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After cryptocurrency, DeFi is a new concept that is steadily making its mark in the world. In 2008, Bitcoin introduced a new way of financial payments, and that made way for decentralized finance to transform the traditional financial systems. DeFi has the ability to address economic pain points, a positive impact that experts have acknowledged. But for that, there's a roadblock that has come to light.
Since the beginning of the blockchain-cryptocurrency hype, speculations and trends have been a driving force. But there are instances where the hype caused harm rather than good. For example, the ICO craze in 2017 resulted in a huge loss worth millions. Hence, experts have realized that a shift is necessary.
DeFi is an upcoming concept in the financial realm. What already exists is Centralized Finance (CeFi) and that can help polish DeFi. Technological innovations are always welcome but at the foundation level, what DeFi needs is practical solutions instead of fancy trends, something that can be extracted out of CeFi. Most financial services that we use in our day-to-day lives, like deposits and loans, are developments in CeFi. But CeFi gets criticism for stringent governance, record maintenance, and risk management. Thus, the need for a new financial system, DeFi has arisen.
For instance, let's talk about the regular loan process, where the central authority has all the control. From the mandatory background checks, determining the credit score, and analyzing the right interest rate, the central authority has the last say. The fact that consumers have little or no say in this matter is unfair in many situations.
In the lending process, banks bear the grunt of defaulting risks. For this, banks charge hefty interests that compensate for the high-risk factor. This negatively affects financial inclusion. Hence, the way value and risk are distributed in the CeFi system is one-sided.
Centralized record-keeping and data storage is always a security risk as they can become an easy target for hackers. While cyberattacks are a growing threat, censorship, espionage, manipulation, and fraud are other threats that prevail in this system.
DeFi has the ability to address the three big financial pain points and more. But being a new concept, DeFi still has a long way to go to replace CeFi completely. But that said, DeFi has already made strides. Compared to CeFi, decentralized finance has a fair distribution of risk across lenders, with no burden on one entity. Record keeping and data storage will also be distributed to eliminate the risk of cyber-attacks and the absence of centralized governance will prevent manipulation and unnecessary monitoring.
Right now, DeFi is in its initial phase, and a lot of needs to be foolproof. For example, the lack of centralized control may encourage enterprises to misuse the system. Businesses that don't comply with KYC requirements become the first targets for the black market and money laundering.
DeFi and CeFi, both have their shortcomings. Without compromising on functionality, there is no way for fully decentralized financial systems to work out. The only ideal system now is to find a middle ground with the best of both worlds. Kor Kiang Sean, the Co-Founder of Centaur explains how decentralized platforms can tie up with centralized credit unions when it comes to lending. To come up with an interest rate, a decentralized method can be used, and to avoid overcollateralized loans, credit reports can be collected and linked with the user's on-chain wallets.
The concept of a semi-decentralized financial system isn't new. Innovators within the financial community are coming up with projects that are adopting this middle ground. Ripple is a popular name that is innovating with this approach, as well as Centaur. These companies are leveraging CeFi's and DeFi's ability to modernize the financial world.
