DeFi – Key insights, risks and challenges

What is DeFi? Decentralised finance (DeFi) is a blockchain-based form of finance referring to digital, peer-to-peer services that allow for crypto trading, loans, interest accounts, and other services. It operates using ‘smart contracts’ – a computer code that can be built into blockchain technology to facilitate, verify, or negotiate a contractual agreement.

DeFi does not rely on central financial intermediaries to offer traditional financial instruments, but instead utilizes smart contracts on blockchains. It allows participants to trade directly and people to lend or borrow funds from others and speculate on price movements on a wide range of assets.

The ability to earn higher rates, to access credit when traditional banks won’t extend it and anonymity appear to be the main selling points of DeFi.

A DeFi service or business model has the following key characteristics:

1. Financial services or products i.e. processing or directly enabling the transfer of value among parties;
2. Trust-minimised operation and settlement i.e. transactions are executed and recorded according to the explicit logic of a DeFi protocol’s predetermined rules, on a trustless basis;
3. Non-custodial design i.e. the assets issued or managed by DeFi services cannot be unilaterally expropriated or altered by parties other than the account owner, even those providing intermediation and other services;
4. Programmable, open and modular architecture i.e. there is broad availability of the underlying source code for DeFi protocols and a public application programming interface (API) enabling service composability, similar to open banking for centralised financial services.

DeFi has the potential for enhancing financial inclusion, create liquidity for crypto-assets, and expand blockchain technology usage. It uses decentralised applications, also known as ‘DApps’, where users are provided with their own crypto-asset wallet, which they can then use to buy, sell, or trade crypto-assets.

DeFi fulfils all digital DNA requirements, such as customer centricity, analytics and leverage on new technology ensuring a great customer experience: easy, reliable, personalised and optimal solutions, but at the same time raises a few questions:

1. How will the DeFi ecosystems ensure that risk management (viz. leverage risk) as well as the KYC/AML functions, are performed properly?
2. How will various jurisdictions evolve by way of regulatory forays around crypo-assets, in particular the US and Canada when implementing KYC, AML combat of terrorism financing measures for ‘virtual currency’ (e.g. Bitcoin) used in money services?

Traditionally the ‘raison d’être’ for banks has always been to ensure that the savings and loans are safe as well as guarantee that the transactions and the people operating are legitimate.

While banks may not be needed any more in their current form, we strongly argue that these functions shall have to be performed in the evolving DeFi environment, including building a prudent regulatory framework around it.

A key challenge shall be to inject in this decentralised financial network ‘the element of trust that will ensure credibility in the network’.

Notably, DeFi functioning is likely to be distinct from banking. For example, there is no information content in the assets traded in banking, while DeFi deals with information-intensive assets.

As it is evident, trust is not an issue in banking, while it is paramount in DeFi. The collateral in context of the former needs to be transparently valued while in the latter valuation of collateral by bank managers is a problem.

Key risks

Technological: Cybersecurity threats and hackers could compromise the functionality of the entire blockchain platform.

DeFi risk shifts to the technology as in the smart contracts and less to a human counterparty risk as the risk model moves to a decentralised ecosystem. As DeFi ecosystems need to interoperate, the composability of technology (sidechains, parachains, bridges, crosschains) presents a risk as these standards are still developing and each protocol has a different software code base.

AML/CTF/compliance/legal: Lack of laws and regulatory frameworks to manage regulatory and commercial risks prudently around DeFi ecosystems including handling of cross jurisdictional disputes.

Regarding the KYC and AML, which are really the key concerns, we will need to add trusted entities that will guarantee that the digital identity and backgrounds have been checked properly.

Regulatory risk looms as regulators are starting to look at the sector with some exchanges under investigation or banned in some jurisdictions. Also, jurisdictions need to be crossed and recent CBDC developments add to the risk.

Legal risks also devolve from questions around the enforceability of smart contract liability, data privacy laws, intellectual property (IP) DApps being developed ought not infringe others intellectual property rights.

Market and Liquidity: The market risk of having an investment loss based on asset or market price volatility is present in DeFi, just as in conventional markets, as crypto is known as a volatile asset class open to hacking, arbitrage and market manipulation.

The crypto market is risky and speculative. Crypto assets trade only on demand and are often influenced by external factors such as social media. Due to the inherent volatility of crypto assets, sudden changes in market sentiment could lead to heavy price fluctuations causing associated liquidity risks, which may lead to significant reduction in the crypto asset tokens value.

Event risk can occur on any financial market, such as the Wall Street crash or Global Financial Crisis.

Leverage is the key difference as centralised finance controls leverage through regulation, such as mandatory limits, while DeFi doesn’t. This potentially higher leverage leads to both higher volatility and higher tail risk. Tail risk also get magnified, while leverage is facilitated.

More hidden correlations and causalities are involved. Market risk quantification will have to involve leverage. Value at Risk (VaR) today looks at asset values, but not how leveraged the individual/firm is.

Credit: Credit risk is inherent in DeFi. Too often, in the current DeFi environments, people getting loans are people who have significant collateral and people without collateral get a prohibitive rate.

Recommendations/proposals

As mentioned above, the main balancing elements to be added in all network are the ones currently supervised by the central banks. These ecosystems shall need to ensure that the rates are sound and that people are getting access to credit in a fair and equitable manner.

We believe that there is a need to inject banking functionalities in order to add trust into DeFi without disrupting the entire eco-system. Core banking functionalities around risk management and AML/KYC compliance shall have to be done seamlessly and invisibly.

While limited, these functions will be critical in providing trust to the entire DeFi organisation and will probably become one of the key assessment criteria to ensure soundness of the new system.

The advantages are manifold of a more efficient, automated, flexible DeFi ecosystem. It eliminates bias towards ordinary folks versus wealthy individuals.

Last, but not the least, the path towards evolution of a trusted DeFi ecosystem is fraught with risks, challenges, opportunities and needs to be treaded cautiously. All stakeholders need to have a compelling vision to resolve the emerging challenges and make pertinent contributions aligned all along the way – be they the users, DeFi corporates, regulators or others for DeFi to be a revolutionary game changer, going forward….rest the time will tell!

Chitro Majumdar – strategic advisor to sovereign institutions and chief founder of RsRL (R-square RiskLab); and Olivier Crespin, co-founder and chief executive officer of Zand Bank