Opportunities and risks of decentralized finance

What opportunities and risks does DeFi (decentralized finance) bring to the future of banking? originally appeared quora: A place to gain and share knowledge, helping people learn from others and better understand the world.

answer Written by Columbia University Professor Agostino Capponi, quora:

Imagine a world where financial transactions take place without intermediaries. Your trades typically involve a broker, bank, or mutual fund that provides these services in exchange for a commission.

The advent of blockchain technology has the potential to redefine banking as we know it. DeFii.e. the provision of financial services on blockchain, aims to replace financial intermediaries with blockchain. smart contract-A computer program on the blockchain acts as the sole interface for users, automating all financial services from asset purchases to derivatives trading, insurance procurement, and lending operations.

Can DeFi shape the future of finance? Decentralization is expected to reduce the cost of financial services compared to traditional brokerage fees. DeFi infrastructure supports a democratized environment, allowing everyone to provide or access financial services with minimal barriers to entry. Countries with unstable monetary systems or limited trust in local intermediaries, such as Lagos and Kenya, are expected to benefit greatly from DeFi solutions. By leveraging DeFi for price discovery, these countries may be able to profit from exporting valuable rare earth mineral commodities that are otherwise under-monetized.

Should we all jump on DeFi? The promise is convincing, but the risks should not be underestimated. Smart contracts are susceptible to hacking and cyber-attacks. Decentralization is usually combined with anonymity, so users have limited legal recourse in the face of attacks or illegal activity. But where there are technological risks, there is also hope for technological solutions. Computer scientists will be able to extend the comprehensive testing and code auditing originally developed for centralized systems to manage decentralized validation of smart contracts. Ensuring that potential bugs are identified before deploying smart contract code to a ledger can increase confidence in the technology and move toward widespread adoption.

What does the future of DeFi look like? DeFi holds the key to an inclusive financial system freed from the hands of centralized authorities, but it is still in its infancy. The path forward requires rigorous research, especially around scaling blockchain technology, strengthening the interoperability of DeFi protocols, and ensuring smart contracts are as airtight as a bank vault. The future I envision is likely to be one in which decentralized finance complements centralized finance (CeFi) rather than replacing it. We all decide whether to offer or seek financial services in CeFi rather than DeFi based on our appetite for risk, market conditions, economic outlook, transaction costs, and trust in the technology. This is not just an evolution in technology, it is also an evolution in finance, and it will take the joint efforts of innovators, regulators, and users to pave the way to complement, rather than replace, the current banking system.

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For more information on our research on this topic, please see:

Capponi, Agostino, Iyengar, Garud, Sethuraman, Jay, Decentralized Finance: Protocols, Risk, Governance (December 2, 2023). Foundations and Trends® in Privacy and Security, Vol 5, Issue 3, 2023, available at SSRN or DOI.

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