DeFi pulls the curtain on financial magic, says EU Blockchain Observatory expert

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As decen­tral­ized finance con­tin­ues its vic­to­ri­ous march — although the road is some­times bumpy — some sig­nif­i­cant ques­tions on its nature remain. How can DeFi appli­ca­tions be pro­tect­ed from becom­ing non­op­er­a­tional under extreme stress? Is it real­ly decen­tral­ized if some indi­vid­u­als have way more gov­er­nance tokens than oth­ers? Does the anony­mous cul­ture com­pro­mise its transparency?

A recent report from the EU Blockchain Obser­va­to­ry and Forum elab­o­rates on these ques­tions and many oth­ers around DeFi. It con­tains eight sec­tions and cov­ers a range of top­ics, from the fun­da­men­tal def­i­n­i­tion of DeFi to its tech­ni­cal, finan­cial and pro­ce­dur­al risks. Con­duct­ed by an inter­na­tion­al team of researchers, the report for­mu­lates some impor­tant con­clu­sions that will hope­ful­ly make their way to the eyes and ears of legislators.

The researchers high­light DeFi’s poten­tial to increase the secu­ri­ty, effi­cien­cy, trans­paren­cy, acces­si­bil­i­ty, open­ness and inter­op­er­abil­i­ty of finan­cial ser­vices in com­par­i­son with the tra­di­tion­al finan­cial sys­tem, and they sug­gest a new approach toward reg­u­la­tion — one that is based on the activ­i­ty of sep­a­rate actors rather than their shared tech­ni­cal sta­tus. The report states:

“As with any reg­u­la­tion, mea­sures should be fair, effi­cient, effec­tive and enforce­able. A com­bi­na­tion of self-reg­u­la­tion and super­vi­so­ry enforced reg­u­la­tion will grad­u­al­ly give rise to a more reg­u­lat­ed DeFi 2.0 emerg­ing from the cur­rent nascent DeFi 1.0 ecosystem.”

Coin­tele­graph spoke with one of the report’s authors, Lam­bis Dionysopou­los — a researcher at the Uni­ver­si­ty of Nicosia and a mem­ber of the EU Blockchain Obser­va­to­ry and Forum — to learn more about the most intrigu­ing parts of the document. 

Coin­tele­graph: How should reg­u­la­tors approach infor­ma­tion asym­me­try between pro­fes­sion­als and retail users?

Lam­bis Dionysopou­los: I would argue that reg­u­la­to­ry inter­ven­tion is not need­ed for that. Blockchain is a unique tech­nol­o­gy in the lev­el of trans­paren­cy and intri­ca­cy of infor­ma­tion it can pro­vide to any­one at no cost. The trade-offs for achiev­ing that lev­el of trans­paren­cy are often sig­nif­i­cant to the extent that decen­tral­ized blockchains are often crit­i­cized as inef­fi­cient or redun­dant. How­ev­er, this is nec­es­sary for pro­vid­ing an alter­na­tive to the exist­ing finan­cial sys­tem, whose opaque­ness is the root of many evils.

In tra­di­tion­al finance, this opaque­ness is giv­en. The every­day saver, char­i­ty donor or vot­er has no way to know if their funds are duti­ful­ly man­aged by the bank or sup­port their pre­ferred cause, or know who spon­sored their politi­cian and by how much. DeFi pulls the cur­tain on the finan­cial mag­ic by encod­ing every trans­ac­tion on an immutable ledger acces­si­ble to everyone.

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Today, tools such as blockchain explor­ers allow any­one to trace the flow of mon­ey in the blockchain econ­o­my, gain infor­ma­tion about the apps and ser­vices they use in the space, and make informed deci­sions. It is true that those with funds and advanced knowl­edge can, and do, take bet­ter advan­tage of this sys­tem. How­ev­er, as the DeFi ecosys­tem expands, I am opti­mistic that new tools will emerge that will make more advanced insights avail­able to any­one. My opti­mism is found­ed on two fac­tors: First, it is com­par­a­tive­ly eas­i­er to build such tools in DeFi; and sec­ond, inclu­siv­i­ty and open­ness are the ethos of the DeFi space. The role of reg­u­la­tors should be to facil­i­tate this.

CT: In the report, DeFi is clas­si­fied as “rad­i­cal inno­va­tion,” while fin­tech gen­er­al­ly is “sus­tain­ing inno­va­tion.” Could you explain these def­i­n­i­tions and the dif­fer­ence between them?

LD: Sus­tain­ing or incre­men­tal inno­va­tions are improve­ments on exist­ing prod­ucts or pro­ce­dures with the goal of bet­ter serv­ing the same cus­tomers, often for a high­er prof­it too. Fin­tech is a prime exam­ple of this. Indica­tive­ly, through e‑banking, cus­tomers can open accounts faster, ini­ti­ate online trans­ac­tions, and gain access to elec­tron­ic state­ments, reports and man­age­ment tools. 

