Defying logic: despite its advantages DeFi makes up just one per cent of financial assets
Haven’t we all been frustrated at some point with high transaction fees charged by banks, while at the same time waiting days for transactions -particularly remittances - to be processed? Or by rising interest rates for loans?
And banks have long been accused of overcharging customers by failing to pass on central banks’ interest rate hike to savers, while ramping up loans and mortgages.
To save us all from the shortcomings of traditional finance, the world of DeFi - or decentralised finance - has emerged. Utilising blockchain and smart contracts, DeFi comes with the promise to resolve some of the key issues with existing finance such as high transaction fees, long processing times, and financial exclusion, and could even pose an existential threat to traditional finance institutions such as banks and credit card issuers.
By removing traditional intermediaries such as banks, DeFi challenges the dominant centralised financial system, empowering everyday individuals through peer-to-peer transactions.
Just think of this scenario: with DeFi, individuals can directly lend their savings to others, and earn an interest rate usually between three and eight per cent. Indeed, in July 2023, the UK's Financial Conduct Authority summoned the chief executives of Barclays, NatWest, Lloyds and HSBC, to investigate why easy-access savings rates were between 0.7 and 1.35 per cent at a time when the central bank had raised the base rate to 4.5 per cent.
This new world represents an unbundling and democratisation of traditional finance by placing financial services such as lending, borrowing, and trading, in the hands of individuals.
Yet, despite its many promises DeFi has failed to go mainstream. Stubborn inflation and unsettling macroeconomic conditions have led to a declining interest in Bitcoin, the world’s largest and best-known cryptocurrency. This has prompted many to refer to this period as yet another ‘crypto winter’.
Further, DeFi still accounts for approximately only one per cent of the total global financial assets market. In fact, research states that only 15 to 20 per cent of small businesses are utilising DeFi services for financing or lending.
So, several factors must be tackled before the DeFi movement can progress.
The flaws DeFi has to overcome to go mainstream
One issue that arises is the usability of DeFi applications. Consumers are familiar with how traditional banking works as they have been exposed to financial services in their day-to-day life.
The sector also worked hard to ensure that online banking, trading systems and any novel applications (for example, peer-to-peer payments) are user-friendly. The challenge for DeFi providers is to exceed that level of usability to drive fast consumer adoption.
Scalability issues, surrounding both technical and environmental perspectives, remain another challenge. Widespread discussions have revolved around the computational and energy efficiency hurdles in Bitcoin mining. While improvements have been made with, for instance, Ethereum’s move to its less energy intensive proof-of-stake consensus mechanism, much more work is needed to manage a substantial surge efficiently and sustainably in growing transactions.
There are also the issues of interoperability between distinct blockchains. In centralised finance, regulation has eased the process of transferring funds between providers, while open banking standards hold the potential to further simplify this procedure.
It will be crucial for DeFi platforms and blockchain protocols to have the ability to seamlessly communicate and integrate with one another to unlock enhanced liquidity, user-friendliness and innovation.
Cybersecurity is the key to unlocking DeFi's full potential
Despite the immutability of a blockchain, which makes it exceptionally difficult to tamper with, the broader landscape of DeFi faces notable vulnerability to hacking, thereby exposing the possibility of funds being stolen or lost.
If DeFi’s full potential is to be unlocked, it requires security improvements of the blockchain protocols supporting these platforms to make them less susceptible to hacking. On top of this, there is a general lack of consumer protection for investments in DeFi today.
While regulators guarantee deposits in mainstream centralised finance, no such protection exists for individuals involved in DeFi. Therefore, when banks failed during the 2008 financial crisis, consumers were heavily protected from the fall-out, but a different scenario unfolded when the crypto exchange FTX collapsed, leading to consumers losing billions.
This user protection needs to extend to consumers falling victim to fraud and scams, sadly common within the sector – for instance, during the wave of Initial Coin Offerings (ICOs) a few years ago.
Building trust among mainstream users involves protection measures against potential risks and providing easily accessible solutions.
Will DeFi lead to greater financial inclusion?
DeFi’s acceptance will be based on various social factors, such as the growing concern for financial inclusion. Questions remain whether DeFi is effectively fulfilling its pledge to offer financial services to otherwise excluded groups.
It is essential to broaden access for individuals currently excluded from traditional financial systems, such as those labelled unbanked or underbanked, to achieve mainstream adoption.
But are there enough educational resources available to help users understand DeFi concepts and associated risks? DeFi should be clarified by widespread education and awareness campaigns, encouraging more individuals to explore these technologies.
DeFi providers must also enhance their value proposition to guarantee substantial and tangible advantages over traditional providers. To attract users away from traditional alternatives, its benefits - such as reduced fees, faster transactions, greater financial control, or increased returns - are required and should be made clear.
If DeFi can address all these issues, then it stands a better chance of achieving mainstream acceptance.
Doing so will require a combination of regulatory developments, user behaviour shifts, technological advancements, and broader societal changes.
Kalina Staykova is Assistant Professor of Information Systems and a member of the Gillmore Centre for Financial Technology. She teaches Platform Strategy on the Warwick Executive Diploma in Digital Leadership and Cybersecurity in Business and Knowledge, Work, and Innovation on the MSc Management of Information Systems and Digital Innovation.
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