How to Build a Sustainable Decentralized Financial Systems?
Decentralized financial systems have brought with them a plethora of benefits. From increased control to better security, DeFi has shown a lot of promise and it is also very likely to have a major impact on how banks operate. Even to the point that it can shift the structure of the whole financial system at a macroeconomic level.
As the pandemic took over in 2020, people around the world relied more than ever on technology. As a result, millions of people across the globe discovered how blockchain technology is lowering the barriers to access. Especially the barriers to access to wealth generation through DeFi. People can access finance in a way they never could in the past.
With DeFi opening up new financial avenues for people, it has the potential to lower poverty. Beyond simply holding and trading, DeFi has enabled anyone with the internet and a digital wallet to make passive income.
Before, only the rich and wealthy could do this.
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Another aspect that sets DeFi apart is the minimal human intervention in a financial transaction. Everything is controlled by protocols, smart contracts, and algorithms. This makes the system much more efficient.
Needless to say, DeFi is a promising technology that can drastically change the typical financial system. It has the potential to accelerate a wide variety of services like trading, lending, and exchanging funds.
But up until now, traditional financial institutions have been reliant on human-dependent processes. So, how do we make a system that is almost completely reliant on technology sustainable and scalable?
In this article, we will talk about the concept of DeFi and how we can build a sustainable decentralized financial system.
Decentralized finance, or DeFi, covers a wide variety of financial applications. These applications do not rely on intermediaries or a middleman. Middlemen could be anything like brokers, exchanges, and banks.
Instead, what DeFi does is use smart contracts that lay out certain rules and regulations regarding a transaction. Those rules are followed rigidly which encourages safety, security, and trust between the parties involved.
DeFi users don’t need to waste time on a long phone call or an email conversation with a customer service representative. We know how common that is in typical financial institutions.
In DeFi, users can interact with open software protocols through digital wallets and the users manage these wallets themselves instead of a service provider. Thus, DeFi users have full control over their money. They are able to perform financial transactions directly with each other without any outside interference.
An interesting aspect of decentralized financial technologies is that they are focused on recreating the entire financial ecosystem. They don’t just aim at building software.
Blockchain technology has seen monumental growth in the last few years. And it shows no signs of stopping. There is a broad audience that is deeply invested and interested in cryptocurrencies and decentralized finance.
Moreover, thanks to robust technologies, Defi offers a lot of advantages to business owners and its users. Let’s take a peek at some of them:
- Easier access to financial services
- Transparent peer-to-peer trades
- Improved market efficiency
- Ability to combine Defi apps on top of each other
- Full control over funds for businesses and end users
- Possibility for international financial transactions
With so many benefits, Defi will only increase in popularity. However, before we make it prevalent, it’s important to see what issues it currently faces. This way, organizations can eliminate them to create more sustainable decentralized financial systems.
If we want to start thinking about scaling our decentralized finance, we first need to address the issues it faces. The decentralized market, as a whole, is fairly new. Since it is in its early stages of development, there might be some pitfalls attached.
Here are a few roadblocks that currently exist and the possible solutions to fix them to make sustainable DeFi:
1) Smart Contract Limitations
A lot of people wonder how Defi foregoes the need for a central authority. The answer to that is smart contracts. Smart contracts are that aspect of Defi that fills the role of intermediaries.
An issue with smart contracts is that a malfunctioning smart contract will affect your Defi solution’s entire ecosystem. This malfunction could happen as a result of poor programming which results in flaws in the code. Or the problem could arise from user errors during a transaction.
A proven way to overcome these issues in smart contracts is to stick to development best practices. This could mean:
- Carefully choosing a blockchain network
- Following the blockchain network’s development standards
- Paying close attention to the testing of code
2) Low Liquidity and High Fees
Liquidity in the crypto world relates to how quickly an asset can be bought or sold at its intrinsic price. Put simply, liquidity is the pool of coins available for performing different operations on a Defi platform.
Low liquidity means that the market is volatile causing extreme fluctuations in cryptocurrency prices.
This low liquidity comes with high transactional fees. In many cases, the only way to buy and sell digital assets is to pay high fees. This creates an issue for users as they can’t freely exchange their assets.
An efficient way to address the low liquidity is to make a certain cryptocurrency more attractive to the audience. To overcome the high fees, we can consider using feeless transactions by either using multiple tokens or subsidizing the platform.
3) Lack of Clear Regulations
Probably the most complicated challenge for Defi is the lack of a legal framework around it. Even if a Defi project is made with top-notch security and best practices in mind, there is no guarantee that the government won’t introduce strict requirements.
These requirements might force a Defi to make big changes to its architecture, and even shut down. This is a major roadblock that can stand in the way of creating a sustainable Defi system.
Due to this lack of regulations, there is a lack of user trust as well. Moreover, the complete anonymity of the system can provide cyber criminals with opportunities.
So, how do we solve this?
The good news is that the process of creating a legal setup around Defi has already begun. This could be great for the longevity of decentralized finance as it will become a part of our law, making it more concrete.
4) Performance Roadblocks
One of the biggest roadblocks of DeFi is its slow transaction speed. This significantly impacts DeFi’s scalability issues and reduces the overall system performance, too.
To keep transactions safe, blockchains register every transaction and make them public. This comes at the cost of longer processing times.
One promising way to solve this issue of sustainability is to use state channels. A State channel is a process in which users transact with one another directly outside of the blockchain. This greatly minimizes their reliance on the blockchain which reduces the strain resulting in higher speeds.
5) Hacking and Other Cyber Attacks
Malicious attackers will always remain a threat in the financial sector. Unfortunately, they are pretty creative and come up with new ways of exploiting the system.
Despite its high security, the blockchain network is not safe from some common dangers.
The most straightforward way to solve this issue and make DeFi sustainable is to find weak spots in the code. But conducting regular security audits is not the only way to reduce malicious attacks.
Programmers should also follow development best practices. One of the most common best practices is to write clean and unique code. A clean code makes it easier to find any possible loopholes.
Clean code also makes it easier to build upon which means the baseline Defi model will be more scalable and sustainable in the long run.
Conclusion – Creating Sustainable Decentralized Financial Systems
Developing sustainable DeFi is a challenge that may take some time to overcome. Since the technology is so new, things are still a bit unclear and can take time to get less foggy.
Thanks to Defi’s rapidly rising popularity, though, the pitfalls associated with its scalability can be addressed a lot quicker than usual. With so many users jumping on this concept of finance, combined efforts are going to be made.
These efforts can then lead to fruitful results and, maybe one day, a completely decentralized financial system.
Further reading: What Is FinTech In Simple Terms?
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