Rev­o­lut and Ven­mo make split­ting the bill or ask­ing for pock­et mon­ey eas­i­er. All those con­ve­niences are often wel­come and demand­ed by con­sumers, but also by com­pa­nies who can find ways to mon­e­tize them. Cen­tral to sus­tain­ing inno­va­tions is a notion of lin­ear­i­ty and cer­tain­ty, mean­ing mod­est changes that result in mod­est improve­ments on how things are done as well as added value.

On the con­trary, rad­i­cal inno­va­tions such as DeFi are non­lin­ear — they are dis­con­ti­nu­ities that chal­lenge con­ven­tion­al wis­dom. Rad­i­cal inno­va­tions are based on new tech­nolo­gies — they can cre­ate new mar­kets and make new busi­ness mod­els pos­si­ble. For that rea­son, they also imply a high lev­el of uncer­tain­ty, espe­cial­ly at the ear­ly stages. The notion that any­one can be their own bank and that open­ness and com­pos­abil­i­ty can over­come walled gar­dens are exam­ples of how DeFi can be per­ceived as a rad­i­cal innovation. 

CT: Is there any data con­firm­ing the hypoth­e­sis that DeFi can help the unbanked and under­banked? It seems that DeFi is pop­u­lar first­ly among tech-savvy indi­vid­u­als from devel­oped countries.

LD: The notion that DeFi is pop­u­lar with banked and tech-savvy indi­vid­u­als is both true and short-sight­ed. For tra­di­tion­al finan­cial ser­vice providers, mak­ing their ser­vices avail­able to an indi­vid­ual is a ques­tion of cost-ben­e­fit. Sim­ply put, a large por­tion of the plan­et is not worth their “invest­ment.” Some­one more sus­pi­cious might also add that depriv­ing indi­vid­u­als of access to finance is a good way of keep­ing them sub­or­di­nate — a look at who the unbanked are might sup­port this ter­ri­fy­ing theory.

DeFi has the poten­tial to be dif­fer­ent. Its glob­al avail­abil­i­ty does not depend on the deci­sion of a board of direc­tors — it is how the sys­tem is built. Every­one with rudi­men­ta­ry inter­net access and a smart­phone can access state-of-the-art finan­cial ser­vices. Immutabil­i­ty and cen­sor­ship resis­tance are also cen­tral to DeFi — no one can stop any­one from trans­act­ing from, or to, a spe­cif­ic area or with an indi­vid­ual. Final­ly, DeFi is agnos­tic to the inten­tions behind send­ing or receiv­ing infor­ma­tion. As long as some­one sends or receives valid infor­ma­tion, they are first-class cit­i­zens in the eyes of the net­work — irre­spec­tive of their oth­er social sta­tus or oth­er characteristics.

DeFi is pop­u­lar with banked tech-savvy indi­vid­u­als for two pri­ma­ry rea­sons. First­ly, as a nascent tech­nol­o­gy, it neces­si­tates some lev­el of tech­ni­cal sophis­ti­ca­tion and thus attracts users with the lux­u­ry of acquir­ing this knowl­edge. How­ev­er, there are active steps tak­en to reduce the bar­ri­ers to entry. Social recov­ery and advances in UX design are only two such examples. 

Sec­ond­ly, and per­haps most impor­tant­ly, DeFi can be lucra­tive. In the ear­ly stages of wild exper­i­men­ta­tion, ear­ly adopters are reward­ed with high yields, hand­outs (air­drops) and price appre­ci­a­tion. This has attract­ed tech-savvy and finance-native indi­vid­u­als seek­ing a high­er return on their invest­ments. Mar­ket shake­outs (such as the recent events of UST/LUNA) will con­tin­ue to sep­a­rate the wheat from the chaff, unsus­tain­able high yields will even­tu­al­ly sub­side, and indi­vid­u­als attract­ed to them (and only them) will seek prof­its elsewhere. 

CT: The report high­lights the prob­lem­at­ic aspects of the pseu­do­ny­mous cul­ture of DeFi. What pos­si­ble com­pro­mis­es between the core prin­ci­ples of DeFi and the secu­ri­ty of users do you see in the future?

LD: DeFi is not entire­ly homo­ge­neous, which means that it can pro­vide dif­fer­ent ser­vices, with dif­fer­ent sets of trade-offs for dif­fer­ent peo­ple. Sim­i­lar to how blockchains have to com­pro­mise either secu­ri­ty or decen­tral­iza­tion to increase their effi­cien­cy, DeFi appli­ca­tions can make choic­es between decen­tral­iza­tion and effi­cien­cy or pri­va­cy and com­pli­ance to serve dif­fer­ent needs. 

