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  • Writer's pictureSolene and Kanav

Decentralized Finance and Blockchain Technology’s impact on the Financial Services Industry

In an era increasingly embracing decentralization, DeFi (Decentralized Finance) emerges as a transformative sector within the dynamic realm of blockchain technology. It represents a groundbreaking shift towards self-governance and peer-to-peer interactions, anchored in the infrastructure of blockchain networks, with Ethereum leading the charge.

 

To demystify the concept, DeFi's primary objective is to democratize financial services, making them accessible to everyone via decentralized mechanisms. This includes an array of services such as lending and borrowing, decentralized exchanges (DEXs), yield farming, liquidity mining, and automated market makers (AMMs), all underpinned by DeFi. Users worldwide, equipped with just a stable internet connection and a cryptocurrency wallet, can engage with these platforms seamlessly. In this blockchain-based network, cryptocurrencies naturally become the primary medium of exchange.

 

From a commercial perspective, trade finance and fintech entities stand to gain significantly from DeFi's facet of smart contracts. These are smart contracts whose terms are encoded in a precise series of conditional statements. Operating on blockchain networks, they execute transactions autonomously once preset conditions are met, epitomizing transparency and eliminating the need for trust. For instance, consider a smart contract between an importer and exporter. The contract stipulates that upon the buyer's confirmation of receiving the goods, the payment – which can be in cryptocurrency or traditional fiat currency – is automatically released to the seller. The funds are securely locked until contract conditions are fulfilled.

 

As we know, DeFi has drastically changed the financial sector and its presence has greatly increased (Graph below, data from 2017-2018). Some of its specific advantages related to areas such as asset management, faster stock market settlement, effective payments, and enhanced compliance procedures are explained below.

 


 

Advantages of DeFi

 

Faster Stock Market Settlement: In the past, stock market settlements took many days to complete. With blockchain's smart contracts and distributed ledgers, transactions occur almost instantly, reducing settlement times and operational risks, and removing intermediaries.

 

Asset Management: Blockchain integration, like FundsDLT, facilitates transparent cross-border trading, reducing costs and errors. Immutable ledgers streamline asset exchanges, ensuring security and accuracy in transactions among parties.

 

Efficient Payments: By guaranteeing transparent, safe, and cost-effective transactions, blockchain revolutionizes payment systems. It makes transactions easier, more affordable, and safer via distributed ledgers and smart contracts. Central banks are looking at implementing blockchain technology into their redesigned payment systems in an effort to improve the efficiency and reliability of financial transactions.

 

Enhanced Compliance Procedures: KYC-chain and other blockchain systems streamline procedures, especially with regard to Know Your Customer (KYC) standards. Automated client identification is made possible by real-time updates, less duplication, and encrypted, decentralised data, all of which ensure regulatory compliance while protecting data privacy.

 

Governance Concerns of DeFi and Blockchain technology

 

Even though blockchain has a wide range of applications in finance and may be used to improve security, lower costs, and expedite operations in a number of sectors, several governance issues remain, most notably those related to financial regulatory compliance.

 

Complications arise from different legislations in different countries and the decentralised nature of blockchain technology. For instance, regulations like Anti-Money Laundering (AML) and Counter-Terrorism Financing (CTF) mandate financial institutions to monitor suspicious activities, which becomes challenging within decentralized blockchain networks.

 

Governance within DeFi is typically managed by governance tokens, granting token holders voting rights on protocol changes. This approach fosters a democratic ethos and encourages active community participation in shaping and managing DeFi services. However, the tradability of these tokens introduces certain risks and challenges, such as regulatory uncertainties and the inherent volatility of tokens and cryptocurrencies, which stakeholders in the DeFi space must be wary and careful of.

 

Another worry is the lack of clarity surrounding liability in blockchain-based transactions. Decentralised networks, in contrast to centralised systems, find it difficult to assign blame for mistakes or fraud, which makes dispute resolution and legal actions more difficult.

 

Interoperability between traditional financial systems and blockchain platforms is also a governance challenge. Bridging the gap between legacy systems and innovative blockchain technology requires standardization and compatibility measures for seamless integration while ensuring security and compliance.

 

To tackle these governance challenges, financial institutions, regulators, and blockchain developers must collaborate in creating frameworks that strike a balance between transparency, privacy, and regulatory compliance. These issues can be mitigated by establishing industry-wide standards, data protection procedures, and cross-border regulatory compliance systems.

 

As can be observed on the picture below, regulatory uncertainty is one of the biggest obstacles to implementing blockchain technology, hence the need for a clear regulation framework.

 

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