Ask Chuck: What is DeFi all about?

Dear Chuck,

Can you help me understand all the buzz about DeFi (decentralized finance)? I just don’t get it.

Traditional Boomer 

Dear Traditional Boomer, 

You and I are in the same boat, as traditional boomers! I know enough to be dangerous, so I asked my team to do some research to help us both understand the big picture. This is an important development that we should all be paying attention to. 

What is DeFi? 

Decentralized finance, or DeFi, as defined by Investopedia.com, “is a system by which financial products become available on a public decentralized blockchain network, making them open to anyone to use, rather than going through middlemen like banks or brokerages.” 

Got it? Just joking. We need to dig deeper to understand both the challenges and opportunities. 

Investopedia offers more detail that I will try to simplify. 

“DeFi refers to a system by which software written on blockchains makes it possible for buyers, sellers, lenders, and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction. Thus, a decentralized system can consist of a mix of open-source technologies, blockchain, and proprietary software. 

Smart contracts that automate agreement terms between buyers and sellers or lenders and borrowers make these financial products possible. Government-issued ID, Social Security numbers, or proof of address are not necessary. Regardless of the technology or platform used, DeFi systems are designed to remove intermediaries between transacting parties.” 

Opportunities and challenges 

DeFi offers better interest rates for borrowing and lending, and low barriers to entry compared to traditional banks. Interestingly, DeFi loans are collateralized with other crypto assets. These financial products, mostly run on Ethereum, were worth around $1 billion a year ago but have surged since the pandemic. As a result, the World Economic Forum published a policymaker toolkit here. 

SmartAsset.com reports that DeFi offers the advantage of cost, speed, and security. Some believe hacking would be reduced. 

A major disadvantage is the inability to protect asset values due to market fluctuations. These can be frequent and extreme like Mark Cuban experienced. He was trading a DeFi token that crashed to zero on June 16. Fraud was first suspected, but panic selling and the algorithmic code were blamed. The cost of trading could become expensive due to fluctuating ethereum transaction rates. Weaknesses in the recent technology of DeFi apps (dapps) along with future regulations and tax implications, are additional concerns. 

According to a Bank of Japan-issued review:

Potential benefits of DeFi:

• Increased competition in the financial sector.
• The creation of new financial services.
• Improved accessibility to financial products and services.

Potential risks: 

• Lack of regulation, possibly problematic in the case of leveraged agreements.
• Smart contract failure incidents.
• User protection related complications.

It was noted that “the tamper-proof nature of blockchain networks could work against DeFi in the world of finance—as in extreme cases, a smart contract could trigger a series of ‘meaningless’ automatic program executions that human users would be powerless to stop.”

Be cautious 

Technology that is dependent on coding, value fluctuation, and lack of regulation or insurance are risks for everyone considering this financial platform. Experts recommend thorough research with the reminder to only invest what you can afford to lose. $156 million were stolen in hacks between January and April—more than all of 2020. The Federal Trade Commission says consumers have reported losses of more than $80 million to crypto-investment scams since October. 

Mark Cuban is calling for stablecoin regulation. So are others. Dan M. Berkovitz, one of five commissioners of the Commodity Futures Trading Commission, expressed his concerns in a meeting on June 8. He stressed that the U.S. financial system is strong because of the legal protections investors enjoy when investing in our markets, primarily through intermediaries. 

Summary

My long-term view is that DeFi will likely catch on and become a meaningful alternative to traditional banking systems. Anything that displaces intermediaries has the potential to save time and money. However, it will also move us a step closer toward a cashless society, which I believe is inevitable. Remain cautious, and before investing, remember to seek lots of advice. 

“…in an abundance of counselors there is safety.” (Proverbs 11:14b ESV)

Before diving into the DeFi space, if you need help getting your traditional credit in order, Christian Credit Counselors is a trusted resource that seeks to free individuals and families from credit card debt.