What is Decentralized Finance?

What is DeFi?

DeFi is the short-hand term used for Decentralized Finance. As the name implies, DeFi represents a financial system that is not centralized around an entity or institution, opposing that system which we see with the typical Centralized Finance in our economy which is centered around an institution such as the Federal Reserve or the SEC. This sort of system is instead distributed in nature, where ledgers are secured and distributed rather than all in one place. The goal of decentralized finance is to allow the "little guy" to thrive as opposed to the big financial institutions; empowering individuals rather than companies. It is pure irony that the DeFi world defies the financial norms we are used to.

DeFi has gained popularity with the surge in interest in the world of cryptocurrency. Just as cryptocurrency circumnavigates banks and their fees charged for the use of their services, DeFi does the same. Individuals have a secure digital wallet and send or receive money via the Internet. It is accessible to all individuals with an Internet-enabled device and a secure connection to WiFi.

The blockchain is a digital ledger that acts as a timestamped receipt which tracks all transactions on a given financial platform. Through use of the blockchain, DeFi allows for decentralized banking which avoid the use of the typical middlemen seen in banks, brokers, and other traditional financial institutions. The world of DeFi is meant to provide the same services to users that are offered by banks, but without the use of these banks.

Challenges to consider

Governing Considerations

As mentioned above, the key difference between centralized finance and decentralized finance is that there is not a central authority to report to in DeFi; this is both a factor that appeals to users who crave more financial independence from banks and creates a challenge when it comes to the safety and security of operating in DeFi space. As with the "banking" that occurs in DeFi, the governance that takes place in this realm is also decentralized and is often autonomous. Decision-making is spread among all interested stakeholders as opposed to one entity making decisions. Though this may seem more fair, it can complicate the process.

Just as many of us fear the control that large entities and rich individuals can gain in the world of centralized finance, there are investors in the online world that gain large steaks and become what is referred to as "blockholders", a play on stockholders. If a blockholder has a large enough stake, they will also be able to enforce things in DeFi in a way which benefits them rather than in a way that is beneficial to all.

Tax Issues

Though many may not think of this, all transactions made in DeFi space are in fact taxable. Despite the blockchain acting as a ledger to keep track of all transactions made, reporting digital transactions is not easy. An estimate from Barclays actually suggested that $50 billion of crypto taxes goes unpaid yearly. Because of the lack of governance, it is hard to enforce things in the same way that the IRS does for individuals working in centralized finance space. The draw of this world of "banking" also poses a major legal challenge.

Cybersecurity Risks

Just as the banking sector is plagued with cyber attacks from malicious individuals trying to gain access to financial and personally identifiable information, the world of DeFi also has some major cybersecurity risks that go along with it as well. According to the FBI, hackers are exploiting DeFi bugs so that they can steal funds from users online. As has been the major issue with the other challenges outlined here, the lack of governance makes it difficult for any recourse to actually be taken in recovering stolen funds. This is one of the many kinks that still needs to be worked through in order for the world of DeFi to gain as much traction as the centralized finance world we are used to.

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