Decentralised finance: Understanding the benefits, risks and challenges of DeFi

This relatively new approach to blockchain-powered finance, which bypasses traditional intermediaries, has seen locked-up assets grow from less than $1 billion in 2019 to more than $100 billion just two years later, attracting at least one million investors in the process. With an increasing number of institutional investors entering the DeFi industry, it’s a market that’s expected to grow to $800 billion in 2022.

The disruption of the traditional financial industry has unsurprisingly led to calls for regulation, but the DeFi space is uncharted territory. In the US, for example, financial institutions are still debating whose regulatory purview it falls under.

For investors considering broadening their portfolio into DeFi, it’s important to understand the key factors of the DeFi landscape. This article provides an overview of the common elements of DeFi, the benefits and risks of the sector, and potential future DeFi regulations.

The basics of DeFi

DeFi uses a combination of existing blockchain-related technologies — such as digital assets, wallets, smart contracts and auxiliary services including oracles — to create a financial ecosystem capable of bypassing banks, brokers, exchanges and the other middlemen who traditionally manage and process financial services.

Smart contracts, consisting of lines of code embedded in the blockchain, are one of the key active ingredients in the DeFi tech mix. They not only outline contract terms and conditions, but also monitor contracts and can automatically set the financial wheels in motion by executing a contract if, or when, its terms and conditions are met.

For example, smart contracts can monitor loan agreements and release collateral upon full repayment. They can also oversee agricultural drought insurance policies, automatically paying out if agreed amounts of rain fail to fall.

Common services offered by DeFi platforms include payments, loans, trades, investments, insurance and asset management. The list is growing rapidly and provides a tantalising glimpse of a new era of crypto-based innovations, such as decentralised exchanges, synthetic assets and flash loans.

The benefits of DeFi

DeFi offers many compelling use cases, many of which are beyond the reach of conventional fiat-based financial systems. Here are some benefits of DeFi:

• DeFi is permissionless and inclusive. Anyone with a crypto wallet and an internet connection, regardless of where they are, can access DeFi services. Users can also make trades and move their assets wherever they want, without having to wait for bank transfers or pay conventional bank fees. (Although other crypto-specific fees, such as gas fees, may apply.)
• Transactions are in real time. The underlying blockchain is updated the moment a transaction is completed, and interest rates are updated multiple times every minute.
• Transactions are transparent. Every transaction on the Ethereum blockchain, which accounts for more than 90 percent of all DeFi traffic, is broadcast to and verified by other users on the network. This level of transaction data transparency ensures any user can view network activity.
• Users can retain custody of their assets using non-custodial crypto wallets or via smart contract-based escrow.
• Smart contracts are highly programmable and can be designed to automatically execute, based on an infinite number of variables.
• DeFi data is tamper proof, secure and auditable, thanks to the use of blockchain architecture.
• Many DeFi protocols are open source. Ethereum and other projects are built with open-source code, which is available for anyone to view, audit and build on. Developers can easily connect multiple DeFi applications built on open-source technology to create new financial products and services, without having to seek permission.

The risks of DeFi

DeFi offers new and exciting financial freedoms, but these come with risks. These risks include:

• DeFi technology is immature and has yet to be fully stress-tested at scale over an extended period. Funds may be lost or put at risk. The DeFi platform Compound, for example, suffered a serious glitch recently during which customers were accidentally sent millions of dollars of crypto.
• A lack of consumer protection. DeFi has thrived in the absence of rules and regulations. But this means users often have little or no protection when things go wrong. No state-run reimbursement schemes cover DeFi and there are no laws enforcing capital reserves for DeFi service providers.
• Hackers are a threat. While hacking is also a risk in traditional finance, DeFi’s extended technological architecture, with multiple points of potential failure, increases the so-called attack surface available to sophisticated hackers. For example, “white hat” hackers exploited a smart contract vulnerability in August 2021, stealing $610 million from the DeFi platform PolyNetwork. Luckily all funds were returned.
• Collateral requirements are high. Nearly all DeFi lending transactions require collateral of at least 100 percent of the value of the loan, if not more. These requirements vastly restrict eligibility for many types of DeFi loans.
• Private key requirements. With DeFi and cryptocurrency, users must secure the wallets used to store cryptocurrency assets. This is an important requirement for both individual private investors and institutional investors using multi-signature wallets. Private keys, which are long, unique codes known only to the wallet’s owners are used to do this. If a private investor loses their key, for example, they lose access to their funds forever.

Preparing for potential regulation

As DeFi disrupts the financial services industry, governing bodies are scrambling to decide who has the jurisdiction to regulate this new field and what those regulations might be. Depending on implementation, DeFi’s rapid growth could see a slowdown in the coming years.

One key player is the G7-backed Financial Action Task Force, or FATF, which exists to combat money laundering. It argues that DeFi platforms are not as decentralised as is sometimes claimed, because platforms have at least one natural, if not legal, person somewhere controlling or influencing platform activities.

In the FATF’s view, DeFi platforms that remain under the control of one person, or a group of people, are virtual asset service providers (VASPs), and so a broad playbook already exists to subject them to regulatory oversight. The FATF also suggests that if a particular DeFi platform doesn’t appear to have an entity running it, a jurisdiction could order a VASP to be involved. 

The FATF’s guidance offers jurisdictions a framework to use when deciding how to regulate DeFi. It’s likely that this new guidance will trigger contentious legal discussions across jurisdictions between regulators and blockchain entrepreneurs over who controls or influences various DeFi protocols.

In anticipation of potential regulation, it’s likely that many DeFi platforms will accelerate their attempts to become truly decentralised by dissolving the links between specific individuals and their platforms.

Jurisdictions will be keen to balance any regulatory oversight, alongside enforcing requirements like AML/CFT, against the economic benefits of DeFi innovation. The path forward may be unclear, but it will certainly be important for DeFi investors to monitor the evolution of regulatory frameworks affecting this new financial sector.