Advantages and Disadvantages of DeFi

Published by Mario Oettler on

DeFi has some advantages over traditional financing services. Here, we have a list of the most common advantages and disadvantages of DeFi:

Advantages of DeFi

Markets are always open: Hence, trading is possible 24 hours, seven days a week.

No single point of failure: Ideal DeFi services have no single point of failure and are not stoppable. They also grant access to everybody. However, this depends on the concrete implementation of the service. As mentioned in the paragraph problems of DeFi, it is possible that a central authority gains control over the smart contract.

Low Entry barriers for users: This depends on the design of the DeFi service itself. In most DeFi applications, there is no KYC process necessary. This streamlines the onboarding. In addition to the lack of rules, there are also no rules that only allow institutional investors.

Anonymous transactions: DeFi allows anonymous transactions depending on the underlying blockchain. While there is no KYC process necessary, transactions in a blockchain are public. If an address is linked to a real-world identity, it is possible to trace all transactions back to this person. However, with mixers and anonymous blockchains like ZCash or Monero, anonymous transactions are possible.

Flexible user experience: Another advantage is that user interfaces are exchangeable. The Smart contract provides the application interface and developers are free to code their own user interface. This could be a website, a mobile app, or any other solution. Users can choose the interface they like most.

Interoperability: It is possible to design and build DeFi services interoperable to other services. This allows dApps to integrate other services seamlessly. And it would also enable dApps to compose their own service out of single DeFi services like a mashup. A prerequisite to this is that the interfaces are publicly known. A word often read is “money legos”. It describes the idea different services can be combined to create a new service. This works because of openly accessible APIs.

Global: dApps are globally available unless their access is blocked or banned by a government.

Critizism of DeFi

Although DeFi has received wide recognition, there is some substantial criticism.

Centralized elements: The basic idea is to replace (centralized) intermediaries with (decentralized) smart contracts. However, in many DeFi offerings, there is still a centralized element that poses the risk of a single point of failure. dApps need to be maintained and this requires update mechanisms for the code. This violates the core idea of a decentralized application. A remedy could be a decentralized governance process that shares the rights for an update among many stakeholders.

Fraud: In some cases, the creators of DeFi-services turned out to be untrustworthy, resulting in financial loss of the investors. Some DeFi services are Ponzi-Like schemes.

Poor quality: Another problem of DeFi is that many smart contracts proved vulnerable to exploits, either because of incorrect code or by setting the incentives and economics wrong. Since the underlying blockchain protocol evolves, it is very difficult to code error-free.

Irreversible transactions: Severe Problems can arise from the incorrect use of DeFi services. Transactions made in error cannot be revoked.

Confusing landscape: There are many competing platforms due to easy-to-copy code. This creates fluctuations of investors between the platforms. And a cluttered landscape makes it difficult for users to find suitable services.

Cost: DeFi services can be prohibitively expensive depending on the underlying network due to high transaction fees. Besides the network transaction fees, DeFi services charge fees for their services. 

Unknown impacts on economies: Some financial instruments can harm economies. With DeFi, such instruments are difficult to regulate.

Money Laundering: Anonymous transactions can be abused for money laundering.

Relying on oracles: An issue for all blockchain-based applications is the access to off-chain data (real-world data). Oracles provide such data. But if a DeFi service depends on a single oracle, it depends on a single point of failure.

Liquidity Risk: Efficient pricing requires sufficient liquidity. New services must first gain sufficient funds to work properly.

Regulatory Risks: But this is not a special problem of DeFi. Also, new centralized finance service experience regulation.