Decentralised Finance – Paradigm shift or pipe dream?

Decentralised Finance (DeFi) refers to an experimental branch of finance where the centralised intermediaries (banks, exchanges, brokers etc.) between the initiation and closing of a transaction are replaced with alternative decentralised systems. Functionally, these are computer algorithms that do the same job as finance workers, such as bankers and brokers, would have done. The decentralised aspect refers to the fact that no single entity owns or controls the systems, and that they are devoid of a single physical location; they are autonomous to the highest degree. Whilst the way in which this decentralisation is achieved (blockchain) is beyond the scope of this report, the potential implications are not and should be assessed.

 

In order to analyse DeFi, an understanding of the technology is beneficial – for example, its usage when transferring money to an individual via a bank. In essence, if this money is electronic (stored in a bank’s computer) then the bank can be thought of as the custodian of a ledger where each account name, and their corresponding sums of money, is noted. Under this simplification, the transfer is a modification to the ledger. The number representing the sum in the sender’s account is reduced, and the number representing the sum in the recipient’s account is increased. This modification is undertaken by the custodian of the ledger – the bank. With DeFi, the ledger is governed by a computer algorithm, and both parts are decentralised using blockchain technology. To make a transfer, the amount to send and its destination are submitted to the algorithm. Then, if it deems the relevant account to have the required funds, it updates the ledger accordingly.

 

Adopting DeFi has the potential to benefit consumers significantly. Of greatest consequence is the removal of human inputs that can lead to bias and errors. Due to this, events such as Citigroup’s 2020 mistaken lending of 900 million USD or racial biases in mortgage offerings are less likely. Furthermore, the lack of employees, and the accompanying payroll, entails the potential for cheaper transaction costs and greater efficiency. While not as inherently financial in nature, there is also a security aspect. With money in a decentralised system, it is insulated from the rest of the world. No government, cooperation or individual other than the owner can touch it; and with advanced encryption protecting most DeFi systems, the threat posed by hackers is minimal. Ultimately, by using DeFi consumers have the potential to benefit from cheaper costs, quicker transactions, lack of bias, and increased security.

 

There are potential drawbacks to using DeFi and challenges to its widespread adoption, however. The relative newness of such systems means transaction costs are volatile and most systems cannot yet handle the transaction volumes traditional financial institutions do. Additionally, if regulators panic at the lack of regulation and implement unduly harsh rules, DeFi could be prevented from entering the mainstream before suitable regulatory frameworks could be created. At present, the lack of such a framework means no DeFi ‘bank’ is recognised under UK law – meaning that DeFi cannot accept traditional fiat currency deposits and instead operate using cryptocurrencies. Concerning regulation, it is also important to clarify one point. Decentralised systems are very difficult to regulate through force, due to their decentralised nature. For example, despite Egypt banning bitcoin, a decentralised cryptocurrency, in 2019 around 4% of Egypt’s internet users still owned some. In fact, the failure of this ban, amongst other factors, led to the central bank making provisions to re-legalise possession in 2021.

 

If the major problem facing DeFi, namely regulation, can be solved, the use of such systems would likely provide a net benefit to consumers. Regulating DeFi in a fair and appropriate manner would remove some of the uncertainty surrounding such systems, and in theory enable their integration into the existing financial system. However, the ineffectiveness of force-based regulation means any future framework is likely going to work on the basis of incentivising desired activities. While undoubtedly more difficult to implement than a blanket ban, there are ways in which this could be achieved. For example, certain DeFi systems could be granted tax privileges, provided that when they are designed, they adhere to standards such as not allowing user anonymity. DeFi’s future impact is difficult to estimate, but provided a fair legal framework is established, there is potential for DeFi to revolutionise finance. It is, however, unlikely to ever fully automate the industry, as it is doubtful that areas relying on human judgement, such as valuation and risk management, will ever be reliably replicable with algorithms, at least for the foreseeable future.

 

By David Bendle

Sector Head: James Float

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