Cryptocurrency

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

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.

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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.