In these series, let’s have a deep dive into DeFi and its key attributes. First one will be the non-custodial nature of DeFi.
In one of our first posts, named ‘Introducing DeFi’ we discussed the emergence of DeFi from user and technology perspective. In that post, we have briefly mentioned the key attributes of DeFi. In this series, we will talk about these attributes in more detail.
Is custody that important?
Custody in finance is a huge issue. Let’s explain why:
Finance is essentially a game built on trust. The main role of financial organizations is to ensure trust is available in financial transactions. Why do we need trust? Well, every transaction involves an exchange - a good, service, investment etc. and money in return. During that transaction duration, be it ten seconds or ten months, the party that expects the goods and service, has to give their money in advance. That money is held somewhere - and you cannot trust the corresponding party, especially in digital life. Therefore, that money is kept in a custodian, usually a financial institution (the same holds for if you make an investment with your money and expect a return such as interest).
Banks are custodians
To hold others’ money is a huge responsibility. Keeping thousands or millions of individuals’ money is even more significant. In order to ensure that these financial organizations hold on to their promises, the regulatory bodies act as controllers on behalf of their citizens. This is why you see strong regulations on banks and other financial institutions. Just ask your friends who are bankers and you will hear lots of complaints that nowadays, the largest departments in banks are regulatory compliance divisions.
|Image by Sophia Hilmar from Pixabay|
These regulations and compliance issues are actually quite a burden on financial institutions. While one may argue most of these resource allocation to compliance is unnecessary, we also accept the fact that this is the fundamental issue of traditional bankings that is almost impossible to change.
How about DeFi?
One of the main premises of DeFi is to give power to the users. As part of that main premise, users do keep full custody of their assets. How is this even possible?
We should thank to encryption as well as blockchain technology for that. Digital assets in crypto are quite different than physical assets in real life, in the sense that they are not ‘physical’, but merely records on the blockchain. While digital assets is actually the sum of 0’s and 1’s and can be changes or modified, blockchain ensures that what ever is recorded on it cannot be altered. This ensures to hold unique digital assets. Encryption or private and public keys of ensures that individuals have access to and full control over (i.e., power) these digital assets.
In decentralized finance, the services that users access, such as Uniswap or Compound are merely smart contracts or piece of software. They do not ‘touch’ users’ assets. Users give these contracts ‘temporary’ access to execute transactions on blockchain. How would users ensure that these contracts are safe? First of all, these smart contracts are open sourced- meaning all the codes and what they can be done, is visible and reviewed and audited by anyone who wishes. There are audit reports published by various institutions.
As DeFi protocols do not take custody of customer assets, it is natural to assume that the regulatory compliance issues would be minimal. In the US, the regulatory bodies accept such fact, but only for truly decentralized protocols and they claim many of DeFi protocols present themselves as such but in reality are centralized and should be under their scrutiny and regulation. While this argument is true, we should remember that decentralization is a long process. Protocols usually start centralized around a small team, as speed is more important in that early stage. Once they get certain maturity, decentralization becomes a phase they have to evolve to. MakerDAO is one of the leading candidates on how protocols would look at and inspire to be in terms of decentralization.
To be continued
We will continue to look at different attributes of DeFi in our future posts.
None of the views expressed in this article should be considered as investment advice