We are already see­ing some attempts at com­pli­ant DeFi, both in cus­to­di­al sta­ble­coins, pro­gram­ma­ble cen­tral bank dig­i­tal cur­ren­cies, secu­ri­ties set­tle­ment using blockchain, and much more, col­lec­tive­ly also referred to as CeDe­Fi (cen­tral­ized decen­tral­ized finance). The trade-off is explic­it­ly includ­ed in the name. Prod­ucts with dif­fer­ent trade-offs will con­tin­ue to exist to serve con­sumer needs. How­ev­er, I hope this inter­view makes a case for decen­tral­iza­tion and secu­ri­ty, even if that means chal­leng­ing conventions.

CT: The report states that DeFi has so far had a min­i­mal impact on the real econ­o­my, with use cas­es lim­it­ed to cryp­to mar­kets. What use cas­es do you see out­side these markets?

LD: DeFi has the poten­tial to influ­ence the real world direct­ly and indi­rect­ly. Start­ing with the for­mer, as we become bet­ter at mak­ing com­plex tech­nolo­gies more acces­si­ble, the whole suite of DeFi tools can be made avail­able to every­one. Inter­na­tion­al pay­ments and remit­tances are the first low-hang­ing fruit. The bor­der­less nature of blockchains, in con­junc­tion with rel­a­tive­ly low fees and rea­son­able trans­ac­tion con­fir­ma­tion times, makes them a con­tender for inter­na­tion­al payments.

With advances such as lay­er 2, trans­ac­tion through­put can rival that of large finan­cial providers such as Visa or Mas­ter­card, mak­ing cryp­tocur­ren­cy a com­pelling alter­na­tive for every­day trans­ac­tions as well. What could fol­low are basic finan­cial ser­vices, such as sav­ings accounts, lend­ing, bor­row­ing and deriv­a­tives trad­ing. Blockchain-backed micro­fi­nanc­ing and regen­er­a­tive financ­ing are also gain­ing trac­tion. Sim­i­lar­ly, DAOs can intro­duce new ways of orga­niz­ing com­mu­ni­ties. NFTs can also be, and have been, more appeal­ing to the wider market.

At the same time, the idea of using con­cepts devel­oped in the DeFi space to increase effi­cien­cy in the tra­di­tion­al finan­cial sys­tem is gain­ing ground. Such use cas­es include, but are not lim­it­ed to, smart con­tracts and pro­gram­ma­ble mon­ey, as well as the use of the tam­per-evi­dent and trans­par­ent prop­er­ties of blockchain for the mon­i­tor­ing of finan­cial activ­i­ty and the imple­men­ta­tion of more effec­tive mon­e­tary policy.

Recent: Bear mar­ket: Some cryp­to firms cut jobs while oth­ers aim for sus­tain­able growth

While each of those indi­vid­ual com­po­nents is impor­tant in its own respect, they are also parts of a big­ger tran­si­tion to Web3. In that respect, I would argue that the real ques­tion is not how much cryp­to can influ­ence the “real” econ­o­my but how much it will blur the line between what we con­sid­er the “real” and “cryp­to” economy.

CT: The report makes a reserved rec­om­men­da­tion to reg­u­late DeFi actors by their activ­i­ty rather than use an enti­ty-based approach. How would this reg­u­la­to­ry struc­ture function?

LD: In the world of DeFi, enti­ties look much dif­fer­ent than what we are used to. They are not rigid­ly defined struc­tures. Instead, they com­prise indi­vid­u­als (and enti­ties, too) that come togeth­er in decen­tral­ized autonomous orga­ni­za­tions to vote on pro­pos­als about how the “enti­ty” will be involved. Their activ­i­ties are not well defined. They can resem­ble banks, clear­ing hous­es, a pub­lic square, char­i­ties and casi­nos, often all at the same time. In DeFi, there is no sin­gle enti­ty to be held account­able. Due to its glob­al nature, it is also impos­si­ble to apply a sin­gle country’s legislation. 

For this rea­son, our con­ven­tion­al wis­dom of finan­cial reg­u­la­tion sim­ply does not apply to DeFi. Mov­ing to an activ­i­ty-based reg­u­la­tion makes more sense and can be facil­i­tat­ed by reg­u­la­tion at the indi­vid­ual lev­el and the DeFi on-ramps. That being said, there are def­i­nite­ly bad actors using DeFi as an excuse to sell repack­aged tra­di­tion­al finance prod­ucts, only less secure and less reg­u­lat­ed — or even worse, out­right scams. Reg­u­la­to­ry cer­tain­ty can make it hard­er for them to seek asy­lum in DeFi.

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