Lights and shadows of decentralised finance

Piselli Riccardo and Tasca Paolo
(Centre for Blockchain Technologies, University College London)

At the beginning of 2017, the watchword that animated the financial circles of the City of London was “Fintech” (English for techno finance): today, more than two years later, the keyword is “DeFi”, decentralised finance.
The distinction has essentially two values: the first is qualitative, the second quantitative.

If it is now well known that the term Fintech encompasses all forms of technological innovation applied to the financial industry (distributed ledger technologies but also crowdfunding and peer-to-peer lending platforms, algorithmic traders and robo-advisors for the management of financial portfolios), the term DeFi includes only those financial innovations that make decentralisation their hallmark. In short: financial innovations made possible mainly by distributed ledger technologies

Indeed, as the well-known crypto-activity exchange platform Binance correctly illustrates (see, https://academy.binance.com/it/blockchain/the-complete-beginners-guide-to-decentralized-finance-defi), Decentralized Finance (or more simply DeFi) refers to an ecosystem of financial applications developed on the basis of a network blockchain. More precisely, the term Decentralized Finance refers to a movement that aims to create an ecosystem of open source and transparent financial services that is available to all and operates without any central authority. Thus, users would retain full control of their assets, interacting with this ecosystem through decentralised peer-to-peer (P2P) applications (DApp).

In a way, the DeFi phenomenon is part of FinTech’s.

This is evidently reflected on a quantitative level: despite DeFi’s growing size, it is in no way comparable to FinTech, an area towards which all traditional operators in the banking-financial sector are also converging.
But it is on the qualitative side that the differences are most appreciated: if Fintech does not matter any break from the traditional financial sector, DeFi is potentially disruptive and dangerously “uncontrollable”. This is because technology (which distinguishes Fintech) is always neutral in its ends: while decentralisation (which distinguishes DeFi) implies a political choice and even before an ideological one.

Then there is a historical and evolutionary aspect: if technological innovation applied to finance has always characterised the development of the sector and its regulation (just think, for example, of the advent of the internet, and even before the mobile phone or ATMs and credit cards), a separate discourse must be made for decentralisation. In fact, blockchain is not only an ICT technology that allows the registration of property or other rights and obligations on physical or digital assets (on/off platform), but it is also an institutional technology that allows the creation of decentralised governance structures for the coordination of economic-financial decisions and transactions. And it is precisely this last feature that the different and multiple DeFi applications aim to exploit; with an indirect consequence of no small importance: hiding the legal subjectivity of those who carry out an economic-financial transaction behind the network.

As a matter of fact, before blockchain, it has never been thought, for example, to restructure stock exchange trading by separating it from the existence of an investment firm; nor to rethink portfolio management using a collective intelligence, nor to modify the essence of trading venues outside any legal entity.

Here is a picture of the ideological battle in progress.

On the one hand, the traditional financial system, built on a complex set of multi-relational personal credit/debit relationships and based on a dense network of contractual ties, with the financial intermediary at its centre. On the other, the DeFi applications, which do not require the intercession of intermediaries or brokers but are based on an IT protocol that depersonalises contractual relations.

An ideological comparison that is played out on the ground of various services and activities.

We can consider, for example, decentralised borrowing: DeFi platforms directly link borrowers and lenders, and compress them to the point — in some cases — of eliminating credit controls (as well as commissions), allowing guarantees to be given through the use of digital resources.

Then there are the well-known stablecoins. Unlike common cryptographic currencies like Bitcoin, known for their volatility, a stablecoin is pegged to fiat currencies like the US dollar or Chinese Yuan (Tether, USDT, USDC, TrueUSD, Dai and Paxos are just a few examples). These assets, which still have a difficult and uncertain qualification, provide the (monetary) foundation on which to build the derived financial infrastructure and give the Central Banks the opportunity to think about Central Bank Digital Currencies (see, for example, https://ssrn.com/abstract=3622089). Thus, most of the DeFi financial contracts are anchored or settled in stablecoin

Finally, there are decentralised cryptoactivity markets or decentralised collective investment vehicles.

The first are the so-called decentralised exchanges (DEX), a term that includes all those platforms where digital assets are traded directly between traders (P2P) without intermediaries and whose transactions are carried out directly between user wallets via smart contracts (for a definition of smart contracts see for example https://edisciplinas.usp.br/pluginfile.php/5552473/mod_resource/content/1/Aula%2023.%20TASCA%2C%20Paolo.%20The%20Blockchain%20Paradox.%202019.pdf).

The second ones are platforms (known as the TheDAO platform) which allow the administration and investment of P2P funds outside of a corporate body.

Each DeFi application is counterbalanced by a corresponding CeFi (Centralised-Finance) actor, to coin a new English language: a lender-bank-intermediary, a legal currency, a trading venue (regulated or unregulated market) or an undertaking for collective investment in savings ( UCITS).
The advantages of this revolution towards decentralisation are impressive; as are the potential risks (for more information on the subject, see https://www.springer.com/gp/book/9783319424460).

Let us start with the first ones.

(1) The use of the blockchain in the DeFi ecosystem promises to give users direct control over their funds, as well as a higher level of security. In fact, the blockchain data recording process is carried out through the use of thousands of “nodes” (servers connected to the network), which make potential censorship and service suspension operations very complex.

(2) Another significant advantage of DeFi is certainly due to the ease with which access to financial services is guaranteed, especially to those who are excluded from the current financial system (the so-called Unbanked). According to estimates provided by the World Bank, more than 1.7 billion people currently do not have a current account with a financial institution, and more than half of them live in developing countries. This is mainly due to reasons related to poverty and lack of infrastructure in certain geographical areas: for example, millions of people cannot access financial services because they do not have an adequate solvency rating and as many millions do not have a bank account because of high fees and the total absence of a developed financial infrastructure. Given the scale of the difficulties, recent applications such as Bitpesa (https://www.bitpesa.co/) have been developed to alleviate these problems.

The use of DeFi thus facilitates access to a wide range of previously inaccessible financial services. The decentralised structure used in the DeFi ecosystem would have a significant impact on the cost of access to financial services, drastically reducing it (e.g. by cutting down on any verification, authentication or authorisation requirements). Smart contracts and “fractioned” investments through asset tokenisation would thus both automate transactions by removing intermediaries and make investments cheaper, faster and accessible to a wider segment of the population.

Closing on risks.

The inflow of capital into the far-west DeFi is likely to result in a speculative bubble not unlike the tulip bubble in the Netherlands in the 17th century and of greater magnitude than that affecting the Initial Coin Offering market in 2017 (see, https://www.ingentaconnect.com/content/hsp/jdb001/2018/00000003/00000001/art00009). When on the (decentralised) side of the enterprise, capital is cheap, and the risk of insolvency (a network does not fail) is totally eliminated, it is foreseeable that a run-up to financing will be opened. If then, in the investor’s perception, there does not seem to be an upward cap on a given asset, a widespread attitude of euphoria is triggered, which opens the door to speculative operations.

This is aggravated by the absence of publicity controls and the absence of a legal safeguard infrastructure (how to regulate a widespread network?). The paradox of the single point of failure of decentralisation is reversed in this: when everyone is called to be liable, in reality, no one is.

The paradox of the single point of failure of decentralisation is reversed in this: when everyone is called to be liable, in reality, no one is.