Investopedia defines decentralized finance as a system by which financial products are made available on a public decentralized blockchain network, making them available to everyone. The system eliminates the need to go through middlemen like banks or brokers. Decentralized finance, commonly known as DeFi, allows buyers, sellers, lenders and borrowers to interact peer-to-peer or with a purely software-based middleman. With the ever-increasing rise of digital currencies and their widespread adoption, DeFi has exploded in recent years. According to tracking service DeFi Pulse, the value of digital assets held in ddecentralized finance Services grew from less than $1 billion in 2019 to over $15 billion by the end of 2020 and over $80 billion in May 2021. That is extraordinary exponential growth. Wharton Professor of Law and Business Ethics Kevin Werbach and David Gogel explore the threats and opportunities of decentralized finance in this fascinating article. This article was first published on [email protected]. – Nadya Swart
The chances and dangers of the decentralization of financing
Decentralized finance — or DeFi — has seen explosive growth over the past year. But for DeFi to fulfill its promise as an independent ecosystem that helps rather than harm, “now is the time to assess its benefits and threats,” write the Wharton Professor of Legal Studies and Business Ethics Kevin Werbach and David Gogel, a recent Wharton MBA graduate, in the following article. Werbach is the author of the book The blockchain and the new architecture of trust and leads Wharton’s blockchain and digital asset project. Werbach and Gogel recently worked with the World Economic Forum to create the Decentralized finance (DeFi) policy maker toolkit.providing guidance to regulators and blockchain observers everywhere.
Intermediaries have always played an essential role in financial markets, fostering trust, liquidity, settlement and safety. However, these benefits come at a cost. Mediation contributes to slow settlement cycles, inefficient pricing and market access limitations. Financial services markets tend to be highly concentrated, with a few powerful intermediaries exercising significant control and generating significant profits. Since the global financial crisis of 2008, attention has turned to structural inequalities and hidden risks in the financial system. Recent controversies like that GameStop short presswhich locked out retail investors from trading during a period of volatility also highlighted the failings of the aging financial infrastructure.
Until now, however, mediation has been a necessary feature of funding. Peer-to-peer fintech lending platforms like Prosper and cryptocurrency exchanges like Coinbase also retain an important central role. This is the environment in which Decentralized Finance (DeFi) emerged.
DeFi is an evolving space at the intersection of blockchain, digital assets and financial services. DeFi protocols aim to disintermediate funding through known and new service agreements. They use stable-value cryptocurrencies known as stablecoins as assets, blockchain ledgers for settlement, and software-based smart contracts to automatically execute transactions.
The market witnessed explosive growth as of 2020. According to tracking service DeFi Pulse, the value of digital assets locked into DeFi services grew from less than $1 billion in 2019 to over $15 billion in late 2020 and later over $80 billion in May 2021. Novel business models such as yield farming – where cryptocurrency holders earn rewards for providing capital for various services – and aggregation to optimize real-time cross-exchange trading are emerging fast. Innovations such as lightning loans, which are either repaid or automatically dissolved in the course of a transaction, open up both new forms of liquidity and unfamiliar risks.
“As with everything in the cryptocurrency world, sometimes the hype surrounding DeFi is out of control.”
Despite its scale and potential importance, DeFi is still in its infancy. Now is the time to weigh the benefits and risks. As with everything in the cryptocurrency world, the hype around DeFi has sometimes gotten out of control. Exceptional – and unsustainable – short-term returns have skewed investor expectations, attracting both bad players and innovative builders. Most DeFi activity is still speculative and conducted by relatively experienced cryptocurrency holders. As mainstream usage increases, so do risks and regulatory considerations.
This was the background to a collaboration we have been involved in for almost a year between the Wharton School at the University of Pennsylvania and the World Economic Forum. Wharton’s blockchain and digital asset project has assembled a global network of regulators, DeFi industry experts, and academics to bring clarity to the DeFi landscape. Our goal is to shed light on the business dynamics of this rapidly evolving ecosystem, identify key risk areas, and help policymakers develop appropriate strategies.
DeFi is a general term that encompasses a wide variety of activities and business relationships. We define four requirements: financial services; trust-minimised operation and processing on a blockchain; design without deprivation of liberty; and systems that are open, programmable, and composable. We then identify six major DeFi categories – stablecoins, exchanges, credit, derivatives, insurance and wealth management – as well as ancillary services such as wallets and oracles (external sources of information). Most resemble traditional financial services, at least on the surface. However, they work without intermediaries. Many incorporate cryptocurrency-based incentive structures to accumulate capital, maintain efficient pricing, and participate in governance decisions.
Within and outside of the categories described here, DeFi is evolving rapidly. Developers are experimenting with new services, business models and combinations of DeFi protocols. technologies mature. Services are moving towards decentralized administration and management of logs. Tools are emerging to simplify the user experience on and between DeFi services. A key aspect of ongoing DeFi development will involve the assembly of basic financial elements as “Money Legos” that can be reassembled in new and dynamic ways.
While DeFi is an exciting, fast-growing field, it also has its critics, risks, and unknowns. And indeed, there have already been significant examples of fraud, successful attacks, governance controversies, and other failures in the DeFi world. The underlying systems remain immature, with a multitude of unresolved economic, technical, operational and public issues to be resolved. Although some protocols have attracted significant capital and associated network effects in a short period of time, the DeFi sector remains volatile. Activities to date have focused on speculation, leverage and generating returns in the existing community of digital asset holders. The very flexibility, programmability, and composability that make DeFi services so powerful also introduce new risks, from hacks to unexpected feedback loops between protocols.
“DeFi will ultimately succeed or fail based on whether it can deliver on its promise of financial services that are open, low-trust, and no-custodial yet trustworthy.”
Developers are actively working to fix vulnerabilities and introduce new mechanisms for efficient risk management, but the process is ongoing. DeFi will ultimately succeed or fail depending on whether it can deliver on its promise of financial services that are open, trust-minimised, and no-custodial yet trustworthy. State action will play a role here. Poorly designed regulation could stifle innovation and drive illegal activity underground. However, insufficient oversight could result in massive investor damage, widespread theft and illegal activities, abusive practices and unacceptable risks of catastrophic failure.
Our first report DeFi beyond the hype, demystifying the DeFi phenomenon. It describes defining characteristics of DeFi services, the structure of the DeFi ecosystem, and emerging developments. Our second report, the Decentralized finance (DeFi) policy maker toolkit. sets out a roadmap for tackling the serious public policy issues posed by DeFi. It breaks down five categories of DeFi risk: financial, technical, operational, legal, and emerging. Some of them, such as B. the liquidity risk, are known from traditional finance. Certain traditional considerations such as counterparty risk can actually be mitigated in DeFi due to the automated operation of smart contracts and the use of blockchain as the settlement mechanism. On the other hand, DeFi opens up a variety of novel risks, such as B. the failure of smart contracts, the extraction of value through Proof of Work miners and the failure of decentralized governance systems. The report helps policymakers assess these risks and provides resources and guidance to address them in a balanced way.
Put simply, politicians and DeFi developers need to better understand each other. DeFi could be a vehicle to achieve key policy goals of more efficient capital accumulation, financial inclusion, a fairer financial system, and better transparency. Or it could cause harm that outweighs the benefits. Now is the time to address those concerns. A better understanding of the DeFi phenomenon is an essential first step.
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