For centuries, traditional finance was regarded as monolithic — large, powerful, and slow to change. However, this seemingly immutable industry is today being disrupted by emerging decentralized finance (DeFi) platforms. Offering immense potential for increased financial inclusion to underserved communities worldwide, the backbone of DeFi is blockchain technology.

For those unfamiliar with the concept as yet, imagine a chain of blocks where each block represents a financial transaction. However, since each block is a part of a chain, it will be impossible to change one block without changing the rest. This underlying principle is what makes blockchain transactions so secure.

It’s partly because of the high levels of transparency and partly because they themselves bring so much safety to the equation. In this article, we explore some of the technology behind DeFi, look at ways in which it’s disrupting traditional finance, and some of the challenges that lie ahead. Let’s begin.

Technology Behind DeFi

As a modern development, DeFi is characterized by modern technological innovations and highly robust computer system architecture. Among these include blockchain technology, smart contracts, decentralized oracles, and decentralized applications. We take a brief look at each of these below.

Blockchain technology

DeFi platforms wouldn’t be able to operate without blockchain technology. It may seem like something out of a science fiction novel or movie, but blockchain is real and it is powerful. Imagine a massive network of computers. These computers record digital financial transaction entries in a ledger.

But what makes blockchain so powerful is that it offers massive levels of transparency into each transaction so much so that changing one past transaction will be visible to everyone. As such, it’s considered a highly secure form of making financial transactions, backed by unparalleled transparency.

Smart contracts

Another key part of the DeFi puzzle is smart contracts. Defined as “self-executing”, they work in the following way: agreement terms are written directly into code. This code then automatically enforces and executes these terms when certain actions are taken or when conditions are met. Considered similar to financial agreements, they work without a middleman, without paperwork, and automatically, introducing heightened levels of convenience for users.

Decentralized oracles

Next up, we have decentralized oracles. This is a system that is powered by blockchain technology. Its main job is to connect this technology to external sources of data. This can turn the entire blockchain ecosystem into an informed source of information that’s collected from the real world. Some examples of information that these oracles tap into include price feed data, external application programming interfaces (APIs), and verifiable randomness, among many others. Oracles also play a key role in detecting any anomalies.

Decentralized applications (dApps)

Wondering how everyday users can tap into these complex networks off the blockchain? The answer lies in dApps and blockchain wallets. These applications run on the blockchain and are defined as open source. Also, they operate autonomously. Any changes to the app will require user consensus. Furthermore, these apps are the consumer-interfaces that enable users to actually operate on DeFi platforms and take advantage of a broad range of financial services.

Disrupting Traditional Finance

DeFi connects users to blockchain technology via dApps. However, the key currency that’s used in financial transactions is called cryptocurrency. A prominent example of this is Bitcoin, which has fluctuating value depending on market conditions and supply and demand much like any other global and real-world currency. Bearing in mind that you can purchase cryptocurrencies, you may be wondering what you can do with them. A few examples include lending and borrowing, trade, insurance, and others.

Decentralized lending and borrowing

Users interested in lending funds to others can do so by lending their cryptocurrency while earning interest from the loan. Meanwhile, those who seek to borrow can provide cryptocurrency as a form of collateral. Both of these methods are fast, transparent, and secure. Perhaps what is more important is that they do away with traditional credit checks and this can make such a service much more accessible to a wider audience.

Decentralized exchanges (DEXs)

If you’ve ever wanted to purchase stocks sold on a stock exchange, you’d typically need a broker or a middle man to facilitate the sale and purchase of your stocks. These intermediaries often come with high costs due to hefty commissions. However, with decentralized exchanges (DEXs), smart contracts enable individual investors to trade in shares at lower fees and with lower security risks all without brokers or intermediaries.

