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How Artificial Intelligence Will Impact Decentralized Finance: Promises and Illusions

Updated: 4 minutes ago

Artificial intelligence (AI) has the potential to increase transparency and decentralization in the world of decentralized finance (DeFi). Predictive analytics, smart contract automation, credit scoring, and other applications promise positive changes. However, we must be realistic about our goals in AI and avoid undue liability and human decision-making constraints, as well as strive for easy profits. Introduction: Artificial intelligence (AI) is one of the most exciting technologies in the world, capable of changing many aspects of our lives, and this also applies to the blockchain and cryptocurrency industry. However, we need to manage our expectations carefully. Despite all the promises of AI, it is also accompanied by certain illusions. Only by identifying places for potential innovation can we successfully implement this technology.

The Potential of Artificial Intelligence in Decentralized Finance (DeFi)

Let's start with defining both terms. Decentralized Finance (DeFi) is an ecosystem of applications built on blockchain networks. DeFi products include crypto loans, liquidity provision, and decentralized exchanges (DEX). Artificial intelligence (AI), according to the Oxford English Dictionary, is "the ability of computers or other machines to exhibit or mimic intelligent behavior." When we talk about AI in finance or trading, common applications include fraud detection programs, trading bots, and even chatbots for customer service.

What unites these two technologies?

At first glance, artificial intelligence and DeFi have the ability to change traditional financial systems through efficiency, transparency, and accessibility. DeFi has transformed products that we can all access, while AI influences how we interact with them. It seems that there is an opportunity for AI to improve decision-making processes and risk management in DeFi. But what could this look like? We can expect new financial products and services developed using AI, as well as trading algorithms and market-making mechanisms.

How Artificial Intelligence Can Be Used in DeFi:

  • Predictive Analytics: Predictive analytics utilizes artificial intelligence to attempt to predict future market outcomes by analyzing historical data and applying statistical models to it. AI can improve its predictive skills using machine learning over time. Simply put, it's like AI conducting technical and fundamental analysis on behalf of a trader. These artificial intelligence tools are already available in the world of cryptocurrencies and finance, but there is also emerging potential for automated trading and portfolio management in the DeFi sector.

  • Smart Contract Automation: AI has the potential to increase the efficiency of smart contracts through automation. For example, a lending protocol could use AI to continuously monitor a borrower's collateral level and predict potential defaults before they occur. This information could then be relayed to the lending protocol. In this case, AI would perform a function that would be challenging for a smart contract to handle on its own.

  • Detecting Fraudulent Activity in DeFi: The anonymity provided by DeFi services can make it more challenging to detect fraudulent behavior, but this issue can be addressed with artificial intelligence by analyzing trends in large volumes of data to identify fraudulent activity. For example, fake trading volume on an exchange or suspicious liquidity movements could be detected using data analysis methods.

  • Assisting in Credit and Lending Through Credit Scoring: As part of the core concept of DeFi, decentralized products require minimal or no intervention from issuers. However, this means that, apart from capital investment, DeFi products such as crypto loans often have very low or no barriers to entry. With proper credit scoring, crypto loan issuers can offer more favorable terms to users with documented repayment reputations. However, introducing a potentially biased human element into this scoring system would remove the decentralization aspect. One way to counter this is to implement AI-based credit scoring, which could analyze a borrower's wallet and history, transparently assessing their creditworthiness.

  • Investment Advice and Portfolio Management: Robo-advisors present an exciting prospect for traders and investors in DeFi markets. An interactive user experience, akin to human interaction, simplifies learning technical and fundamental analysis and high-level predictive analytics. Since transactions on most blockchains are entirely transparent, AI has plenty of data to analyze and utilize.

Are there any negative effects of using artificial intelligence in DeFi?

Considering the bigger picture, we can see potential dangers in using artificial intelligence. AI will undoubtedly reduce the need for human labor in certain tasks, which may render some jobs - and to some extent, accountability - obsolete. DeFi is already a complex sector to regulate due to its anonymous nature, and involving non-human actors will exacerbate the problem.

We should also consider potential issues related to training artificial intelligence on limited datasets. Compared to traditional markets, cryptocurrencies, and especially DeFi, are in the early stages of development, and we have relatively few long-term data to build a balanced view of the market as a whole.

The introduction of new tools also comes with security risks. Entry points for AI tools and how they access our data and wallets also mean additional attack vectors for fraudsters. If these tools are not open-source, they are typically developed by private companies or individuals. How secure these tools are depends entirely on the reliability of the security features built into them by their developers.

It's also worth considering the risks of decentralization that the implementation of privately developed artificial intelligences can bring. Often, there is a lack of transparency in how these tools work. You may not fully understand new updates or even precisely know what access this artificial intelligence has. If the developer discontinues support for this artificial intelligence, you may end up with useless software.

What are the illusions associated with using artificial intelligence in DeFi?

Although artificial intelligence provides exciting possibilities in the DeFi space, we must be realistic. To fully harness the potential of artificial intelligence in DeFi, developers must focus on where it can truly make a difference. Most of the following illusions have already been seen in the traditional financial world, so they are easily spotted in the DeFi world as well.

  • AI can replace human decision-making

Human input is always required when using an AI-based tool. Artificial intelligence must be trained and used properly, which requires a more complex process than simply deploying it on markets without any guidance.

  • AI can solve all DeFi problems

While AI can increase transparency and decentralization in DeFi, it is not a magic solution for all its problems. Attempts to "shoehorn" AI into every possible problem are ineffective and can actually cause more problems.

  • AI-based trading systems will be much more profitable

Just look at existing systems on centralized exchanges (CEXs) to see that this is not the case. AI-based systems have some advantages, but there is no guarantee that they will be more profitable.

  • AI will eliminate the need for trust in DeFi

DeFi already operates with a significant degree of mistrust, but there are usually valid reasons for trust in certain cases. Artificial intelligence should not attempt to replace careful research into the reliability of the project team or founder.

The future of artificial intelligence in DeFi?

Undoubtedly, in the future, artificial intelligence will bring revolutionary discoveries. However, we cannot be sure of the extent to which this applies to DeFi. The potential of using AI to increase the accessibility and efficiency of financial services is evident and should be our goal.

This can be achieved by using artificial intelligence to enhance the efficiency and effectiveness of DeFi systems in predictions, risk management, and automating routine tasks. We can also use it to improve user experience and security.

However, one should not expect quick and easy profits from artificial intelligence. If that's what you're looking for, you're almost certain to be disappointed. Therefore, it is much more practical to focus on the potential of AI not to increase profits but to increase accessibility and financial freedom for DeFi users.

Final thoughts

The potential of artificial intelligence in the DeFi space is undeniable. Artificial intelligence can revolutionize our interaction with DeFi by automating financial processes and providing more accurate forecasts of market trends.

However, despite the promising potential of artificial intelligence in DeFi, there are a number of illusions to consider. Therefore, as this area develops, it is extremely important for the crypto community to remain vigilant in the implementation of artificial intelligence, recognizing its capabilities but being wary of unforeseen consequences.

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