The next big threat to the financial sector – BRINK – Conversations and Insights on Global Business
Decentralized finance, or DeFi, is a rapidly growing segment of financial markets. Based on a blockchain platform, DeFi provides software services that can eliminate intermediaries in financial transactions, thereby enabling financial services, such as mortgages and investments, to be provided at lower cost. The question is: will it take off or will the financial sector retreat?
Kevin Werbach is the director of the Department of Legal Studies and Business Ethics at Wharton Business School, University of Pennsylvania.
WERBACH: At a general level, DeFi is about rebuilding the entire financial system on decentralized blockchain-based foundations.
Right now we have a large and growing market around cryptocurrency trading, as well as payments in things like bitcoin. However, most of this activity still goes through centralized actors. If you buy Bitcoin on an exchange like Coinbase, for example, Coinbase takes custody of your assets and provides a type of intermediation function similar to a traditional financial services provider.
No one takes custody of your assets
DeFi is about taking the actual provision of financial services and turning it into software that works like so-called “smart contracts” on a blockchain.
Today, most of this type of activity is on the Ethereum blockchain, but there are a number of other blockchains with increasing levels of DeFi activity.
There are three key attributes of DeFi.
The first is that settlement is made on a trust-minimized blockchain platform. The basic layer is that these are digital assets – cryptocurrencies where the ultimate record of transactions is a blockchain – as opposed to a centralized database in a financial entity.
The second element is that the services are not custodians – no one takes full ownership or control of investors’ assets. The investor always has control of his assets – even if they are the subject of transactions – whether it is a commercial relationship or a lending relationship via the financial services platform.
The third element of DeFi is that services are open, programmable, and composable. This means that all of these are just software components that run on a blockchain network. It is therefore easy to add additional functionality or combine functions from different services because everything runs on a standardized software environment.
Which of the intermediaries will be the most threatened?
EDGE: Which intermediaries are likely to be most disturbed by this?
WERBACH: We first have to ask whether DeFi is actually disrupting traditional finance, operating alongside traditional finance, or integrating with traditional finance.
It will likely be one of three, but the growing success of DeFi doesn’t necessarily require undermining traditional financial institutions. The question DeFi poses to traditional finance is whether intermediation is valuable.
If the things that a bank or an asset manager does turn out to be things that can be delivered in an automated way cheaper and more efficiently through software, that will ultimately lead to capital s move away from these traditional intermediaries.
In terms of the infrastructure, people, processes and relationships that surround this core intermediation function in traditional finance, what will happen to all of these if we move to a world where software and decentralized blockchains are at the heart of existing finance? structures?
EDGE: Can you describe new services or new areas of financial activity that could emerge thanks to this innovation?
WERBACH: Currently, there is a lot of experimentation in DeFi because these basic functions in finance can be combined in different ways. So one area of experimentation that we see are aggregators – where if, for example, you have multiple opportunities to earn returns to provide capital as liquidity, that can be automated and optimized very effectively.
So there is a new layer of DeFi providers that have already sprung up above the first tier of DeFi applications to do this automated management. We have things a bit like that in traditional finance, but generally speaking, they are only accessible to the biggest investors, hedge funds and very sophisticated players. They also have a lot of manual activities and costs associated with them. It is therefore a field of experimentation.
There are a host of technical risks and concerns about attacks and hacks that have been very significant in DeFi and have cost hundreds of millions of dollars because these systems are not mature, robust and resilient enough.
Getting your mortgage through DeFi
Another area of experimentation is the potential opening up of financial products that were not accessible to retail investors, or the billion people worldwide who do not have bank accounts and access to the financial system. traditional.
Now, this has to be said with some caution as there is risk involved, and DeFi today is very immature. Making complex financial services accessible to someone who lacks the experience, knowledge, or legal protections enjoyed by traditional banking customers is not a desirable outcome.
Right now with DeFi, we’re seeing people trying all kinds of creative things because they can – but that doesn’t necessarily mean all of those things will succeed or should.
EDGE: For example, could we potentially see mortgage services provided in this way?
WERBACH: Of course, any type of lending relationship can be done in DeFi. The idea is that the collateral pool can be drawn from multiple holders of these digital assets in a very flexible way. Loans can be made in an automated and fully secured or even over-secured way. This addresses some of the risk issues associated with these assets.
That being said, the markets, like the mortgage markets, are extremely large, sophisticated and regulated based on experience of when things can go wrong. I think we will see DeFi integrate and provide alternatives to some of these markets. But again, there’s a long way to go to the point where people would feel comfortable doing this on a large scale.
EDGE: What are the major risks on which regulators should have an early lead?
WERBACH: First of all, there are a host of technical risks and concerns around attacks and hacks that have been very prominent in DeFi. Hundreds of millions of dollars have been lost because these systems are not mature, robust and resilient enough.
Manipulate the Oracle
For example, DeFi systems depend on so-called oracles. A blockchain does not know the price of an asset – it only knows what is on the blockchain. There must be a decentralized mechanism to allow the price signal to be recorded in the blockchain. It turns out that these can be manipulated. If you can manipulate the price oracle, you can use it in some cases to drain funds from the DeFi application that depend on this price oracle.
There is now a lot of sophisticated technical work underway to strengthen these systems, but we still have a long way to go.
All of these applications are based on smart contracts, and they usually have built-in safeties and mechanisms to deal with significant price volatility. But as we have seen time and time again in the world of finance, it is impossible to fully predict how systems will react to all possible scenarios. We don’t know exactly what will happen if there are rapid fluctuations in the prices of these assets.
There are also legal risks, where regulators are rightly concerned about things like money laundering and fraud happening in the broader blockchain and cryptocurrency world, as well as in DeFi in particular.
The value of these DeFi services is that they are decentralized, so there is no single actor responsible for all transactional activity. However, this cannot simply open the door to eliminating all protection against various types of financial crimes and frauds. This is certainly an area that regulators are looking into, as there have been many examples in the cryptocurrency world where this has happened.
EDGE: In ten years, what percentage of the financial landscape do you think will go through DeFi systems?
WERBACH: That’s a difficult question to answer: probably still a relatively small amount because finance is so gargantuan in the world and tied to so many different kinds of systems. The value of transaction volumes in trade finance, for example, is astronomical.
Finance is a software application
I think the core concept that finance is increasingly becoming a software application is unstoppable, and it’s happening independently of DeFi. FinTech is also moving in this direction.
I think we will see more and more crossovers where DeFi-like architectures are built in the traditional financial services world once we can have more confidence in managing risk and regulatory issues.
And there will be more and more gateways where business may not primarily flow through these new DeFi providers, but the line between DeFi and traditional finance will blur. So in 10 years, I think a version of what we now call DeFi will be pretty well established as part of the financial landscape.