Decentralized Finance or DeFi, is a fairly new term in the ears of many people. DeFi is an idea that promises to create a more open financial system that will allow everyone to participate in many different ways.
Among the many qualities and properties DeFi promises, the most important one is censorship-resistance. Censorship-resistance is a property inherited by the underlying technology, the blockchain, and implies that any party wishing to transact on the network can do so as long as they follow the rules of the network protocol.
There are many qualities and great ideas coming out of the DeFi space, however, there are also many myths surrounding DeFi. As decentralized finance grows further, it’s worth having a look at some of the most popular myths surrounding the DeFi at its current state.
1. There are no fees in decentralized finance.
Many sources are claiming that there are no fees associated with DeFi protocols. Similar statements you sometimes hear in small or big gatherings of crypto and blockchain enthusiasts. They promote DeFi as a great alternative to the traditional financial system that enables everyone to send and receive money, trade, lend and borrow money with no fees. That’s not just a myth, but rather a completely incorrect statement.
There are fees users pay in DeFi on many different levels. First, whenever a user performs an action on the network, this action is translated into a transaction on the blockchain. In order for a transaction to be executed, it requires the user to pay a certain fee. Some networks might have lower fees than others, but there’s a certain fee that the user has to pay for every transaction.
That’s not necessarily bad. For the network to operate, it requires individuals like you and me to run miners or validators that execute the transactions. The transaction fees users pay on the network are used as the payment to the validators for running and securing the network. With no fees, there will be no rewards for the validators. Nobody would be willing to run a validator for free as there are certain costs associated with running a validator. Individuals and companies are running validators to make a profit.
Blockchains and validators are the backbones of DeFi, the infrastructure. On top of blockchain networks, usually, we have decentralized applications such as exchanges, lending platforms, etc., that make up the DeFi ecosystem as we know it today.
Most of the times, these decentralized applications also require the user to pay a fee. For instance, whenever a user performs a swap or trade on a decentralized exchange, it pays a certain fee. Depending on the exchange this fee might be 0.05% to 0.3% of the swap’s amount. This fee is partially split between liquidity providers and the protocol itself. In this way, the decentralized exchange rewards the liquidity providers for providing their funds as a service and keeps a portion of the fee to cover the future development of the protocol.
Decentralized finance and by extension decentralization as a whole, did not mean to be free. For decentralization to work, it requires individuals, like you and me, collectively to provide different types of services, based on our skills and resources and create value. In return, all contributors are rewarded for their services, with fees paid by the end-user and collected by the various platforms.
2. Decentralized finance is completely anonymous.
Decentralized finance protocols allow users to create, trade, and manage digital assets on the blockchain. This implies that every transaction is recorded on the blockchain, shared, and distributed across a network of computing nodes that verify the transactions, the validators. Consumers do not need to through any KYC process to use and transact on the network. All their actions are recorded in a transparent way on the ledger for anyone to see. The lack of identification provides a certain level of anonymity but not complete anonymity.
By nature, blockchain technology records every transaction on the network. Furthermore, the transparent nature of the majority of public blockchain networks allows anyone to go and see the transactions. Someone can fairly easy go and trace funds on the blockchain network, by observing the wallets from which the funds were transferred.
The lack of identification prevents regular users from identifying the person behind such transactions. However, someone with a certain level of authority can trace the funds back to a centralized exchange or a bank from where the initial transaction was triggered, and identify the person behind these transactions.
There are networks that users can use to keep their transactions completely anonymous today, or even use other methods to keep their anonymity on public blockchains. However, the idea that today’s DeFi preserves users’ anonymity is rather a myth than reality. Today, DeFi is predominantly built on public smart contract platforms that allow everyone to track the trace of funds.
Privacy in DeFi, also coined as PriFi, is an emerging trend that aims to bring privacy in DeFi as well as in the whole decentralized space as a whole. Privacy is also key in the wider adoption of DeFi and blockchain technology, especially for legal entities that would like to use crypto as a payment method or leverage blockchain technology in parts of their operations.
3. Decentralized finance is decentralized.
Decentralized finance is based on the principle of having an open financial system where people do not rely on a 3rd party or a central authority to manage, govern and have control over individuals’ assets. Instead, financial services are available for everyone to use, everyone can provide services, contribute to this open financial system and people have control over their funds – how to use and manage them.
For a truly decentralized protocol to exist, it requires a truly decentralized infrastructure and truly decentralized governance. At the point of writing, there are very few, if any, protocols out there that have these two characteristics.
Although a large number of protocols have on-chain governance, the majority of the decisions are taken by the founding team off-chain. This goes against the fundamental principles of decentralization where there’s no central authority that users need to trust. In such a scenario, the central authority is the founding team, since they take the majority of the decisions associated with the future of the protocol.
Achieving decentralization is not easy, especially decentralized governance. Expecting thousands of token holders to vote for a proposal might take an eternity. However, there are ways to achieve efficient on-chain decision-making using delegation. Without decentralized governance, there’s no decentralization.
Decentralized finance requires decentralized infrastructure. This includes a decentralized network of thousands of nodes and decentralized (fair) token allocation such that no one can take control of the network. Another consideration when it comes to decentralized infrastructure is associated with where these nodes are hosted. Having a thousand validator nodes securing the network and all of them being hosted on Amazon or Google Cloud doesn’t sound so decentralized. The cloud provider can shut down the network at any point in time. That’s a farfetched scenario, but a possible one.
Certainly many projects launch while having a centralized approach and plan to move to more decentralized models at later stages. This makes the management of the project in the beginning to be more efficient. As of now, decentralized finance is more centralized than you may believe. The ideas of decentralization are in place. Many teams and projects are working towards decentralization. We are just not there yet.