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As summer of 2020 is coming to an end, the DeFi movement is peaking. With ETH up over 70% in July, the total value locked in leading decentralized finance protocols surpassed $7 billion, making it impossible for both crypto and traditional finance industry not to pay attention.
As access to the new internet for developers is simplified through tools like blockchain API and node hosting, more and more players start to build Web3 applications – potential rivals for legacy financial institutions. This competition makes us ask some fundamental questions about the differences of DeFi and traditional finance. The answers pinpoint the real value of the growing industry.
DeFi or traditional regulated markets?
During the last six months, players in the new DeFi ecosystem have been on a mission to participate and find ways to make a return. While most dApps failed to become profitable due to the lack of participation and real world use cases, lending platforms took off as one lucrative element of decentralized finance. Successful examples include Compound and Aave.
The higher the value, the more attention the industry attracts from governments. This leads us to the first question: What’s really going on? Governments want their hands in the game for many reasons: for tax, control, and audit.
Regulations, in theory, are designed to protect people –– and in many cases, they do. But there are always nefarious players that are going to try and take advantage of that. And in the case of crypto, regulation kind of goes against the ethos of the entire system.
When Bitcoin came out, it was first and foremost a way to take monetary control away from centralized entities. They want to run KYC, they want to see what's happening, they want to protect investors –– which is, again, perfectly understandable. On the other hand, there is the decentralized side of crypto. The side that does not want to run KYC or monitor your activity. The side that wants to give power back to the people. Are there bad actors on this side?
There sure are: remember the crazy ICO days? What companies used to do is create a fake coin, come up with a story, sell it, keep a big enough percentage making themselves whales with power to manipulate markets. They would pump and dump all day taking advantage of inexperienced traders.
The thing is, that's what traditional finance does too! Multiple cases during the last several years show that centralized exchanges and involvement of brokers doesn't intervene with the plans of whales, who are concentrating a lot of power in their hands. And if we learn more about the "penny stock" (small cap stock) cases and how governments print money for banks to artificially inflate markets, we will start to have a better understanding of how the system works today so that we can path the way for change tomorrow. In its core, the more distributed the markets are, the more free, less corrupted they can be.
Inclusive liquidity in decentralized finance
Right now, if you use decentralized exchanges, you can see the trades happening in real time on the blockchain. This way, you can analyze and assess activity and holdings to determine which projects are more legitimate than others.The more distributed the project, the less likely it is to have whales, who could potentially manipulate price action. Take for example the $MEME project. This was an airdrop experiment to examine what would happen if an equally distributed amount of tokens was given to random users. From tweet, to code deployment, to an airdrop followed by liquidity locked in under 30 minutes, this had some of the best qualities of tokenomics I’ve seen.
On centralized exchanges, you can't see this activity: there is an internal database, an order book, that the exchange controls, sees, and analyzes. The exchange knows who has money, and who doesn't: imagine one big wallet, where all the funds are deposited. If the exchange has bad actors internally or gets hacked, a series of wash trading could happen. A wash trade is a form of market manipulation in which an investor simultaneously sells and buys the same financial instruments to create misleading, artificial activity in the marketplace. Yes, this is happening today.
With DeFi, decentralized exchanges and wallets that the user controls, this is less likely to happen
There is a lot of money to be made in liquidity pools. In capital markets, the only players who can provide liquidity are the big entities, who have hundreds of millions of dollars. But with DeFi, even if I have five dollars, I can provide liquidity and make a return. It won't be a lot, but I get to participate, learn, and earn.
Final thoughts
The lessons from traditional finance raise very important questions for the DeFi industry that has shown that it is ready to accept the challenge. While the signs are already promising, decentralized finance is yet to prove whether transparency is a better way to battle with market manipulation and financial crime than traditional regulations on a bigger scale. If it does, we will have a better, more inclusive financial system worldwide.
This content is provided by an external author without editing by Finextra. It expresses the views and opinions of the author.
Alexander Boehm Chief Executive Officer at PayRate42
02 September
Azimkhon Askarov Co-partner at CONCRYT
Edvards Margevics Co-partner at CONCRYT
30 August
Ellen Roberson Global Marketing Advisor, Risk, Fraud & Compliance at SAS
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