Decentralized finance - the “Wild West of Crypto” – and what it means for the future of money

While the hysteria over NFT’s (non-fungible tokens) continues, a new blockchain-based form of finance called decentralized finance or DeFi has caught the attention of everyday consumers and Wall Street veterans alike.

Merav Ozair, a FinTech professor at Rutgers Business School and leading expert on blockchain and cryptocurrency, says DeFi has lowered access barriers to financial services where everyone can access economic activities – like high-yield savings, trading, lending or insurance – without a bank account or a credit check.

Ozair demystifies decentralized finance – aptly called the “Wild West of Crypto” – and what it means for the future of money.

What is decentralized finance and how is it different from traditional finance?

DeFi takes complex financial services and products traditionally offered by legacy financial institutions and codes them to enable self-executing services. These are automated, self-executing products and services where users directly interact with the application without interfering with third parties like banks, insurance companies, agents, exchanges or brokerages. DeFi applications utilize blockchain technology and thus is a peer-to-peer system that can be accessible to anyone and anywhere. The benefits include a 24/7, instant service with little to no cost.

Think of it as a vending machine of banking services. A vending machine is an automated, 24/7, no-cost service with zero intermediary interactions. But because every activity in the economy is transaction-based – be it retail, gaming, technology, social media – DeFi applications can go beyond financial services and connect the virtual world with the physical by integrating with the services or products we use.

But what’s wrong with our “normal” banking systems?

DeFi has the potential to democratize financial systems, making it possible for anyone to access financial services, especially those in underserved communities who either do not (e.g., those who live in remote areas) or cannot (e.g., those who are unemployed or have criminal convictions) have access to financial institutions. There is no controlling organization dictating when and if a person can make a transaction. DeFi is a member-user consensus system that incentivizes good behavior and penalizes bad “actors.”

Since there is no go-between, transactions are instantaneous and costs diminish because there’s no need for clearing and settlement processes. Therefore, it can solve settlement delays and high-cost problems like in the GameStop and Robinhood saga, which resulted in severe losses to traders and a $70 million fine to Robinhood for misleading customers. 

What are the risks and what should beginners know? 

Bear in mind that DeFi is a software application. Thus, it can have issues or “bugs,” which is the embedded technology risk of any software. Many botched DeFi projects have been launched with unaudited code, resulting in losses like the YAM code bug disaster. The industry will likely self-regulate itself in the future to audit any application before uploading it to a blockchain.

The crypto market is also very illiquid. Every small quantity of “buy” or “sell” of these assets may hugely impact their value. Billionaire Mark Cuban made it known he is not immune to risk when he traded a DeFi app that crashed in one day. He later admitted to Bloomberg, “Even though I got rugged on this, it's really on me for being lazy. The thing about DeFi plays like this is that it’s all about revenue and math and I was too lazy to do the math to determine what the key metrics were." 

It’s essential to engage with a reputable and transparent product like you would with any other. One of the fundamental features of blockchain technology is transparency. Thus, if developers of a DeFi application prefer to remain anonymous — like the botched protocol Harvest Finance developed by an anonymous team — that should raise a red flag about its trustworthiness or whether it may be a scam.

What does the future look like for DeFi? 

Exciting times ahead! In the foreseeable future, financial and economic services will run on distributed ledger technology – a decentralized database managed by multiple members and users with no central administrator. Think about it this way – if financial systems and applications are the trains, then distributed ledger technology is the rails.

Banks and economic activities will be automated, run by codes and algorithms with no human interactions (e.g., “self-driving banks” like self-driving cars). In the age of economy-of-things, where machines can talk to each other, DeFi will enable every product or service to become autonomous. The concept of embedded finance – integrating financial services with a traditionally non-financial service or product – will be significantly enhanced.

An example of an existing embedded finance service is an online store like Amazon, which offers a “buy now-pay later” option that converts a purchase into an automatic loan from a third-party lending institution. But what if your Peloton offers you “rewards tokens” as an incentive for your cycling workout, and you can then send these tokens from your Peloton to pay for your loan? DeFi can enable such a scenario and will play an integral role in the Metaverse universe evolution. Of course, all DeFi products and services must be compliant, secure and appropriately audited and monitored to ensure users’ security and privacy. Blockchain technology can enable that as well. 

This Q&A was originally published in Rutgers Today. It was done by Megan Schumann from Rutgers University's Office of Communications.