DeFi vs CeFi

As finance has evolved over time there has been a trend towards greater levels of centralisation. Trusted intermediaries are at the core of the financial system. Banks, Exchanges, and government regulators exist to generate the trust that is necessary to finance the modern economy. Without these intermediaries there would be far less financial activity in the economy and as such much less economic activity.

One of the important features of these economic institutions generating trust is that they have emphasised investor protection. They have attempted to minimise counterparty risks and prevent fraud. This means that investors face investment risk – i.e. that the investment itself may be a poor choice – and not risks associated with opportunism and malfeasance. By necessity, however, a risk mitigation system that emphasises investor protection becomes a permissioned financial system. It also becomes a one-size-fits-all system, and ultimately a financial system that emphasises size.

Another feature of centralised finance is standardisation. This has the effect of facilitating ease of trade, but it does work to exclude a lot of transactions that would benefit individuals with niche financial requirements – especially in, say, insurance. It also inhibits the development of local markets that rely on local information.

In order to manage the enormous risks associated with the financial system, financial institutions have had to become large. This places smaller investors and firms at a comparative disadvantage relative to those institutions. It has also resulted in the notion that these large institutions have become too large to fail. This in turn leads to them taking on excessive risks and placing the entire financial system under additional risk of failure. It has been suggested by some that the relationship between financial institutions and government is unhealthy for the economy at large. This certainly was one of the motivations Satoshi Nakamoto had for developing Bitcoin.

Blockchain technology industrialises trust. The rationale for large trust-worthy financial institutions has been undermined by the emergence of a technology that substitutes code for expensively created trust.

Rather than having to trade with a large institution in an uneven power relationship or being entirely excluded from the system DeFi (decentralised finance) provides users with a permissionless environment for trading. DeFi service providers do not need to be large in order to bear large financial risks, because they are not intermediaries – rather they are matching agencies that bring individuals together so that they can engage in peer-to-peer trading.

Decentralised finance offers the promise of democratising access to sophisticated financial products and opportunities. Historically only the already-wealthy could access institutional such as hedge funds. In future, anyone with access to any financial resource will be in a position to invest in opportunities that previously were reserved for the wealthy. Individuals will be able to insure themselves in local insurance markets trading on the basis of local information. This is a feature of the industrialisation of trust – information that previously had to be centralised and aggregated for trust purposes and so lost its local value can now be deployed in a ‘trustless’ environment for local benefit.

DeFi offers advantages to users – it is permissionless, peer-to-peer, and will likely be very innovative and responsive to local needs. But it does have some disadvantages relative to centralised finance. Large intermediaries take on a lot of risk, and they offer a portfolio of additional services that users may or may not value. They offer some protection against fraud and loss of security. In the DeFi environment users need to take responsibility for their own security and protect against fraud. These services are valuable and it is likely that users will be willing to pay for those services.

In the meantime, however, DeFi offers the potential for users to diversify their financial affairs to include opportunities that they are currently unable to access via traditional financial institutions.