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There’s a lot of talk about DeFi (decentralized finance) these days.
If one were to believe all the hype, it would seem that DeFi is a foregone conclusion it’s not a matter of if complete decentralization will happen, but rather a matter of when.
Admittedly, it does appear that things are heading in that direction. The potential, the market need and the technology are all there.
While some infer that we could make the switch right now, that’s beyond optimistic.
It’s true that decentralization is dependent on blockchain technology, and you’d be hard-pressed to find people who will argue that blockchain doesn’t work.
Even naysayers, when pushed, will concede that the technology itself is solid and has the potential to disrupt finance as we know it.
But just because blockchain technology has proven itself doesn’t mean that DeFi is a necessary inevitability.
DeFi will almost certainly play a role in the future of finance. But I can see at least three major roadblocks that need to be overcome before DeFi has a chance of overcoming traditional payments.
Consumer buy-in and trust
Our current centralized systems have been in place for a long time. They’re accepted because they’re familiar – and for the most part, they work very well.
People are resistant to change, particularly when they don’t see a clear benefit.
Even when shown the upsides, many will distrust a new way of doing things, taking refuge behind an ‘if it ain’t broke, don’t fix it’ mentality.
One of the chief arguments for DeFi is that it removes the middleman. But that doesn’t take into account that some people would rather pay a third party to perform a service.
We generally accept that – like attorneys or CPAs – financial professionals know more than we do about their specialty and will do a better job.
More importantly, when professionals provide a service, they also take on the accompanying risk.
Consumers will be even more hesitant to accept a new system if it also means losing protection and accepting liability.
This was effectively proven at the dawn of the credit card age. Payment card usage did not gain wide-scale acceptance until 1974, when stronger consumer protection mechanisms were put in place.
Acceptance increased once consumers knew they had a safety net if they were scammed or defrauded.
Even then, though, it still took decades for credit cards to become a dominant payment preference.
People needed formalized assurance that card payments worked across the board. That required at least some degree of centralization, as would any consumer protections used with DeFi.
Banks and financial institution acceptance
Financial organizations are understandably dragging their feet over a move to DeFi.
Our existing banking model is deeply rooted in the most basic tenet of capitalism – being paid to perform a service. In this case, arranging financial transactions on behalf of the customer.
As we’ve seen, decentralization empowers users to do the work without a go-between, and consumers may not go for that. For the financial industry, however, DeFi could be devastatingly disruptive.
Services that are currently integral to their business could become obsolete, meaning banks stand to lose the biggest revenue source they have.
DeFi could also potentially expose financial institutions to increased fraud risk.
Currently, US banks are legally required to use KYC (know your customer) protocols to identify the individual attached to a transaction.
That won’t work with blockchain – in a completely decentralized blockchain system, users can remain strictly anonymous.
If actual names and other personal information aren’t used, it’s exponentially more difficult to determine if people or organizations are engaged in illegal activity.
Money laundering, market manipulation and bank fraud are serious concerns.
That’s something that could impact the institutions in question, as well as the account holders and merchants they work with.
Lack of clarity regarding government oversight
While proponents of DeFi like to emphasize the absence of government regulations, that’s actually one of the challenges in achieving wide acceptance.
Without a centralized system, legislation like the aforementioned KYC rules would be nearly impossible to enact. To some, that may sound like a feature, rather than a bug.
However, legislators are not going to see the situation in the same light.
The same goes for any government mandates and agencies that protect consumers, including the FDIC (Federal Deposit Insurance Corporation) – and even the government itself could be a target.
Since transactions are extremely difficult to trace to an individual, it would theoretically be simple for a person to understate the amount of taxes owed or avoid paying them altogether.
Faced with the likely increase in criminal activity and an associated drop in government revenue, oversight legislation is almost inevitable. That means at least some centralization will be mandated.
So, finance can only really be as decentralized as lawmakers will allow it to be, and it’s unclear how they will respond.
DeFi and CeFi (centralized finance) – can this be a ‘yes, and?’ situation
None of this means DeFi isn’t viable. Rather, it means that some amount of centralization is probably necessary to make it work on a wide scale.
And in fact, we’re already seeing de facto centralization popping up, even in arenas considered fully decentralized.
Stable coins, for example, remain stable by requiring a centralized issuer who backs sales by legal tender.
CBDCs (central bank digital currencies), while controversial, are still in the works. Even Bitcoin mining is seeing centralization become a point of contention in the community.
That may be splitting hairs, as far as what we call centralization, but the crypto market is growing. The bigger it gets, the more likely we’ll see centralized regulation from FIs, the government or both.
We’ll also see combined efforts to sell the benefits of crypto to the public.
Individual brands will promote themselves, naturally, but advertisers, marketers and even lobbyists will recognize that selling the entire concept will also be necessary.
It would be hard to do that effectively without centralization. Again, that doesn’t make DeFi a complete impossibility.
The two systems are in competition, to some extent, but they are not mutually exclusive.
DeFi and CeFi – striking a balance
As convenient as it may be, trying to characterize this issue as a ‘good guys versus bad guys’ battle isn’t in our best interest.
Neither centralization nor DeFi are inherently bad.
One could argue that it would be easier to stick with the traditional way of doing things, but that genie is already out of the bottle.
Going backwards isn’t really an option, even if fully realized DeFi is unlikely to materialize.
The next generation of development, DeFi 2.0, is already addressing some of the challenges of decentralization, including scalability and seamless cross-chain interoperability.
But widespread acceptance is still a ways away.
There are multiple layer two solutions, and as with any decentralized service, that raises questions as to how well they work and how safely any given code performs.
Can we have two competing ecosystems existing side-by-side? Probably not indefinitely – one or the other would eventually triumph.
But a better question might be – why would we want to?
DeFi is going to continue to evolve in parallel to traditional payments. It would make sense to eventually work toward a single, fully realized solution that combines the best elements of both models.
A payments ecosystem that benefits from the speed, privacy and egalitarian ethos of DeFi, with the security and institutional legitimacy of TradFi (traditional finance).
The trick is to pull this off without losing sight of the main goal – safe, secure transactions, high efficiency and enhanced customer experience.
The future of DeFi will depend on how we strike that balance between maximizing benefits and still enjoying the protections of centralization.
Monica Eaton is the founder and CEO of Chargebacks911. This risk mitigation firm protects more than two billion transactions annually to help online merchants optimize profitability through dispute management. Monica is a globally recognized speaker who has shared her insights on technology, finance and entrepreneurship with audiences around the world.
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