decentralized apps (dApps), which take the same services but decentralize them using blockchain protocols, are not to be confused with financial tech (FinTech), apps (Venmo. Revolut. Paypal. Robinhood). As this is the main difference between these financial worlds, we will be focusing our attention on decentralization (the "De" in "DeFi") Let's first look at DeFi's advantages.
DeFi's key benefit is its permissionlessness. This allows you to use DeFi to communicate with your bank without needing permission to send money, request a loan or make payments online. You need to have permission from the bank or FinTech apps you mentioned above to access or use their services. You may need to give personal information or go through Know-Your Customer (KYC), depending on your needs.
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Nearly anyone can access DeFi alternatives with an internet connection, a cryptocurrency wallet and a smartphone or computer. You can send any number of blockchain protocols, permissionless, to anyone around the globe. These payments can be large or small (buying coffee or a house), and they are often cheaper than legacy remittances.
This permissionless isn't important until you have your permissions revoked. A DeFi alternative is a financial lifeline for those who have been restricted or banned by the traditional financial systems.
This permissionless also applies to borrowing and lending. After the loan has been repaid, your crypto will be returned to you. You can also lend your crypto out to receive a return, allowing you to serve as a bank alternative to others. These DeFi rates are usually much higher than those one would get from a standard savings account (0.01-1% respectively).
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Finally, your crypto can be traded for stablecoins and other crypto via a decentralized Exchange (DEX), in a permissive fashion. Robinhood, a permissioned FinTech app, ended up closing your ability to purchase Gamestop shares in the GME short squeeze of 2021. Many people began to look into DeFi and blockchain alternatives after this event.
DeFi permits anonymous or pseudonymous online transactions. Proponents believe that online financial privacy is an essential human right. DeFi is an alternative to legacy and fiat payment networks. It allows individuals to take full control over their finances. DeFi protocols can often be faster and more affordable than traditional payment methods. They also offer better borrowing and lending rates. A standard remittance can take several days. However, a crypto payment takes only seconds to a few minutes.
This permissionless feature allows for censorship resistance. Financial censorship measures that require permission from third parties are not required. This, along with the optional privacy, makes them less effective and less enforceable. DeFi allows capital to flow freely around the globe as a way of avoiding restrictive laws and sometimes burdensome financial sanctions. DeFi's censorship resistance allows robust payment networks to operate with minimal downtime, allowing them to avoid what some might call malicious financial restraints or government intervention. Even major credit card networks can experience intermittent outages which can cause havoc in developed countries and economies that require online payment functionality.
Trustlessness is the last benefit of DeFi. This means that you don't have to trust anyone or any financial institution to protect your finances. Blockchain makes this possible. Verified crypto transactions are immutable, which means they can be reversed or suspended by customers. DeFi protocols make it possible to control all your assets. You don't need to trust any intermediary, third-party, or financial custodian. This eliminates counterparty risk, which has plagued TradFi (Bernie Madoff Ponzi Scheme, Cyprus bank account levy), and centralized cryptocurrency exchanges (CEXs), and services (FTX BlockFi, Gemini earn). For crypto natives, the mantra "not your (private keys), not your coins" is a way to avoid third-party risk. DeFi allows you to have your keys and your coins. This means you have complete control over your crypto funds and no one else can.
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.
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The DeFi ecosystem also has the notable advantage of allowing people in developing and underserved countries to access financial services. Millions of people around the globe still live in cash-only economies due to a lack of infrastructure for banking services or its proximity. Others might not have the required financial capital or be afraid of opening a bank account for any other reason.
DeFi solutions allow the unbanked access to crypto payments, crypto savings accounts and collateralized loans. These innovative solutions enable the unbanked skip the intermediary banking step and move directly from 'cash economy' to "DeFi economies" in much the same manner that many people went from a 'no phone to a'mobile phone', without the need to have an intermediary landline or the associated infrastructure.
DeFi is not an option or alternative for the banked population and developed world. This could allow you to take advantage the DeFi pros outlined above, or incentivize TradFi/FinTech ecosystems offer better rates and lower fees to retain customers.
These individuals are "unbanking" themselves by replacing their existing services with DeFi alternatives. DeFi can be used as a supplement to TradFi or FinTech offerings for many who have pre-existing FinTech apps and checking accounts.
There are 2 sides to every cryptocurrency coin and 6 sides to each block. Some people see the advantages differently while others counter that some of these disadvantages are actually benefits. DeFi is a way to have greater control over your finances. However, there are risks and more responsibility.
Many people lament the difficulty of using DeFi and/or the need to have technical crypto knowledge in order to use it. This has improved, but DeFi still lacks dApps capable of matching the user interfaces (UIs), and simple user experience (UX), of FinTech apps and other financial products. This can make it difficult for new users to use DeFi products.
Transactions' immutability or irreversibility can cause financial problems. You could lose any crypto contained in a transaction if it was sent to an incorrect address. You can, however, often get your bank or credit union to reverse a fraudulent or faulty transaction. Many are reluctant to use DeFi because they lack a financial backup in case of mistakes. Self-custody errors can lead to crypto losses. DeFi makes it possible. Your crypto can be stored safely on your personal crypto wallet(s), but this does not mean that your crypto will be lost. If you do not have any recovery measures (a secondary wallet backup, a recovery phrase or a recovery key) for your wallet and lose it or forget the access password, all crypto on it will be lost. Unrecoverable crypto wallets and misdirected transactions can lead to financial loss and horror stories. Permanent access to your bank accounts or stock portfolio is difficult, if not impossible.
This could lead to illegal activities that could be prevented, ranging from tax evasion and human trafficking. Proponents of DeFi counter that TradFi enabled fiat payments still account the bulk of these illegal activities.
Last but not least, there is always the possibility of a smart contract exploit or hack within a DeFi protocol or dApp. Even if there are no errant transactions or a loss of your crypto wallet and its holdings, you can still lose it via DeFi. Black hat hackers could steal crypto from your wallet to DeFi projects by exploiting a protocol flaw, cross-chain bridge or other DeFi exploit. Notable examples are the DAO hack, Ronin bridge exploit, or Wormhole incident. DeFi users should use products that have been around for a while. The chances of a hack succeeding decreases over time.
You can experiment in this emerging sector by starting with a DEX such as Uniswap or Ox Protocol. You could then explore more feature-rich DeFi options like Lido and Aave, Curve or Compound. These options allow you to explore lending, borrowing and stake options within DeFi.
Although most people would agree that DeFi has pros and cons, opinions may differ based on political or philosophical leanings. Traditionalists and those who are from the TradFi community would argue about the merits and importance of KYC, AML and trusted financial institutions. They also need to have a plan of action in case of any hack, fraud, or other financial issue. DeFi is the answer to financial intermediaries, counterparty risk, unbanked population, anonymity, financial censorship and financial delays in traditional banking. It is best to leave the decision of whether to explore DeFi or stay in TradFi up to each individual and their particular circumstances.
DeFi permits for trustless, permissionless and censorship-resistant transactions.
DeFi allows online financial privacy.
Financial transactions and processes with DeFi are usually faster and more affordable.
DeFi offers financial services to the unbanked.
DeFi is able to 'unbank' the banked by offering them an alternative method of managing their finances.
The less-than-optimal UI/UX, and/or the requirement for crypto knowledge can make DeFi options more difficult to use.
Inadvertently misdirected transactions or unrecoverable cryptocurrency wallets could result in funds being lost that cannot be recovered.
Hackers have taken large amounts of crypto through exploiting bugs in DeFi protocols. This can lead to your funds being stolen.