What is DeFi?
The first cryptocurrency, Bitcoin, is still the most well-known application of blockchain. However, this technology has since rapidly evolved and expanded in many other areas. The initial hope with Bitcoin was to make both money and payments decentralized and universally accessible. Although Bitcoin failed to live up to this promise, decentralized finance based on blockchain (“DeFi“), also called open finance, is a fledgling technology with potential. DeFi operates via decentralized, permisionless (without any central authority) applications, called DApps, built on a blockchain network, most commonly Etherum. Visionaries see this as an open-source alternative to every financial service we use today. Picture savings, loans, and trades, to insurance and even more, as all globally accessible.
In theory, it is possible to adopt every financial service currently offered by financial institutions to the crypto-sphere through DeFi. This will thus replace (even if only partly) centralized financial infrastructures and shift power to individual users and investors.
- Borrowing and lending – lending cryptocurrency and earning interest on it, depositing crypto as collateral and borrowing against it. Smart contracts determine the loan terms, connect lenders to borrowers, and oversee the distribution of interest.
- Decentralized marketplaces and exchanges, trading digital assets directly without the need for a centralized exchange due to the use of smart contracts.
- Creating monetary banking services, e.g., stablecoin mortgages and stablecoin insurances, including the benefits of cryptocurrency without the volatility.
Innovative and revolutionary?
The current financial system allows for the exchange of value easily through debit and credit cards, and the exchange of currencies for goods and services through digital banking. It also allows individuals to store wealth, save money, and earn interest on those savings. Lastly, banks and other lenders provide individuals and businesses access to capital (through loans).
Despite the services mentioned above, current financial systems have significant issues:
- Unequal access to financial services – According to the World Bank, about 1.7 billion people worldwide do not have access to financial services.
- Censorship – In countries that suffer from poor governance and corruption, people are sometimes unable to protect their wealth. Intervention comes in the form of governments, central banks, and big corporations.
- Counter-party risk – In financial transactions, such as loan transactions, there is a risk the other party will not meet the payments.
- Lack of transparency – There is room to improve transparency in financial corporations, especially since the financial sector’s duty to transparency contributes to the stability of the system. Lack of transparency and access to information was one of the causes of most global economic crises.
Addressing many of the shortcomings of the current financial system, DeFi challenges the old order by offering new possibilities:
- Globally available and transparent.
- Removes the need for reliance on central banks and governments.
- Allows increased access to financial services to those currently excluded from the financial system, due to physical location or resources.
- Does not rely on third-person intermediaries, such as banks and arbitrators, since users interact on peer-to-peer (P2P) networks.
- No company or employees manage it. DeFi runs based on smart contracts deployed on the blockchain. Designed to be self-executing, they require minimal to no human intervention.
- Some DApps are interoperable with other DApps, much like piecing Lego sets.
- All you need to participate is an internet connection, a device, and a cryptocurrency wallet.
DApps can provide a variety of services. Some DApps enable lending and borrowing, with minimum loans of just $25 and maximums of $2M (Nexo, Salt Lending, Bankers, and Oasis). Others enable margin trading, where customers can use borrowed funds from a broker to trade a financial asset that forms the collateral for the loan from the broker (Margin DDEX, NUO, and dYdX). There are also completely decentralized exchanges that operate with no central authority (IDEX, Ox, Bisq, and Bancor).
The vast majority of countries’ laws and regulations envision centralized businesses or structures with a singular seat of control and responsibility. Deviating from this arrangement poses a challenge from a legal and regulatory perspective and raises enforcement issues. This is particularly true when it comes to regulated sectors like financial services. In this sector, there has traditionally been some form of central counterparty, often regulated. Within a particular system or process, that central party is accountable. It takes responsibility for providing services to all the other participants through a contractual framework underpinned by the legal and regulatory structure. An example of this is the role of a central bank or other institution in clearing and settlement processes.
However, in many blockchain uses, such as DeFi, no such centralized party takes responsibility for providing services or controls the associated data sets. This thus presents jurisdictional issues.
Cross-border interconnectedness involving participants in different sectors at different geographic locations is not unique to new decentralized technologies. Still, legal and compliance risks could arise around the question of which laws and jurisdictional authority apply to a given set of transactions. For example, the enforceability of a digitally signed contract may vary across jurisdictions, as might the available tools to resolve disputes. Consensus on the designated location may be more difficult to reach if the network scales up quickly. The novelty and subsequent unclear legal value of smart contracts in many jurisdictions may lead to disputes. This is especially true in P2P lending in a DeFi system, where the location of parties is unclear. Thus, the regulatory frameworks applying to P2P platforms can vary by jurisdiction.