Decentralized insurance

Another area of similarity between traditional finance and DeFi platforms is found in insurance offerings. Such insurance packages are generally specifically aimed at mitigating potential risks within the blockchain ecosystem. For example, in the event of a smart contract failure, an exchange hack, and other events. This is a further way in which transparency and security are enhanced within the system.

Challenges in Security, Regulation, and Other Aspects

With DeFi’s potential to completely disrupt traditional finance, our enthusiasm for it must be curbed in some respects. The reason behind this is that it poses some important challenges that will need to be addressed if this technology is to thrive in the future and reach more people. Some of these challenges are discussed below.

Security concerns

A common security concern in blockchain technology relates to smart contracts. We mentioned that these conditions and terms of the agreement in these contracts are already placed in code. However, in cases where the code is weak, it is possible to exploit vulnerabilities, leading to significant losses as has already been seen in some instances. A potential solution is to audit and test protocols to ensure that all risks are minimized.

Regulatory frameworks

Although DeFi is not adopted fully across the world as yet, its potential for growth is astounding. However, since there’s no single regulatory body or framework governing financial transactions being carried out on the blockchain, it’s unclear who will be responsible for investigating a potential financial crime or security breach. This is a legitimate concern as a recent study found that regulatory issues were a major concern cited by 30% of senior executives.

It’s also unclear how such a body will operate across borders, while managing, monitoring, and enforcing the performance, security, and legitimacy of protocols and apps. While many see the absence of regulation as a platform that allows for innovation and limits restrictions of traditional finance platforms, users have little to no recourse for protection in the event of fraud or failure.

It’s also unclear how tax services will perceive and record crypto transactions as the industry does not, as yet, appear prepared for what’s to come.

Market volatility

If you’ve followed the ups and downs of the value of Bitcoin, you’ll quickly come to notice that it’s a highly volatile cryptocurrency. But Bitcoin is just one of many. When digital assets such as currencies swing in value with such a high velocity, there is greater risk for users. A potential risk mitigation approach in such a case would be investment diversification and the implementation of risk management techniques.

User education, responsibility, and scope for errors

Because blockchain technology is quite a difficult concept to grasp and it requires a steep learning curve in order to understand it, it may be difficult for regular users to figure out how it works or how it can benefit them. Absence or a lack of knowledge and education around this technology can be a hindrance to adoption. However, the opposite is also true. By developing user-friendly interfaces and knowledge resources, it will become easier to promote sound investment practices.

Network congestion

Ethereum is a major blockchain network. Its role is to host DeFi applications. And to date, it is one of the biggest providers. However, network congestion is a big possibility when many DeFi apps are used and transactions are performed simultaneously. An often cited issue with this congestion is that transaction fees can increase. Ultimately, this has scalability implications as there are limits to how quickly the DeFi ecosystem can expand.

Artificial intelligence (AI)

The rise of artificial intelligence in many use cases around the world is not leaving DeFi untouched. For example, since oracles tap into real-time and real-world data, it’s possible to use certain AI techniques to identify irregularities, odd patterns, or any outliers in a dataset. In particular, this can be achieved through generative adversarial networks (GANs), isolation forests, local outlier factors, and other AI functionalities.

This data can be relayed back to an oracle before it passes it down to the blockchain. However, improperly trained data, incomplete datasets, and other AI-related challenges can pose threats to the robustness of the data an oracle taps into. Issues of ethics and ownership surrounding non-fungible tokens (NFTs) and the related NFT software development will also play a key role.

As such a sound AI strategy in conjunction with reliable blockchain technologies will play key roles in the future.

Conclusion

Blockchain technology and its impact on DeFi is immensely significant in our modern communities.

As this technology offers new avenues and opportunities for the unbanked or underserved societies to gain access to financial services they couldn’t previously access before, a growing number of people can enjoy the convenience of financial services without banking intermediaries.

While this has the potential to reshape our societies, it also comes with critical challenges that must be addressed to prevent innocent users from malicious actors, to halt illicit financial flows, and to ensure greater security in the entire ecosystem.