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Analysis: The potential problems with decentralised finance

By Rob Griffin

05:00, 10 December 2021

Image of DeFi
The DeFi ecosystem is still developing - Photo: Shutterstock

No one can deny that decentralised finance (DeFi) is a fast-growing part of the crypto financial system – but what are the vulnerabilities in this system?

The Bank for International Settlements (BIS) has analysed the area, identified potential problems and come up with a list of issues that need to be tackled over the coming years.

Here we take a look at its main findings, along with recent concerns about DeFi that have been raised by the US Securities and Exchange Commission.

DeFi ecosystem background

The aim of decentralised finance is to provide financial services without intermediaries, using automated protocols on blockchains and stablecoins to facilitate fund transfers.

According to the BIS report, the system can be traced back to the early days of blockchain, the peer-to-peer transaction mechanism, and crypto asset bitcoin more than a decade ago.

The report noted how blockchain technologies and crypto assets have since mushroomed, with a key milestone being the development of ethereum and ether (ETH), its associated crypto asset.

“This technology supports automated contracts with pre-defined protocols hosted on blockchains, commonly referred to as ‘smart contracts’, and was instrumental to spurring on the DeFi ecosystem,” it added.

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The “decentralisation illusion”

DeFi aims to provide financial services without using centralised entities by digitising and automating the contracting process.

As well as providing users with greater anonymity than traditional finance, the industry hopes it will improve future efficiency by reducing layers of intermediation.

However, BIS questions the suggestion that DeFi is decentralised. In fact, the report said it is “illusory” to suggest that it can be fully decentralised.

“This is due to the inescapable need for centralised governance and the tendency of blockchain consensus mechanisms to concentrate power,” BIS stated.

Vulnerabilities 

Just as DeFi offers similar services to those provided by traditional finance, it suffers from “familiar vulnerabilities”, according to BIS.

“The basic mechanisms giving rise to these vulnerabilities – leverage, liquidity mismatches and their interaction through profit-seeking and risk-management practices – are all well-known from the established financial system,” it stated.

For example, BIS noted that stablecoins are “inherently fragile” and designed to target a fixed face value using various types of reserve assets.

“This arrangement gives rise to mismatches between the risk profiles of these assets (the underlying collateral) and the stablecoin liabilities,” it stated.

Conclusions

The BIS report pointed out that the DeFi ecosystem is still developing and predominantly geared toward speculation, investing and arbitrage in crypto assets, rather than real-economy use cases.

“The limited application of anti-money laundering and know-your-customer provisions, together with transaction anonymity, exposes DeFi to illegal activities and market manipulation,” it stated.

The report also suggested DeFi’s growth posed financial stability concerns. An example is the possible risk of runs on stablecoins that could compromise their ability to transfer funds within the DeFi ecosystem.

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Regulatory safeguards

While arguing that full decentralisation was an illusion, BIS pointed out platforms had groups of stakeholders taking and implementing decisions.

“These groups, and the governance protocols on which their interactions are based, are the natural entry points for policymakers,” it stated.

According to the report, such entry points should allow public authorities to “contain DeFi-related issues” before this ecosystem attains systemic importance.

“Regulatory safeguards would also help to ensure that the innovative potential of DeFi brings overall benefits to finance,” it concluded.

Risks and challenges

Commissioner Caroline Crenshaw of the US Securities and Exchange Commission recently highlighted the issues surrounding DeFi, which also presents a “panoply” of opportunities.

“It also poses important risks and challenges for regulators, investors and the financial markets,” she said. “While the potential for profits attracts attention, sometimes overwhelming attention, there is also confusion, often significant, regarding important aspects of this emerging market”.

While Crenshaw acknowledged it was not the SEC’s role to prevent all investment losses, she insisted it was essential investors had access to the information needed to make informed decisions.

Lack of transparency

Crenshaw said that DeFi investing was not transparent in important ways, even though transactions are often recorded on a public blockchain.

“I am concerned that this lack of transparency contributes to a two-tier market in which professional investors and insiders reap outsized returns while retail investors take more risks, get worse pricing and are less likely to succeed over time,” she said.

She also highlighted the fact that markets were “vulnerable to difficult to detect manipulation” and pointed out this was a challenge for DeFi.

Limited visibility

Crenshaw acknowledged that DeFi transactions occur on a blockchain, with each transaction recorded, immutable and available for all to see, but highlighted potential issues.

“That visibility extends only down to a certain identifier,” she said. “Because of pseudonymity, the blockchain displays the blockchain address that sent or received assets, but not the identity of the person who controls it”.

Without an “efficient method for determining the actual identity of traders”, she pointed out, it is very difficult to know if asset prices and trading volumes reflect organic interest.

Growing confidence

The report comes as a survey revealed more than a third of millennials and half of Generation Z would be happy to receive 50% their salary in bitcoin or other cryptocurrencies.

The study by financial advisory firm deVere Group shows 36% of those born between 1980 and 1996, and 51% of those born from 1997 to 2012, would welcome payment digitally.

According to deVere CEO Nigel Green, younger generations are more willing to embrace these payment forms as they are “digital natives”.

“They appear to trust an autonomous decentralised digital currency and payment system over a traditional system where legacy financial institutions and governments are in control,” he said.

Read more: What is decentralised finance?

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