What is DEFI (Decentralized Finance) system?

defi

Multiple technologies and protocols are used to achieve the goal of decentralization. For example, 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. Regardless of the technology or platform used, DeFi systems are designed to remove intermediaries between transacting parties.

Though the volume of trading tokens and money locked in smart contracts in its ecosystem has been growing steadily, DeFi is an incipient industry whose infrastructure is still being built out. Regulation and oversight of DeFi are minimal or absent. In the future, however, DeFi is expected to take over and replace the rails of modern finance.

In its simplest form, decentralized finance 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. Unlike a bank or brokerage account, a government-issued ID, Social Security number, or proof of address are not necessary to use DeFi. More specifically, 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.

Decentralized finance uses technology to disintermediate centralized models and enable the provisioning of financial services anywhere for anyone regardless of ethnicity, age, or cultural identity. DeFi services and apps are mostly built on public blockchains, and they either replicate existing offerings built on the rails of common technology standards or they offer innovative services custom-designed for the DeFi ecosystem. At the same time, DeFi applications provide users with more control over their money through personal wallets and trading services that explicitly cater to individual users instead of institutions.

The DeFi ecosystem is still riddled with infrastructural mishaps and hacks. Scams also abound in the rapidly evolving DeFi infrastructure. DeFi “rug pulls,” in which hackers drain a protocol of funds and investors are unable to trade, are common, though there are well-established protocols that can reduce this risk significantly.

The open and relatively distributed nature of the decentralized finance ecosystem might also pose problems to existing financial regulation. Current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction span presents important questions for this type of regulation. For example, who is culpable in a financial crime that occurs across borders, protocols, and DeFi apps?

Smart contracts are another area of concern for DeFi regulation. Aside from Bitcoin’s success, DeFi is the clearest example of the “code is law” thesis, wherein law represents a set of rules that are written and enforced through immutable code. The smart contract’s algorithm is encoded with the necessary constructs and terms of use to conduct transactions between two parties. However, software systems can malfunction due to a wide variety of factors.

For example, what if an incorrect input causes a system to crash? Or, if a compiler (which is responsible for compiling and running code) errs. Who is liable for these changes? These and many other questions need to be worked out before DeFi becomes a mainstream system used by the masses.

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