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Decentralized Finance, aka DeFi, is a loose concept used to describe the digitisation, automation and expansion of traditional financial services (i.e., payments, lending, trading, investments, insurance, and asset management) using blockchain, digital assets and smart contracts.
The growth that has occurred in both the value of digital assets within DeFi and the number of participants involved has focused a lot of attention on the space. In less than 2 years, the Total Value Locked (TVL) in DeFi protocols grew from approximately USD 1 billion (Jan 2020) to over USD 250 billion (Dec 2021) and participation grew to over 4 million users.
Source: https://defillama.com/
Problems with DeFi
While the adoption curve for DeFi, has been quite remarkable, the risks and vulnerabilities of its current incarnation have been laid bare in the early months of 2022 and trust in the sector has been greatly eroded.
The risks and vulnerabilities include:
Immature Technology/Sector with Anonymous Participants
This nascent technology/sector has yet to be fully stress-tested at scale over an extended period and has a large attack surface for hackers. Moreover, the anonymity of participants hampers the development of an effective legal and regulatory infrastructure.
Illusion of Decentralisation
DeFi platforms are not as decentralised as is often claimed, and most platforms have at least one natural, if not legal, person somewhere controlling or influencing platform activities.
High Collateral Requirements and Volatility
As market participants in DeFi are anonymous, risk assessment of the borrower, traditionally carried out by financial intermediaries, is not possible. DeFi uses over-collateralisation of loans to mitigate this risk.
As DeFi loans are disbursed in cryptoassets and secured by crypto collateral, they do not currently finance real economy activities. The volatility of the digital assets being utilised can mean significant losses for those involved as has been recently witnessed.
User Experience and Custody
The user experience for most platforms is sub-par to what would be expected when dealing with multi-million-dollar platforms.
Also, participants (both individuals and institutional investors) must secure the wallets used to store digital assets. Private keys, which are long, unique codes known only to the wallet’s owners are used to do this. If a user loses their key, they lose access to their funds forever.
Lack of Consumer Protection
Participants often have little or no protection when things go wrong. There are no state-run reimbursement schemes and no laws enforcing capital reserves for DeFi service providers.
Permissioned DeFi
While there are clear issues to be addressed, the anonymity and volatility of the sector are the two factors most often cited as impeding the widespread adoption of DeFi.
Enter “Permissioned DeFi”, and the realisation that, quite paradoxically, the widespread adoption of DeFi seems dependent on the participation of banks and financial institutions.
Permissioned DeFi provides a gateway for financial institutions to enter the space as it enables effective implementation of KYC/AML processes and allows operational, legal and regulatory oversight.
This gateway for regulated financial companies is important for the evolution of DeFi in a number of ways:
Trust
It brings financial expertise to DeFi and a proven track record of providing financial services within legal and regulatory guardrails, thereby enhancing trust in the sector.
Customer Service
It facilitates the introduction of enhanced customer service and user experience including custodial services.
Liquidity
It offers the potential to provide much greater liquidity for (permissioned) DeFi protocols.
Real World Digital Assets
It facilitates the use of ‘real-world’ assets (e.g., tokenized real-estate, stocks, and bonds) that can add greater stability to the space.
Widespread Adoption
Banks, funds, and other financial institutions have large existing client/customer bases that offer a clear route to the widescale adoption of Permissioned DeFi.
Permissioned DeFi in Action
There are a growing number of players offering Permissioned DeFi environments that provide a gateway for financial institutions to enter the space to leverage the benefits of DeFi while remaining aligned with their compliance requirements.
For example, Aave, one of the largest DeFi lending protocols, offers Aave Arc a permissioned-version of the protocol in which every user in the private liquidity pool has been whitelisted by digital asset custody firm, Fireblocks.
As Aave Arc’s first active “whitelister”, Fireblocks has developed a framework for whitelisting institutions that references globally accepted KYC/CDD/EDD principles, in accordance with FATF guidelines.
(Whitelisters are regulated custodians and financial institutions that are approved to KYC and whitelist their customers to participate in the KYC’d DeFi protocol’s marketplace.)
This essentially creates a sandboxed environment where institutional participants are known and can transact within the liquidity pool based on their strategy and permissions:
Suppliers: Earn interest for providing liquidity to the marketplace.
Borrowers: Put up collateral in order to borrow from the liquidity market.
Liquidators: If a borrower isn’t meeting their terms, liquidators enforce “good behavior” by buying a portion of the debt at a pre-decided discount. They find out via API or smart contract who is not meeting their loan terms.
Furthermore, all transactions within the environment are subject to ongoing AML monitoring.
Evolution of DeFi
While DeFi and Permissioned DeFi will most likely form two lanes in the evolution of this new technology, given the heightened need and understanding for regulatory oversight, we expect many more Permissioned DeFi environments to emanate from both the DeFi and traditional finance sectors.
The challenge coming for traditional finance institutions is how agile they can be in adapting to this new technology … which will likely determine their place in the changing financial system and how rapidly DeFi scales to mainstream adoption.
To gain a thorough understanding of the fundamentals of DeFi, sign up to our 9-Part Tour here, which will be sent directly to your inbox over the next 3 weeks.
Recommended Reading
EY
Report: The DeFi Wave is Approaching
OECD
Institutionalisation of crypto assets and DeFi–TradFi interconnectedness
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