Jun 9, 20223 min read

Demystifying DeFi: Advantages and challenges faced by the DeFi space

Updated: Sep 19, 2022

Decentralized Finance, also known as DeFi, was envisioned to remove third-party networks or the middle man from financial transactions. It aims to eliminate the control that banks and financial institutions have over money matters and enable everyone to participate in finance, regardless of identity and location.

But as promising as it sounds, DeFi technology is still young. It offers revolutionary solutions to problems that have riddled the financial world, but it also comes with a host of risks. Let’s dive into the pros, cons, and future of the DeFi space.

Advantages of DeFi technology

DeFi technology aims to break away from centralized financial systems (also known as CeFi), where your assets are controlled by banks that, by and large, run for profit. CeFi systems also charge fees for transactions, set restrictive loan regulations, and have complicated rules for money transfers across borders.

DeFi eliminates these inconveniences.

DeFi is inclusive and permissionless.

Unlike CeFi, DeFi allows for simple and effective access to financial services. No need to present heaps of documents to open a bank account or apply for a loan. Anyone with a crypto wallet and internet connection can participate. Location doesn’t matter, too. Because it’s decentralized, financial transactions are not governed by a national banking system, and users can manage their assets anytime, anywhere, with no banking fees.

DeFi is transparent

DeFi platforms offer a remarkably high level of transparency, so much so that any user can access information about all activities in the blockchain network. Take Ethereum for example. All transactions made on the Ethereum blockchain are broadcasted to other users, creating a solid audit trail.

DeFi guarantees immutability

DeFi technology has achieved immutability, which means that once a transaction has been recorded on the ledger, it can’t be changed. As such, it’s impossible to manipulate records on the blockchain, making DeFi tamper-proof and secure.

DeFi reflects changes in real-time

DeFi technology updates the blockchain the moment that the transaction is completed. In contrast, CeFi money transfers could take hours or even days. In some cases, CeFi transactions are limited by business hours, and banks operate only within a specific time zone.

DeFi puts an end to human errors

DeFi agreements are carried out by smart contracts, which are self-executing digital contracts run by code. These drastically reduce the risk of human errors and mismanagement often found in CeFi. In addition, smart contracts are highly programmable, and you can set any number of conditions based on infinite variables.

Challenges of DeFi technology

Like any emerging technology, DeFi is saddled with challenges it has yet to solve.

User responsibility

In the absence of intermediaries, the bulk of the responsibility is shouldered by the user. You are responsible for keeping your funds and assets safe. The decentralized nature of DeFi platforms is a double-edged sword. It’s unburdened by rules and regulations, but it also means there’s little to no consumer protection. In the event of fraud or scam, there are no laws to be enforced, and there are no authorities to hunt down the perpetrators.

Security

Like all blockchain-based technologies, DeFi projects are a hot target for cybercriminals. Compared to CeFi’s digital architecture, DeFi offers more potential entry points for attackers. A vulnerability in the Poly Network, for example, has enabled an attacker to siphon off $600 million in August 2021, which eventually — and thankfully — has been returned.

Errors in smart contracts

While smart contracts guarantee flawless execution, it’s vulnerable to wrong codes. A small error in the code could put funds at risk of loss.

Above all, DeFi technology is still immature, and with it comes the problem of scalability. It has not been tested for large-scale use, and it’s a big source of uncertainty for many would-be users.

The Future of DeFi

DeFi technology is evolving at lightning speed, and with every year that passes, its use cases and applications increase. Investors are pouring billions into this frontier, and solutions are developed at a rapid-fire pace. Who knows — the problems DeFi is facing now might just be a footnote next year.

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