What is DeFi, which is said to “disrupt existing finance”? What are its advantages? (above)

In this in-depth report, the mystery behind DeFi today is broken down in depth with a clearer logic, bringing a sharing of the definition, attributes, classic use cases and lessons that can be learned from DeFi.

What is DeFi, which is said to "disrupt existing finance"? What are its advantages? (above)

Note to editors.

The emergence of smart contracts has provided an important necessity for the development of blockchain, and since then the world of blockchain has become rich in applications. deFi is an important part of the blockchain application implementation that cannot be ignored, and many large institutions and good investors have never stopped discussing around DeFi. ING Bank has been analyzing and studying the risks and opportunities facing the DeFi space in anticipation of optimizing and modeling the application of its system.

Recently, ING Bank wrote a report titled “Lessons Learned from Decentralized Finance” and made the key conclusion that “a better way to provide financial services can be achieved if traditional finance and decentralized financial services are combined”. In this in-depth report, we share the definition, attributes, classic use cases, and lessons learned from DeFi in a clear and logical way.

The following is compiled by the Chain Bazaar team for your understanding and learning, and we hope it will inspire you. Because the paper is long, we will push it in three parts, please enjoy the following:

Abstract

Globally, blockchain and distributed ledger technologies are being used to transform existing traditional financial services, and the so-called divide between centralized and decentralized financial services may lead us to bias their services.

In this white paper, we analyze the characteristics of DeFi and provide lessons learned for both centralized and decentralized financial services. Based on our analysis and lessons learned, we conclude that the best of both services can be achieved if centralized and decentralized financial services work together.

Brief Introduction

Since its inception in 2017, decentralized financial applications (DeFi) have taken the world by storm.DeFi can be defined as the transformation of traditional financial products into products without intermediaries through smart contracts on the blockchain. In principle, any existing traditional financial service can be transferred to a similar decentralized financial service.

There seems to be a split between traditional finance, which is considered centralized because there are intermediaries managing the books, and DeFi, which is considered decentralized because there are no intermediaries for its financial services.

This apparent difference is further fueled by colloquial headlines in the gray literature (editor’s note: non-secret, hard-to-access printed and electronic literature of all kinds published by all levels of government, research institutes, academic institutions, business and industry, etc., not controlled by for-profit publishers, but not sold as normal commercial publications), suggesting, for example, that DeFi could replace traditional banks. In this white paper, we analyze whether there is a split between traditional and decentralized financial services.

To do so, we first discuss the current perception of DeFi in Section 2. Then, in section 3, we analyze and discuss 10 common attributes of DeFi. We argue that these properties can be a double-edged sword. On the one hand, these attributes allow to improve existing processes or even introduce new financial services; on the other hand, they may have serious consequences for the entire DeFi system on a global scale.

To further clarify these properties, we describe and analyze a DeFi use case in Section 4. In Section 5, we present 15 lessons learned for the central institution as well as for the DeFi community. Finally, in Section 6, we argue that DeFi’s goal is to improve current traditional financial processes. While improvements do occur, DeFi’s financial services are not without risks or drawbacks.

Indeed here, financial services with a central institution can support DeFi in sharing experiences and strengths in specific services, such as KYC regulation.

In conclusion, we conclude that traditional financial services and DeFi should work together to combine the best of both worlds to create a global financial service.

Editor’s note: In consideration of readability, we have divided the full text into three articles – top, middle and bottom – for better reading and understanding, and this is the first article in this report.

Definition of DeFi

The literature contains multiple perspectives on what DeFi is, such as a paradigm or a financial model, and multiple definitions of DeFi can be found. In this section, we will discuss these perspectives and the definition of DeFi.

DeFi is a paradigm. A paradigm can be seen as an example of traditional finance, a paradigm of a financial system characterized by a centralized institution managing a ledger, or DeFi, another paradigm of a financial system characterized by decentralization, with multiple parties managing a ledger.

DeFi as a financial model. deFi is a financial model that provides financial services. For example, Brown and Oates explore the design of different levels of government in assisting the poor, and they discuss both centralized and decentralized approaches (“decentralized finance and administration”) to helping the poor.

There are many definitions of DeFi. For example, Meegan defines DeFi as “…… the transformation of traditional financial products into products without intermediaries through smart contracts on the blockchain.” Another definition is proposed by Gudegeon et al. who see DeFi as a “peer-to-peer financial system that uses distributed ledger-based smart contracts to ensure its integrity and security.”

Both definitions include smart contracts as a key component of DeFi. However, Meegan focuses on the transformation process of traditional financial products, while Gudegeon et al. focus on which properties (integrity and security) are achieved.

Popescu defines DeFi as “an ecosystem of financial applications being developed on top of blockchain and distributed ledger technology (DLT)”. Here Popescu’s definition includes both blockchain and distributed ledger technology, while Meegan considers only blockchain and Gudegeon et al. consider only distributed ledger technology. However, Popescu’s definition of DeFi does not include smart contracts.

Samani makes a clear distinction between what type of blockchain DeFi deploys in the following definition.” DeFi executes financial contracts through code running on a censorship-resistant and license-free public blockchain.” According to Samani’s definition, public permissioned books, as well as private permissioned books, are not included. In contrast, Popescu and Gudegeon et al. include DLT in their definition of DeFi.

