The Federal Reserve Bank of St. Louis says decentralized finance (DeFi) has “unleashed a wave of innovation” that could create a more transparent financial infrastructure in the future.
DeFi is an umbrella term for a broad push to create crypto-based projects that automate and remove middlemen from traditional financial services like borrowing and lending, derivatives, margin trading, and insurance.
In the reserve bank’s quarterly review, Fabian Schär, a professor of distributed ledger technologies and fintech at the University of Basel in Switzerland, highlights both the potential and risks of DeFi.
Schär argues that DeFi smart contracts decrease counterparty credit risk and increase the efficiency of financial transactions. He also says the transparency of DeFi applications could provide easily accessible data that could help thwart undesirable financial events in the future.
Additionally, the professor notes that DeFi could open up the financial system to the world at large.
“By default, DeFi protocols can be used by anyone. As such, DeFi may potentially create a genuinely open and accessible financial system. In particular, the infrastructure requirements are relatively low and the risk of discrimination is almost inexistent due to the lack of identities.
If regulation demands access restrictions, for example, for security tokens, such restrictions can be implemented in the token contracts without compromising the settlement layer’s integrity and decentralization properties.”
Despite DeFi’s potential, Schär also argues that the sector is vulnerable to several risks that people should be aware of. Smart contracts can contain errors that put funds at risk of attack, compromised admin keys can cause the smart contracts to be compromised and high transaction fees and long confirmation times can favor wealthy individuals and hurt the DeFi ecosystem, according to the professor.
Schär also says the term “decentralized” can be deceptive.
“Many protocols and applications use external data sources and special admin keys to manage the system, conduct smart contract upgrades, or even perform emergency shutdowns. While this does not necessarily constitute a problem, users should be aware that, in many cases, there is much trust involved.
However, if these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.”
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