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What Are the Top 3 Things People Get Wrong About DeFi?

Decentralized finance or DeFi is one of the largest niches in the crypto space. DeFi is a generic term for a system of applications and protocols built on a blockchain that is open, transparent, and trustless. DeFi removes intermediaries in financial markets and services, reducing the time and bureaucracy required to access financial services. DeFi protocols currently have over $170B in total-value-locked (TVL) according to DefiLlama. If you are a crypto trader, there is a good chance that you have explored protocols in DeFi. The ecosystem has grown rapidly over the last four years and remains cryptocurrency’s home for ‘passive income’.

But beyond the farms, liquidity pools, staking rewards, and lotteries, there are misconceptions that people have about the ecosystem. DeFi is broad and perhaps complex and this makes it easy for people to get certain things about it wrong. Today, we will explore the top three things that people get wrong about DeFi.

DeFi has massive potential but it's also risky.

Misconception #1: DeFi Will Replace Banks

Traditional banks and financial systems can be a pain in the neck no doubt, especially when trying to access loan services. There is also the risk of having your account frozen for the flimsiest reasons. The idea, however, that DeFi will be the end of banks is a far-fetched myth. The collapse of the financial market in 2008 birthed Bitcoin, and the cross-border acceptability of cryptocurrencies make DeFi attractive, but they are unlikely to dethrone banks.

Blockchain technology which powers the DeFi ecosystem is not exclusive to DeFi and banks can always borrow or imitate the technology. Barclays Bank in the UK has already begun the process of involving smart contracts in its payment processes. Several other banks including the Bank of America and the Development Bank of Singapore are in various stages of testing smart contract services.

Banks are usually slow to change but it is unlikely that they will sit on their hands and allow DeFi to relegate them to oblivion, not if they can copy the tech too.

Misconception #2: DeFi is Safer Than Traditional Finance

Decentralized finance is often touted as the safer financial system. The likelihood of human error is minimal and users get to interact directly with the smart contract. There are also several safeguards put in place to verify and record transactions. This is in contrast with centralized financial systems that leave room for both human error and manipulation.  DeFi however, offers unique risks of its own and some of them are irreversible.

DeFi protocols and apps are sometimes hacked and the funds of users are stolen. In many cases, users lose these funds permanently. With centralized systems, there are regulatory laws in place that require them to refund users partially or fully. Such guarantees are rare if non-existent in DeFi.

Certik reported that over $1.3B was stolen in hacks of DeFi protocols in 2021. 2022 appears primed to be a worse year for DeFi hacks, more than $1.6B has been stolen from the DeFi ecosystem in the first four months of 2022 alone, more than the whole of 2021.

Hackers usually exploit the flaws in the code of a smart contract which are often unnoticed by the developers. DeFi may be safer from censorship but the funds are every bit as vulnerable to cyber threats as those in centralized systems.

Misconception #3: DeFi Grants Complete Anonymity

A commonly talked about perk of DeFi is that it does not require KYC and as such users can use the ecosystem anonymously. DeFi allows for the creation and trading of digital currencies on the blockchain. These trades and the wallets that undertake them are however recorded on the blockchain. The information is also available to anybody with access to the blockchain. If authorities or law enforcement decide to trace the initiator of a transaction or owner of a wallet, all they need to do is follow the money trail till they are deposited in a bank account.

What makes blockchain technology unique is the decentralized nature of the system which allows thousands of nodes to verify and record transactions. They then share this information with the public to enhance transparency. These records do not disclose a person’s identity but they make it impossible for one to be completely anonymous.

In February 2022, the United States Justice Department arrested a New York couple for a $4.5B Bitcoin heist they carried out in 2016. The duo had moved the funds to a wallet after stealing the funds in 2016. The DOJ was however able to trace proceeds from the sale of the assets to the accounts of one of the individuals involved. So much for anonymity.

Conclusion: DeFi Is Revolutionary But It Has Limits

Decentralized finance has been one of the most successful niches in crypto since it made its debut in 2018.  With DeFi,  it is possible to access unbanked populations without the need for the often rigorous bank registrations. The ecosystem has incentivized lending and borrowing with mouth-watering APYs and low-interest rates on loans. Yield farms have been a hotbed of activity for profit-seeking investors. It has been revolutionary and as is so often the case with unique innovations, misconceptions about them soon flourish.

There are limits to the features and services DeFi can offer. This does not make it any less of a unique innovation. As more countries like China continue to crack down on crypto, the adoption of DeFi as an alternative will continue to spur growth and misconceptions.

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