Musan argues that “DeFi are DApps that enable interoperable proto-cols dedicated to leveraging and trading ERC-20 passes” and that a DApp is a combination of a smart contract and some form of user interface such as a website. musan extends the definition provided by Meegan and Gudegeon et al. by stating that DeFi requires a user interface.

To summarize the definitions discussed above include.

What is DeFi? (e.g., an ecosystem for financial applications)

What components are used in DeFi? (e.g., smart contracts)

What properties are implemented? (e.g., integrity, security)

How are these properties achieved? (using DLT, via blockchain)

Clearly, there is no consensus on the definition of DeFi. We aim to separate these questions and provide a broader definition based on the question “What is DeFi?”, and in this white paper we use the following definition.

DeFi is a financial service that operates on a public unlicensed blockchain.

Currently, most of such financial services consist of the following.

Banking services for converting currencies (e.g. issuing stable currencies)

Providing a peer-to-peer (or pooled) lending platform

Enabling advanced financial instruments, such as decentralized exchanges (DEX), pass-through platforms, derivatives and prediction markets

Attributes of decentralized finance

DeFi attributes are mentioned as promises, opportunities and principles. Based on our literature research, we have identified the following ten DeFi attributes. In the following, we will discuss each attribute.

Composability

Arguably, composability is a defining attribute of DeFi. composability is defined by Gudgeon et al. as “the ability to build a complex, multi-component financial system on top of crypto assets”. a common metaphor in DeFi is “crypto Lego”, the main idea being that the community benefits from individual progress.

Composability is a property of a system where the components of the system can be easily connected. Here, blockchain provides a foundation on which financial services can be built. Following the above analogy, the blockchain can be considered as a silo in which the “Lego” components, i.e., financial services, are composable, with the benefit that

Components can be easily connected, as opposed to siloed and centralized payment systems.

Components are publicly available and can be reused to create new financial services.

However, a major drawback of composability is the creation of an intertwined debt system, which has the potential to lead to financial crises, similar to the 2008 financial crisis, and it is unclear how DeFi will manage the potential impact of this composability.

Flexibility

Many authors mention flexibility as an attribute of DeFi, although none of these authors define exactly what flexibility is in DeFi.

Flexibility can be defined as the ability to be easily modified, and we discuss DeFi’s flexibility in terms of software and lack of regulation. deFi is built on open source, which makes software (such as smart contracts) flexible because it can be used by anyone and can be copied and adapted by anyone. Continuing the composability property using Lego as an analogy, Lego blocks can also be modified in size, color and shape.

Furthermore, DeFi is flexible because of the lack of regulation, and this lack of regulation allows for the creation and use of services that in principle have no limitations. Obviously, however, the lack of regulation of DeFi has its drawbacks, as it can easily be used for fraudulent activities.

Decentralization

DeFi literature refers to decentralization as an adjective for the following terms: authentication, network, exchange, business model, governance, and application. However, in most cases, the literature does not further define decentralization.

In the context of DeFi, decentralization can be described as a convenient way to provide financial services without the need for a trusted intermediary, and Catalini and Gans argue that DeFi services do not have a centralized intermediary. They also argue that decentralization can be thought of as digital information validation, settlement and protocols without a central party. However, it is still unclear what constitutes a centralized intermediary, which could be, for example, a single entity but also a limited set of multiple entities.

Popescu also does not further define who is the trusted intermediary (single entity, multiple entities) or which party trusts this entity. However, Catalini and Gans argue that trust shifts from a central party to code and consensus rules. This suggests that trust is needed despite the absence of a central party. In fact, Ether users are convinced that there is no cooperation between the 8 miners because it would lead to a monopoly on the Ether network by these mines.

Clearly, there is no consensus on what decentralization is, nor is there a consensus on what terminology applies to decentralization in the DeFi literature.

In this white paper, we consider decentralization to refer to the technology, i.e., the provision of financial services on the basis of DLT, including blockchain. In this context, decentralization refers to multiple parties proposing, verifying and reaching consensus on ledger updates.

Accessibility

Schar believes that the DeFi protocol can be used by anyone. This is consistent with Schar’s definition of DeFi as a financial service that is built on top of a public platform such as Etherado. However, the broader definition of DeFi also includes DLTs, as described in Section 2. Since some DLT platforms are licensed private platforms, access to financial services on such platforms becomes very limited.

However, accessibility on public unlicensed ledgers creates a paradox in that, on the one hand, countries that currently have limited access to financial services will be able to start using such services. And on the other hand, lowering the accessibility threshold will allow malicious actors in the financial ecosystem to participate and use these services. Clearly, accessibility is a double-edged sword, and firms should consider what controls to put in place to ensure that requirements such as anti-money laundering (AML) and KYC regulation are met.

Innovativeness

By open-sourcing and publicly sharing core technologies, platforms such as Bitcoin, Ether and Diem allow anyone to (re)use these technologies. As a result, new applications can be built on top of these technologies, enabling innovation in these platforms and applications.

