Decentralised Finance ('DeFi') & its implications for 'Financial Stability'

DeFi (or “decentralised finance”) is an umbrella term for financial services on public blockchains, primarily Ethereum. With DeFi, one can do most of the things that banks support ie earn interest, borrow, lend, buy insurance, trade derivatives, trade assets, and more but it’s faster and doesn’t require paperwork or a third party.

As with crypto generally, DeFi is global, peer-to-peer (meaning directly between two people, not routed through a centralised system), pseudonymous, and open to all.?

More specifically,?DeFi refers to a system by which software written on blockchains ?makes it possible for buyers, sellers, lenders, and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction.

According to CoinMarketCap, at present DeFi is a USD160?Billion Market.

Why is DeFi important?

DeFi takes the basic premise of Bitcoin digital money and expands on it, creating an entire digital alternative to Wall Street, but without all the associated costs (think office towers, trading floors, banker salaries). This has the potential to create more open, free, and fair financial markets that are accessible to anyone with an internet connection.

What are its benefits?

• Open: You don’t need to apply for anything or “open” an account. You just get access by creating a wallet.
• Pseudonymous: You don’t need to provide your name, email address, or any personal information.
• Flexible: You can move your assets anywhere at any time, without asking for permission, waiting for long transfers to finish, and paying expensive fees.
• Fast: Interest Rates and rewards often update rapidly (as quickly as every 15 seconds), and can be significantly higher than traditional Wall Street.
• Transparent: Everyone involved can see the full set of transactions (private corporations rarely grant that kind of transparency)?

How does it work?

Users typically engage with DeFi via software called dapps (“decentralized apps”), most of which currently run on the Ethereum blockchain. Unlike a conventional bank, there is no application to fill out or account to open.?

Here are some of the ways people are engaging with DeFi today:?

• Lending: Lend out your crypto and earn interest and rewards every minute - not once per month.
• Getting a loan: Obtain a loan instantly without filling in paperwork, including extremely short-term “flash loans” that traditional financial institutions don’t offer.
• Trading: Make peer-to-peer trades of certain crypto assets — as if you could buy and sell stocks without any kind of brokerage.
• Saving for the future: Put some of your crypto into savings account alternatives and earn better interest rates than you’d typically get from a bank.?
• Buying derivatives: Make long or short bets on certain assets. Think of these as the crypto version of stock options or futures contracts.?

What are its downsides??

• Fluctuating transaction rates on the Ethereum blockchain mean that active trading can get expensive.
• Depending on which dapps you use and how you use them, your investment could experience high volatility – this is, after all, new tech.????
• You have to maintain your own records for tax purposes. Regulations can vary from region to region.

For regulators, the decentralised nature of DeFi is somewhat of a headache, as it is cumbersome to regulate something when no single entity is to be held accountable. In traditional finance applications, the linchpin that enables the enforcement of financial regulations is the personal responsibility held by executives in the financial services industry. This causes regulator to express increased concern regarding the regulation of cryptocurrencies and DeFi.

However, in BIS latest Report, it is argued that

DeFi is far from as decentralised as we are led to believe. The point raised in the special feature is that there’s a limit to how far you can run a whole financial system purely based on those automated transactions.

According to the report,?“there are some incentive issues related to the fact that, through this decentralization, at some point you end up with some agents that play an important role, and not necessarily for the best [interests] of users of financial services.”

According to the report, the tendency for blockchain consensus mechanisms to concentrate power also makes it easy for a small number of stakeholders to make big decisions. The existence of so-called governance tokens which are cryptocurrencies that represent voting power in decentralized systems is one of the factors the report highlights as a threat to the promise of decentralization.

Governance-token holders can influence a DeFi project by voting on proposals or changes to the governance system. These governing bodies are called decentralised autonomous organisations and each one can oversee multiple DeFi projects.

(Excerpts taken from BIS and other research reports on DeFi)