Unravelling Decentralised Finance (DeFi)

by Georgia Fairweather

2020 was marked by a Decentralised Finance (DeFi) boom, the total value locked in DeFi contracts surged 40x to $83 billion at the end of December 2020, from $600 million in January 2020 and continued to rise. Automation is the game changer in DeFi as Blockchains enables the creation of ‘smart contracts’ that can self-execute once certain criteria have been met, eliminating the need for middlemen. DeFi basically decentralises traditional financial services and encompasses: 

  1. Issuance: Stable Tokens, Debt, Securities, Insurances NFTs, 
  2. Trading:  Decentralised Exchanges, Derivatives, SWAPs, Prediction Markets; and Liquidity Relays
  3. Ownership: Wallets; Baskets and Fund Management; and Payment Networks.  

So, what are the pros and cons of DeFi?:

Pros of DeFi 

  • DeFi can offer greater returns than traditional investments, such as bank deposits or investing in the stock market. 
  • A DeFi investment plan can be flexible and growth-oriented and ensures efficient asset diversification.
  • Investments are completely automated with smart contracts and zero human intervention. 
  • Automation also means quicker transactions and lower fees due to the absence of middlemen.
  • DeFi solutions are highly interoperable and can potentially be integrated.
  • DeFi offers greater transparency as all the data is stored immutably using Blockchain technology, which can be viewed by the participants anytime and anywhere. 

Cons of DeFi

  • It is a new and unregulated sector. 
  • Investors can lose money because activities are not regulated, moderated, intermediated, hosted or validated by a central authority, only driven by smart contracts. If the smart contract malfunctions, is hacked, or otherwise has a problem, there is no recourse.
  • DeFi relies on a decentralised governance mechanism, such as a Decentralised Autonomous Organisation (DAO), but individual project governance can be opaque. 
  • DeFi platforms rely on open-source computer codes, and some pay security researchers to conduct audits of the code to ascertain if there are any vulnerabilities. Unaudited projects are riskier than audited but just because a project has been audited it does not mean that it is safe. 
  • DeFi products and services are available to a global audience which means it’s hard to undertake meaningful due diligence. 
  • Questions remain about definitions, developer liability, legal status of code, application of AML/KYC and jurisdiction. 

DeFi presents a dilemma for regulators SEC Commissioner, Hester Peirce  comments when asked about DeFi:It’s going to be challenging to us because most of the way we regulate is through intermediaries and when you really build something that’s decentralized, there’s no intermediary. It’s great for the resilience of a system. But it’s much harder for us when we’re trying to go in and regulate to figure out how to do that.”

The lack of KYC and AML in the DeFi sector sends shivers up compliance officers’ spines. But, if DeFi platforms commence embracing regulation could we see the biggest asset class in the world, derivatives, begin to use DeFi-style exchanges, as undoubtedly DeFi offers some real attractions by trading 27/7 in a more efficient, transparent manner?  

Equally of note is that DeFi, being peer to peer and not using a centralised exchange, shares similarities with Over The Counter (OTC) trading markets. OTC trading in derivatives is massive, as the Bank of International Settlement has pointed out when stating, “OTC derivatives, rose from $11.6 trillion to $15.5 trillion during the first half of 2020.”  Could the migration of derivative trading to DeFi-style exchanges prove to be the killer app which uses Blockchain technology (assuming it is able to handle the $trillions of transactions) and catapult Blockchain technology from a ‘fringe’ technology that some claim it is, to be taken seriously as a must-have technology?

As Lee Schnider of Global Blockchain Convergence  points out, DeFi does not exclusively involve financial instruments, so DeFi platforms permit the mingling of asset types in ways never before achieved.  The question is how will DeFi be regulated in the future?  

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