What is Decentralized Finance & Risks Involved in it? 

(DeFis & Risks)

DeFi : Decentralized Finance 

During the early stages of crypto development, there used to be Bitcoin only. Then general perception about crypto was that crypto does nothing, it’s a place of gamblers. 

Even I remember about myself when during 2012, I was in a book fair at Pragati Maidan in Delhi to buy some books. I saw a book ‘Bitcoin – Profit Making Strategies’, but i did not buy even though I am addictive to books. The reason of not buying was that Bitcoin is for gamblers.

But now, with the development of DeFis – people stopped saying such things.

What is Decentralized Finance? 

Basically, it’s system of finance where various players from finance world participates. Such players may be like banks(lenders/borrowers), pooled entities, providers of financial instruments/negotiable instruments, entire space connected to finance companies, etc. 

As on date the entire finance world is associated with the centralized agencies in various ways of one or another like licensing system etc. 

Let’s assume, if the entire finance world comes on decentralized platform where there is no boss/controlling central authority  like in case of bitcoin, then this finance world will become DeFi (Decentralized Finance). 

DeFi is Technology : 

It’s a huge accomplishment stage where we are moving towards removing central authority from the finance system in various ways. This achievement is getting possible with the help of technology which I would better say marvel technology i.e. Blockchain technology. 

DeFi is a technology. Underlying architecture to DeFi is blockchain technology. We need to have token to power DeFi . We need to have layers in blockchain where blocks are written, multiple ledgers are required in distributed form, etc.  All these things in altogether make DeFi as technology. 

It’s a system of financial products written on blockchains enabling buyers, sellers, lenders, and borrowers to interact.

DeFi is a Movement. Why DeFi is a movement? 

If we talk about traditional finance system, then already we have banks like HDFC, ICICI, SBI, JP Morgan, Bank of America etc. and other financial institutions at micro/macro level both. Now the question is if already we have settled & approved finance system in place, then why we need DeFis?

Whenever new innovation comes in place, that is for something better so that existing work can be done in an improved & better way. DeFi is an alternate to the existing traditional finance system for betterment. Like in the past, lot of other movements were there in the world like privatisation, policy of less govt. interference etc. Same way DeFi is a movement in the space of finance world. 

I will use two words – Disintermediation and Decentralization.  

Disintermediation :

There is no middleman in the DeFi. Finance provider and user is connected with each other without any intermediary but with technology of blockchain.

Decentralization : 

Removal of central authority from the finance system is decentralization. 

This is something like we remove the C.E.O. of a company. Then how the system will run without head of the system?

Decentralized DeFi system is run on the voting mechanism where stake holders are vested with the power to vote and decisions are taken as per voting by majority in the system. Such voting mechanism is built with in the system and system is controlled by the such voting mechanism. 

Total valuation of the entire DeFi developments till date has been valued up to approx. USD 60 billion which is very small at present in compare to the traditional finance system. In India, one bank like HDFC is valued at approx. USD 160 billion. But there is exponential growth in DeFi in the world which is going to explode in the near future.  

Risks of DeFis

DeFi is very interesting available alternate to centralized finance system. 

Of course DeFi is very interesting movement/technology development  over centralized finance but huge risks are also involved with DeFis. 

Some of the risks are to DeFis and some are in to the traditional finance system.

Big four risks in DeFis are : 

Technology Risk : As I said earlier that DeFi is technology. Applications of DeFi are usually written in computer codes which are sometimes independent codes or written on other platforms using the open sourced codes available on open source platforms which are used by everyone . In such a case, such programs written in coded language are at the risk of hacking, bugs, different types of errors, etc. This is also true that technology of any type is at such risks of hacking, bugs etc. like in traditional finance is net banking, online transfers, e-commerce payments, etc. Anybody can steal your money in illegitimate manner either from centralized finance or DeFis. But DeFi is new ecosystem of finance world, thats why DeFi is at high risk because of it’ under development stage. 

Collateral Risk : One risk was the technology risk of the technology of DeFi with in itself, another risk is with the crypto assets running at the DeFi system. Risk with such crypto assets may be in regard to their technology like technology of USDT, technology of any native token of the DeFi, technology of other crypto assets lying in the wallets at such DeFis, etc. OR it can be valuation risks of such mentioned underlying crypto assets like there may be down or upside movement in the market value or value pegged to such assets like stable coins, etc. Possibilities are there that contractual obligations may be denied by the participating parties at the time of maturity due to such mentioned risks.  Good examples are derivatives/margin contracts which need performance at the time of maturity, but market players may abandon the contract rather than fulfilling it due to heavy fluctuations in the valuation of underlying assets.

Such risks are called as collateral risks.   

Product Risk : More than 100 types of products are there as on today in DeFis. Majority of the DeFi products are transacted on the basis of their price predictions which is something related to price prediction of bitcoin after one month or share prices in stock market, etc. In DeFis, problem in regard to prediction is much more because crypto assets are priced differently at different crypto exchanges which are not connected to any single uniform price mechanism which means price at one exchange can be different from the price at another exchange. Such product risks are actually the oracle problems, which means prices are being derived from the data sourced from external sources. Non-orcale problems also can be there like flaw in the logic of the program written for the underlying asset.

Such risks are the product risks. 

Regulatory Risk : It’s related to the regulating the conduct of someone/something or DeFi or traditional finance world. In traditional finance, there is regulation of getting license for operating a bank/non-bank finance entity, etc. In DeFis, as on today there is no such regulation of getting license to operate crypto bank under DeFi. Certain countries have different types of mechanism in place for regulation of DeFis but such are voluntary. It may be possible that today you start operating any financial entity under DeFi without license from the regulator and after sometime regulator comes in and ask you why you are operating business of financial transactions when I have not licensed you to do this. Similar type of situation arose with Ripple’s XRP in USA by SEC, the financial watchdog of USA. I know one crypto bank ‘CASAA’ which has taken licenses from various regulators in UK/Europe, etc.

Crux of the story is that we should be aware about various types of risks involved in DeFis and their products.