Does DeFi sound the death knell for centralised finance, or should the two systems borrow from one another to create a banking system that’s fit for the future?
Defy. To openly resist.
DeFi. The contraction commonly used for decentralised finance.
The buzzword used to describe the financial ecosystem getting plenty of mainstream traction sounds similar to the verb used to describe a refusal to obey. And from the outset, DeFi has been all about a defiance of the established hierarchy of banks, brokers and other assorted gatekeepers of traditional finance.
“DeFi is the latest financial disruption technology that’s changing the financial landscape and architecture of finance as we know it,” says Jeremy Eng-Tuck Cheah, Associate Professor of Decentralised Finance at Nottingham Trent University.
Inextricably linked to blockchain, DeFi uses the revolutionary public ledger’s decentralised position to make permissionless, peer-to-peer financial exchanges, without anyone else getting in the way.
These contracts are ‘if…, then…’ instructions which are coded into a blockchain. In this context, for example, the instruction might be to measure the interchange of supply and demand to set interest rates and dictate the terms of specified financial exchanges in real time. No need for third-party involvement – which speeds up transactions – nor for negotiating, as all parties already know the terms of the smart contract.
“Smart contracts are stored on the blockchain and run when predetermined conditions are met,” explains Anton Mozgovoy, co-founder of Mover, a DeFi savings platform. “They’re a revolution because of their composability. They’re open and everyone has to play by the same rules or code and anyone can build innovative things because everything is open and accessible. This composability also makes the whole DeFi system transparent.” Immediately, this gives DeFi an advantage over the established transactional methods of centralised finance because it isn’t subject to the opaque internal workings of incumbent financial institutions.
There is, though, a counter to these positives. DeFi has been described as the Wild West of finance – not a phrase that promotes investor confidence. Many critics seek to expose the fact that certain aspects of DeFi amount to little more than a get-rich-quick scheme.
“This crypto space is only lightly regulated, if at all,” warns Dr Igor Makarov who is Associate Professor of Finance at the London School of Economics and co-author of a recent working paper on DeFi. “Investors are as a result exposed to many types of risk. This year’s Beanstalk hack is one of many colourful examples.”
Makarov is referring to the attack in April 2022 when a hacker siphoned some $182m (£0.83m) of cryptocurrency from Beanstalk Farms, a DeFi project whose goal was to balance the supply and demand of cryptocurrency assets. This was proof, if any were needed, that legitimate endeavours could still be exposed to bad actors set on exploiting the vulnerabilities of smart contracts; in the first five months of 2022, there have already been $1.4bn-worth of DeFi hacks, according to cybersecurity auditor Hacken.
Also, the fact that so much of DeFi’s infrastructure is founded on smart contracts means that investors can be left open to flaws in the software itself that can reduce or wipe out token value.
“If there are faulty or incomplete codes it’s likely that funds can be drained out to those who can exploit the weaknesses,” Cheah reveals. “Apart from source code vulnerabilities, there’s a lack of sophisticated due diligence processes to ensure codes are free from faults. If they have the expertise, investors can either go through the codes themselves or hire an auditor to do the same. Ultimately, smart contracts are only as good as the people who write them.”
Perhaps the biggest investor concern is the lack of user safeguarding baked into the DeFi system, especially when compared to traditional finance – things like deposit protection, governmental level insurance and the various other guardrails that centralised finance investors rely on. But, regulations cannot preempt innovation, argues Cheah.
“If the principles underlying innovation are regulated, they can either be circumvented or might end up stifling innovation. And there is a lot of financial incentive to develop software very quickly to replace the role of financial intermediaries or, in short, there is money to be made for first movers. So it’s not surprising that DeFi has earned its Wild West and ‘get-rich-quick’ reputations. That’s the price you pay for the innovation.”
For all its flaws, it’s hard to ignore the attraction of DeFi to a broad range of investors and the interest of the big banks has clearly been piqued with a slew of research papers commissioned by the big players in an attempt to establish the impact DeFi could have on their business.
Goldman Sachs issued a report in October 2021 that highlighted how DeFi has clear advantages over traditional finance with its ability to provide “access for underbanked populations and faster settlements for users” but the report concludes that it’s not the finished article and has “flaws like hacks, bugs and outright scams”.
Dutch bank ING also recently commissioned a white paper in an attempt to accelerate their understanding, which concluded that DeFi was “a coin with two sides” and that the two services combined could bring benefits to the centralised institution, as well as “to DeFi, and more importantly, it’s customers”.
So, what form might this future collaboration take? Cheah believes that banks have a stark choice: to adapt or die.
“Banks slow down transactions and can be costlier in the services they provide because they defray costs arising from legislation compliance and providing consumer rights,” he says. “These higher costs need to be weighed up against the benefits of allowing banks to be part of the DeFi solution. And it would certainly be wise for banks to migrate to blockchain technology and principles from their existing ageing systems. However, this will not be a cheap endeavour.”
It seems that DeFi’s disruptive innovation will continue to defy and challenge banking but for now will remain a financial frontier populated only by the hardiest investors. But if incumbent financial institutions become less risk-averse and decide to embrace blockchain innovation, they stand a much better chance of establishing a strong position in a digital asset economy that’s only gathering pace.
Meanwhile, the DeFi coin is still turning in the air with plenty of interested parties watching closely to see how it will land.