DeFi, DApps, and the Like: How the Financial System Is Becoming Decentralized

You can hear more and more people in financial circles these days whispering the word “DeFi” auspiciously. The abbreviation stands for “decentralized finance,” and it sounds promising because in many quarters DeFi is being celebrated as a revolution and is viewed as a viable alternative to the traditional financial market.

Traditional financial systems work with a centralized system in which the transaction database is managed by intermediaries such as a bank, a securities exchange, or a payment processor.

The word “decentralized” in DeFi means, in contrast, that parties on both sides of a transaction can directly interact with counterparties’ computers from their own computers, rendering intermediaries unnecessary.

The inventor of the Ethereum blockchain deliberately chose the name “DeFi” in 2018 because it also sounds a lot like the English verb “defy.”

In the DeFi universe, new financial applications create a completely novel decentralized financial ecosystem. They belong to a group called decentralized applications, or DApps for short. In principle, DApps replicate all of the applications that people are already familiar with in the traditional centralized financial market. They enable users to save, invest, borrow, and lend money, as well as to trade digital assets.

But that is no longer done with the help of an interposed bank or other financial intermediary, but is instead done directly between users via a DApp. The classical business with interests is then called lending or borrowing. All DApps are freely accessible to everyone.

Participants in DeFi remain anonymous – no one has to present an ID or provide proof of income or creditworthiness, unlike in the traditional financial system. In DeFi, anyone from anywhere around the world can participate and set up a wallet on an application that can be used to trade or transfer assets regardless of nationality, age, or wealth status.

Particularly for people in developing and emerging economies where the financial system may be rudimentary or corrupt, DeFi can present a great way especially for business founders and entrepreneurs to raise capital or invest.

The blockchain and smart contracts guarantee the security and trustworthiness of the transactions. Smart contracts are programmed contracts which ensure that a transaction is executed only when all predetermined terms and conditions are met. And once executed, every transaction is immutable and cannot be manipulated. So much for technical security.

However, since DeFi obviates the involvement of banks and other intermediaries, there ultimately are no longer any authoritative entities in this space that provide investment advice or conduct transactions for investors. “Do your own research” is thus arguably the most important maxim in the world of DeFi.

This would make regulating DeFi all the more important. But the regulation issue is still raising a lot of questions at the moment. Alongside investor protection, governmental interests with regard to capital-gains taxes and money laundering are playing a big role in the current debate. Traditional financial market regulation is based on overseeing financial intermediaries, i.e. banks, asset managers, and trading venues. But since they simply no longer exist in DeFi, it’s a mystery precisely where regulation of DeFi should start in the first place.

“All regulatory authorities have this issue on their radar,” Professor Fabian Schär explained to the media outlets of the NZZ Group. The managing director of the Center for Innovative Finance at the University of Basel is of the opinion that “true DeFi” does not require any additional regulation because smart contracts make it impossible to commit fraud. For all other applications that merely pretend to be decentralized, Schär explains, you only have to dig down until dependencies on a central entity come to light. Then normal regulation takes hold, he says. He therefore sees only two options in the long run: financial players will be either completely decentralized or completely regulated.