Finance has evolved to become extremely centralized, a trend that has benefited banks and other financial services institutions. Decentralization may be a guiding principle of future versions of the Internet, and finance will be affected by it as well.
Web3 is the next potential iteration of the Internet. It will be based on decentralization and, ideally, it will be interoperable and users control their data. Decentralized finance (DeFi) aims to transform traditional finance by using blockchain-based smart contracts and eliminating the need for intermediaries.
Decentralized financing and regulation can coexist
DeFi will not be widely adopted until it is sufficiently regulated. The permissionless nature of some DeFi projects means they could be used for money laundering, tax evasion and fraud. This is one of the reasons why China has banned all cryptocurrency transactions, as well as the fact that the lack of an intermediary makes it a difficult system to control. China is trying to limit capital flight, which cryptocurrencies can often facilitate. The irreversibility of offers and transactions made on the blockchain adds to this difficulty.
DeFi can be regulated and decentralized, but this requires regulators to work with platform creators and both to understand the potential challenges and pitfalls of the specific DeFi project. Hazards may have been built into the system, either accidentally or on purpose, highlighting why collaboration between suppliers and regulators is crucial. Creators can be anonymous entities, which makes this more difficult to facilitate. Closed-source DeFi projects may seem counterintuitive, since one of the advantages of decentralized platforms is transparency. However, closed source systems can be more difficult to exploit, as the details of the system are not accessible to everyone.
Smart contracts play a vital role in DeFi, as they automatically facilitate transactions that run a program on a blockchain when prearranged conditions are met. Controls will need to be included within these contracts to provide a defense against financial crime. These could be AML/CFT (Anti-Money Laundering/Combating the Finance of Terrorism) controls, which are not typically found in DeFi applications today, but are common in centralized markets. However, the decentralized nature of DeFi makes it difficult to find appropriate entry points for regulation, which poses a challenge for law enforcement.
The failure of cryptography undermines the vision of Web3
According to its core philosophy, Web3 and the Web3-based metaverse will need a decentralized payment mechanism. Cryptocurrency is the ideal candidate for this, but it’s clear that the crypto industry is facing growing pains.
Decentralized apps may have a harder time attracting venture capital after the recent cryptocurrency crashes. However, the system is acknowledged to be in its infancy, so investors are still pouring money into the underlying technology. The cryptocurrency would be the cornerstone of a decentralized financial system, with blockchain technology proving ownership of assets through distributed ledgers. The use of cryptocurrency can reduce the cost of transactions by eliminating intermediaries.
Recent market volatility raises the question of which, if any, cryptocurrencies are stable enough to be the foundation of a new digital economy. For example, the so-called ‘Stablecoin’ TerraUSD recently collapsed. This is because it lost its peg to the dollar as the company had no US dollars in reserve to back it. Bitcoin, considered the industry’s gold standard, has fallen 68% in value in the past year. These are examples of the structural immaturity that prevents the development of decentralized financing.
Meta tried to break into the cryptocurrency scene with little success, eventually shutting down its crypto payment wallet, Novi, and sweeping the failure of its payment system, Libra, under the rug. Web3 platforms have benefited from the additional features offered by cryptocurrencies, such as MANA, Decentraland’s native cryptocurrency, which has been used to purchase virtual land. This is an example of a more democratic form of financing, where customers have the right to vote.
Decentralized finance is not a black and white issue. Fully decentralized finance could be exploited by financial criminals, but traditional finance creates barriers to access to banking. A fine balance is needed to secure DeFi’s place in a Web3 world.
