One of the aspects of decentralization that I don’t often mention is Decentralized Finance, or DeFi.
Wikipedia defines DeFi as: ‘a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum.’
Normally, if you want a loan to buy a car or house, you go to a traditional bank. The bank represents the money deposited by their account holders and they negotiate the lending of some of that money to you. The bank charges interest on the loan to recover the cost of all those employees, branches and fancy downtown office towers.
Some of the money is paid back to account holders through interest payments on savings and chequing accounts but at 0.5% interest few bank customers are getting rich from the interest paid on their balances. The balance of the interest charged goes back to the bank just for brokering a transaction between two willing participants, someone who needs to borrow money and someone who has money to lend in return for a price.
Not so De
DeFi promises to remove the middleman by allowing borrowers and lenders to connect directly and broker their own transactions guaranteed by writing them on a public blockchain for all to see. DeFi removes the bank and the need to pay extra-interest for brokering the transaction, so theoretically, a DeFi loan should be cheaper for the borrower, and also pay a bigger return to the lender. In theory that sounds great. However, let’s start at the core; is DeFi really decentralized?
As reported by Matthew Heller on CFO.com in Central Banks See DeFi Decentralization as ‘Illusion’. International banking regulators don’t consider DeFi to be truly decentralized because the underlying blockchains that guarantee the transactions, Ethereum in the Wikipedia example, still have a central authority or governing body that could be subject to banking regulations.
There’s not a lot of talk about regulating DeFi because it is often believed that regulating decentralization is impossible, but Matthew is right. Ethereum may be a decentralized open source Blockchain with no one ‘owner’, but there is a technology steering group of contributors and people like co-founder Vitalik Buterin, who make fundamental decisions regarding what consensus model to use, and whether to ‘fork’ the blockchain.
Same old loan new Risk!
Just like a bank, these central governing bodies bear responsibility for decisions that could involve making or losing money for borrowers and lenders. Just like a bank, this makes blockchains subject to regulations meant to ensure that real people don’t lose real money, not to mention their cars and homes.
Also, DeFi is not a free transaction because blockchains require incentives to be paid to write your transaction onto the chain. In the case of Ethereum that means you need ‘gas’ and ‘ether’ and that stuff is getting more expensive all the time. Ether started 2021 around USD $750 per token, but is closer to USD $4000 per token at the end of 2021.
That’s a 530% increase in fees for any DeFi transaction in one year! This might be great for people holding Ether tokens, but it could easily erode any efficiencies provided to people transacting business on Ethereum.
Blockchain ain’t no Panacea
Just because DeFi can match a borrower and lender directly does not mean it is any less risky. What happens if the borrower defaults on their loan? How does a DeFi platform with no supposed central authority make a claim to recover the house or car that is subject to the default to mitigate its losses? Who suffers the losses when they happen? Just the parties to the individual loan or does everyone holding Ethereum suffer a loss? What happens when some hacker steals the tokens that are supposed to be payment for your house or car? Is your DeFi loan suddenly canceled?
DeFi is a great idea but like many blockchain-based business models, it is still half-baked. Banks have been lending money for a thousand years. Ethereum was founded in 2016 and it is still largely a science experiment. I am fine with experimenting with tracking lettuce from a farm to a Walmart, but it’s far too early to start betting people’s financial lives on something that still belongs in a lab.