Evaluate the potential of Decentralized Finance (DeFi) in developing an alternative system to the existing banking and financial system. (15 marks, 250 words) [GS-3: Indian Economy]

Introduction
Decentralized finance (DeFi) refers to a financial system that is not built on or around a central figure or institution and instead is powered by a number of distributed actors and organizations often working independently or in tandem. The system removes the control banks and institutions have on money, financial products, and financial services. E.g. crypto transactions.

Body
Features of DeFi in contrast to traditional financial services:

• Permissionless: DeFi does not follow the conventional principles of access followed in traditional finance. On the contrary, it follows the open, permissionless access model. Any individual could access DeFi solutions through an internet connection and a crypto wallet.
• Programmability: The programmability in DeFi opens up new avenues for creating new financial instruments and digital assets. DeFi has all the necessary support required for addressing any type of conventional financial service function.
  • Also, the lack of barriers to entry means anybody with programming skills can take part in building financial services and could view, audit, and develop on the existing code on top of public blockchains.
• Transparency: DeFi is a more open and transparent than traditional finance. The enhanced transparency regarding transaction data enables comprehensive data analysis.
  • In DeFi every transaction is broadcast to other users on the network. All the users has to verify the transaction broadcasted to them.
• Immutability:
  • The exchange of information and financial transactions in DeFi requires the assurance of data integrity. So, it is important to have tamper-proof data coordination throughout the decentralized architecture of blockchain. As a result, it can contribute to profound improvements in security and scope for audits.
  • With the assurance of safe and secure data transmission without any unauthorized modifications, DeFi offers the assurance of integrity for all transactions.
• Interoperability: The characteristics of DeFi also take the discussion towards interoperability as one of the prime requirements in the financial services ecosystem today.
  • The composable software stack helps in ensuring that DeFi protocols and applications are tailored for integrating with each other and complementing one another.
  • DeFi gives adequate flexibility to developers and product teams.
• Non-Custodial: DeFi stands out as an alternative to traditional finance. The use of digital ledger technologies has made it possible for people to gain full control of their assets and their personal financial data when transacting in the global financial sector.
• Easy to send and receive money without any restrictions: The traditional financial sector comes with a lot of regulations and requirements that, at times, make it difficult for people across borders to transact business. The integration of block chain technology into a number of financial products makes it possible for people to send and receive money without having to worry about bans or restrictions.

Potential of the DeFi in developing an alternative system to the existing banking and financial systems:

• Democratize Finances: By relying on peer-to-peer philosophy and self-executing “smart contracts” on the block chain network, DeFi democratizes finance and replaces traditional centralized institutions such as banks, brokerages, and NBFCs.
• Geographically Independent: Decentralized finance has the ability to provide financial services without geographical barriers. Traditional finance has struggled to reach some remote parts of the world, leaving billions without access to banking services.
• Easy to send and receive money without any restrictions:
  • The traditional financial sector comes with a lot of regulations and requirements by government that, at times, make it difficult for people across borders to transact business.
  • The integration of block chain technology into a number of financial products makes it possible for people to send and receive money without having to worry about bans or restrictions.
• Circumvents Hyperinflation:
  • Following the 2008 Financial Crisis, many people lost their fortunes as a good number of banks went under. Concerned by the threat posed by the current global financial systems, many people are looking to emerging technologies to shield themselves.
  • DeFi will provide a reliable method of circumventing issues related to hyperinflation resulting from currency manipulation or unexpected devaluations, as is the case in China.
• Increases Efficiency: DeFi uses smart contract technology on the block chain network with zero human intervention. This reduces the chances of errors and increases efficiency.
• Low Cost Financial services: DeFi projects on the block chain network provide easy and cheaper access to capital, efficient lending and borrowing and decentralized crypto and synthetic stock exchanges. In addition, DeFi removes middlemen and enables more efficient financial services at low costs.

Limitations of DeFi:

• Immature:
  • DeFi technology is immature and has yet to be fully stress-tested at scale over an extended period. Funds may be lost or put at risk.
  • The DeFi platform Compound, for example, suffered a serious glitch recently during which customers were accidentally sent millions of dollars of crypto.
• A lack of consumer protection: DeFi has thrived in the absence of rules and regulations. But this means users often have little or no protection when things go wrong. No state-run reimbursement schemes cover DeFi and there are no laws enforcing capital reserves for DeFi service providers.
• Hackers are a threat:
  • While hacking is also a risk in traditional finance, DeFi’s extended technological architecture, with multiple points of potential failure, increases the so-called attack surface available to sophisticated hackers.
  • For example, “white hat” hackers exploited a smart contract vulnerability in August 2021, stealing $610 million from the DeFi platform PolyNetwork.
• Collateral requirements are high: Nearly all DeFi lending transactions require collateral of at least 100 per cent of the value of the loan, if not more. These requirements vastly restrict eligibility for many types of DeFi loans.
• Private key requirements:
  • With DeFi and cryptocurrency, users must secure the wallets used to store cryptocurrency assets. This is an important requirement for both individual private investors and institutional investors using multi-signature wallets.
  • Private keys, which are long, unique codes known only to the wallet’s owners are used to do this. If private investor loses their key, for example, they lose access to their funds forever.

Conclusion
While the use of digital ledger technologies in the global financial system is still in the early days, one cannot dispute this technology’s ultimate potential. Decentralized finance has what it takes to revolutionize the financial sector in a time of growing concerns about data and privacy security.