An additional legal issue that may arise is the role and liabilities of the party originating the digital asset and the existence of a legal claim on the underlying asset for investors. DeFi systems may be structured to mimic familiar legal relationships, like lender or escrow agent. However, most platforms will fail to adhere to the formalities necessary legally to establish that a given DeFi system has created an enforceable loan or is holding an asset as legal collateral to secure a promise. The issue of identification of the counterparty is significant for deciding who is liable for a DeFi system’s operation.
Moreover, the lack of a documented legal relationship between users of DeFi technology and a counterparty may pose a challenge if that user seeks protection from creditors by filing a petition for relief under the law.
Most DeFi applications to date are representations of existing financial instruments or systems built using smart contracts. Smart contracts are encoded in hardware and software that bind parties to enforce automatically the terms of the agreement. DeFi actually places the technology in the position of the typical counterparty and decentralizes the power to control and modify those technology systems. Thus, the service or product provider may be unknown to the user. This conflicts with the thrust of privacy laws. These require the party controlling the personal data of an individual to safeguard the security and privacy of that data on behalf of the individual or data subject. In addition, most DeFi applications are inherently permissionless, and currently operate in a gray area.
There are many possible interpretations of the accountability regarding smart contracts. The creators of DeFi smart contracts may be seen as responsible, as could the operators of those smart contracts, or the parties who benefit from their operation. In at least one case, regulators have identified code developers and parties with power to control the function of smart contract code as responsible for its conduct. In another analogous case, involving the decentralized file-sharing system Grokster, a court found it was difficult, if not impossible, to hold a broadly distributed group of individuals liable. Instead, it held the central coordinating entity liable.
The decentralization of financial services can vary in the degree to which it affects different segments of financial services, but generally takes three broad forms:
- Decision-making – This means veering away from a single trusted financial intermediary or infrastructure toward systems in which a broad set of users is able to make decisions about whether and how to undertake financial transactions.
- Risk-taking – This represents a shift away from the retention of risk (e.g., credit and liquidity risk) on the balance sheets of individual traditional financial intermediaries toward more direct matching of individual users and providers of financial services.
- Record keeping – This involves a move away from centrally held data and records toward systems in which the ability to store and access data extends across broader consortia of users. Verification of such data and records may also be more distributed, for example via consensus mechanisms.
Regulators have been behind the curve, and DeFi has been able to flourish in this vacuum. For instance, in traditional unsecured lending, there is a legal requirement that lenders and borrowers know one another’s identities and that the lender assess the borrower’s ability to repay the debt. In DeFi, there are no such requirements. Instead, everything is about mutual trust and preserving privacy.
In addition, regulators may find the censorship-resistant product and services provided in DeFi systems problematic with regard to KYC/AML compliance requirements. On the one hand, censorship is contradictory in the narrow sense of DeFi, as the user is the custodian of his assets and DeFi is about financial transactions, which are usually heavily regulated (especially lending activities) and not allowed for non-licensed entities. On the other hand, with more and more interest from banks and fintech companies in providing DeFi as well, it will be different from DeFi as defined in Etherum. Thus, if regulated entities want to provide DeFi, KYC/AML compliance will probably be necessary.
Regulators must weigh the delicate balance between stifling innovation and failing to protect society from such risks, as individuals put their money into an unregulated space, or as banks and other financial institutions potentially become unable to make a living as intermediaries.
In summary, individuals or entities looking to establish a disruptive new DeFi application often find they do not fit (either neatly or at all) within any existing regulatory frameworks.
DeFi has exploded during the COVID-19 crisis. Loans on such platforms have risen more than seven-fold since March to $3.7 billion, according to industry site DeFi Pulse. Investors are hunting returns at a time when central banks across the world have slashed interest rates to prop up economies battered by the pandemic. Some jurisdictions, such as the Eurozone, are now in negative interest rates territory. Others, such as the US and UK, could potentially follow.
In this climate, DeFi potentially offers much higher returns to savers than high-street institutions. Compound, for example, has been offering an annualized interest rate of 6.75% for those who save with stablecoin Tether. Not only does a user gain interest, but it also receives Comp tokens, an added attraction. With two-thirds of people without bank accounts in possession of a smartphone, DeFi also has the potential to open up finance to them.
One final important reason for the surge in people putting money into DeFi tokens is to avoid missing their explosive growth. Many tokens are worth nothing or close to nothing in practical terms, so we are seeing a lot of irrational exuberance.
What makes DeFi even more interesting is the movement of institutional investors and traditional finance professions to DeFi as a way to break free from what the industry considers an outdated and insular financial system.
Entrepreneurs should keep DeFi on their radar as the industry matures and continues to attract significant capital investment.