This is in stark contrast to traditional financial institutions, of which we are not aware of any having opened up their core technologies, with a few exceptions.

We believe that this would be a shift in the mindset of centralized financial institutions, however the use of complex proprietary software for decades makes it difficult for these institutions to open source and change their core technologies at this time.

Interconnect Interoperability

Schar distinguishes between functional interoperability and technical interoperability. In functional interoperability, different financial services can work together because they exist on the same platform. In technical interoperability, financial services on two different platforms can work together.

DeFi can enhance interoperability. Because centralized financial institutions maintain their own books, one financial service may not be interoperable with another, or moving money between two or more financial institutions may become expensive and cumbersome. However, Chen also believes that DeFi is not yet fully (technically) interoperable due to the lack of interconnectivity between blockchains. As a result, full functional interoperability has not yet been achieved in DeFi either.

There is a high level of interest in interconnect interoperability in the blockchain community. This suggests that if DeFi achieves interoperability, then DeFi has a huge advantage over traditional financial services. It is expected that financial services offered on the DeFi platform can be seamlessly interconnected with other financial services.

For example, pass-through transfers from one blockchain to another can already occur within minutes from anywhere in the world. This is in stark contrast to traditional payment systems where transferring funds from one continent to another can take days For example, if a company uses the DeFi payment transfer service instead of a centralized payment transfer service, this can be an extremely competitive advantage.

Borderlessness

Chen and Bellavitis argue that borderlessness is achieved when financial services are not tied to geographic location or legal tender and are available to anyone around the world.

According to Chen and Bellavitis, traditional finance cannot be truly borderless because it is always tied to geographic location or legal tender. Furthermore, Chen and Bellavitis argue that blockchain-based crypto-assets are borderless because anyone around the globe can use them. One disadvantage of borderlessness is that financial services may not be able to comply with AML and KYC regulation, and Popescu even argues that AML and KYC are concepts that “don’t really fit the DeFi ecosystem”.

In contrast, we believe that AML and “KYC regulation are concepts that do fit the DeFi ecosystem. The current lack of regulation and the discussion about AML, KYC and early DeFi cannot be a reason to exclude these concepts from DeFi.

Instead, large financial institutions can bring their knowledge and experience on AML and KYC to this discussion and embed these concepts into DeFi. we expect that once this discussion comes to fruition, large enterprises will also adopt DeFi.

Transparency

Schar sees the transparency of data on the blockchain as an opportunity for DeFi. Transparency can apply to smart contracts or financial data. In both cases, anyone can observe the content of a smart contract or financial data. Transparency in smart contracts allows anyone to review the code of a smart contract. Therefore, any individual can choose to use different financial services depending on their review of the smart contract code.

Schar also believes that transparency of financial data can mitigate the financial crisis. However, we do not believe that simply alleviating the financial crisis is enough to make financial data transparent. Rather, privacy is a human right, and if only a single financial system can provide transparency of smart contracts and financial data, then that financial system does not seem to comply with that human right.

While some efforts are underway to enhance the privacy of public blockchains, we believe that traditional finance and decentralized finance working together to provide financial services that protect the privacy of their users is a good solution.

Automation of business processes

Smart contracts can automate business processes. As Popescu points out, with the automation of business processes, it becomes more cost effective to execute those business processes. Once a smart contract is created, both parties can conduct transactions without the need for any outside agency, thus increasing autonomy.

However, both parties aiming to do business with each other rely on the creator of the smart contract, which means that the presence of an external agency (i.e., the coder of the contract) must be present. Furthermore, if the smart contract does not work as expected, then three questions arise.

Who is responsible for the proper functioning of the smart contract?

How are transactions reversed in an immutable blockchain?

How do the two parties ensure that the next smart contract works as expected

To mitigate the risks associated with the use of smart contracts, additional measures must be taken that will increase the cost of doing business through smart contracts. Whether these costs exceed the costs incurred by the centralized institution providing the service is an open question.

Contrary to Popescu’s view that DeFi is more cost effective, Chen believes that traditional finance may be able to reduce costs. Obviously it will be an open discussion whether DeFi is really more cost effective than a centralized institution.

Finality

The finality of transactions is achieved under the assumption that, ultimately, all network nodes will receive the transaction and agree to its validity. Furthermore, it is assumed that once a transaction is stored on the blockchain, it can no longer be reversed or modified.

However, there are challenges if we assume that the blockchain can achieve invariance, and two known challenges are the emergence of rigidity and inflexibility. Since DeFi is built on top of a blockchain, DeFi inherits these characteristics as well. This can hinder the testing, learning and discovery of smart contracts. Another impact of the blockchain is that progress on updating the platform may stall when there is no consensus on the network.

Editor’s note: DeFi, a new paradigm of decentralized financial services, is a transformative force for business, and we analyze its ten attributes and discuss its strengths and weaknesses. We argue that on the whole DeFi combined with centralized financial services is good for the financial system. In the following, we focus on the classic case of DeFi and the lessons we can learn from DeFi, so stay tuned.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/what-is-defi-which-is-said-to-disrupt-existing-finance-what-are-its-advantages-above/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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