24th June 2024

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The Opportunities And Risks Of Decentralized Finance

What opportunities and risks does DeFi (Decentralized Finance) pose for the future of banking? originally appeared on Quora: the place to gain and share knowledge, empowering people to learn from others and better understand the world.

Answer by Agostino Capponi, Professor at Columbia University, on Quora:

Imagine a world where financial transactions occur without middlemen. Typically, user transactions involve brokers, banks, or mutual funds that offer these services in exchange for fees.

The emergence of blockchain technologies has the potential to redefine banking as we know it. DeFi, namely the offering of financial services on blockchain, aims at replacing financial intermediaries with smart contracts—computer programs on the blockchain serving as the sole interface for users, and automating all financial services from asset purchases to derivative trading, insurance procurement, and lending operations.

Could DeFi shape the future of finance? Decentralization holds the promise of reducing costs of financial services compared to traditional intermediary fees. The DeFi infrastructure supports a democratized environment, allowing anyone to offer or access financial services with minimal barriers to entry. Nations with unstable monetary systems or limited trust in their local intermediaries, such as Lagos and Kenya, are expected to benefit greatly from DeFi solutions. Leveraging DeFi for price discovery, these nations could make profits from exporting valuable rare-earth mineral commodities that might otherwise remain under-monetized.

Should we all jump on DeFi? The promises are compelling, yet the risks should not be underestimated. Smart contracts are susceptible to hacking and cyberattacks. Decentralization is typically paired with anonymity, leaving users with limited legal recourse in the face of attacks or illicit behavior. But, when there are technological risks, there is also hope for technological solutions. Computer scientists can expand comprehensive testing and code audits, initially developed for centralized systems, to manage decentralized verification of smart contracts. By reliably identifying potential bugs before deploying smart contract code onto the ledger, it will be possible to raise trust in this technology and move towards widespread adoption.

What might the future with DeFi look like? While DeFi holds the key to an inclusive financial system, free from the clutches of centralized authorities, it is still in its infancy. The journey ahead requires rigorous research, particularly in scaling blockchain technologies, enhancing the interoperability of DeFi protocols, and ensuring smart contracts are as airtight as a bank vault. My envisioned future most likely involves decentralized finance complementing, rather than replacing, centralized finance (CeFi). We will all decide whether to provide or seek a financial service in CeFi rather than DeFi based on our appetite for risk, market conditions, economic outlook, transaction costs, and trust in the technology. It is not just a technological evolution, but a financial one, and it will take the collective effort of innovators, regulators, and users to forge a path ahead that complements rather than replaces the current banking system.

For more details on our research on this topic:

Capponi, Agostino and Iyengar, Garud and Sethuraman, Jay, Decentralized Finance: Protocols, Risks, and Governance (December 2, 2023). Foundations and Trends® in Privacy and Security, Vol 5, Issue 3, 2023 , Available at SSRN or DOI.

This question originally appeared on Quora – the place to gain and share knowledge, empowering people to learn from others and better understand the world.