By Sumantra Banerjee
As blockchain and cryptocurrency continue rising in popularity, one trend emerges on account of its unique applications and implications – the rise of DeFi, or decentralized finance. DeFi involves utilizing blockchain technology to maximize efficiency and reduce transaction costs by substituting costly financial intermediaries with smart contracts. The total value locked in Defi has skyrocketed by 1,887% from $691 million in January 2020 to around $13.73 billion as of November 16.
Total Value Locked in DeFi as of November 16 (Source: https://defipulse.com/)
But what exactly are blockchain and smart contracts? Blockchains are decentralized ledgers that store transactional information. Each block stores a unique “hash code,” and while transactions are publicly recorded on the blockchain, user data is kept private. Since hash codes are changed with each transaction edit, and a network of millions of computers verify transactions, hacking blockchains is quite difficult. Smart contracts are computer code that uses the blockchain network to enable the exchange of anything of value without third party intervention. Moreover, they perform specific tasks through programs known as decentralized applications (Dapps). One such DeFi Dapp involves decentralized exchanges, which enable asset swapping at very little cost through a lack of fund-holding intermediaries.
DeFi is not without its challenges, though. Currently, DeFi projects predominantly run on Ethereum, the second largest cryptocurrency platform by market cap behind Bitcoin. Despite Ethereum’s popularity, digitization of more common assets is necessary for DeFi’s long-term growth. NYU Stern’s Professor David Yermack, who teaches cryptocurrency topics to joint MBA-Law School students, asserts that unlike credit cards, “decentralized networks cannot be used by millions of people in real-time. [The technology] requires so much work that more research is needed to get to the industrial level of volume.”
Professor Hanna Halaburda, who teaches and researches blockchain applications, affirms that despite DeFi showing promise, “we must be careful in seeing who it benefits and who it harms. It could lead to money laundering and terrorist finance.” A joint research effort by BCG Platinion and Crypto.com revealed that DeFi protocols could enable easy money laundering, hindering its trustworthiness to users. Prospective criminal activity may lead to regulatory authorities blacklisting DeFi protocols.
Looking into the long-run, with blockchain rising in popularity, financial and accounting firms may become “coding factories” as employing code auditing and security teams becomes a necessity. Without blockchain-compatible auditing strategies to ensure privacy, firms may risk losing clients. Professor Yermack and Professor Halaburda agree with these contentions, with the former claiming “the audit industry will have to employ much more IT people and train them in very different ways [compared to accountants].” He also hypothesizes that big tech companies, especially Facebook and Amazon, may move into finance within the next decade, a development that “would be great for consumers, but a big challenge for regulators.”
Despite DeFi’s multitude of challenges, its rapid rise, applications, and benefits cannot be ignored. While it may not impact traditional finance in the short-term, DeFi’s growth may engender significant long-term alterations to the status quo.