Decentralised Finance: Opportunities, risks and legal challenges

In one year alone, the value of crypto assets locked in DeFi smart contracts grew from USD 670m at the beginning of 2019 to USD 13bln at the end of 2020. Despite these numbers, compared to the traditional financial markets DeFi is still in its infancy.

What is DeFi?

Intermediaries like agents and brokers of trust, liquidity, settlement and security have always played a major role in financial markets. But using and trusting intermediaries also comes with many shortcomings in the infrastructure of traditional financial markets. These include slow settlement cycles, liquidity challenges and lack of assurance around underlying assets. Now, DeFi is trying to rethink the traditional financial markets by leveraging blockchain technology to facilitate alternatives to central intermediaries and market infrastructures.

"DeFi is trying to rethink the traditional financial markets by leveraging blockchain technology to facilitate alternatives to central intermediaries and market infrastructures."

Given the rapidly evolving DeFi space it is hard to find a one-size-fits-all definition. For this reason, the Wharton Blockchain and Digital Asset Project came up with a functional description to help distinguish DeFi from traditional financial services and auxiliary services. According to this description, a DeFi protocol, service or business model has the following characteristics:

• financial services or products (i.e. processing or directly enabling the transfer of value between parties);
• trust-minimised operation and settlement (i.e. transactions are executed and recorded according to the predetermined rules of a DeFi protocol on a permissionless basis);
• non-custodial design (i.e. assets issued or managed by DeFi services cannot be altered by parties other than the account owner);
• open, programmable and composable architecture (i.e. broad availability of the underlying source code for the DeFi protocol and a public API).

Thanks to its programmability, the possible configurations of DeFi services are extensive. Nevertheless, the core functions of traditional financial services can be identified in many DeFi services. On this basis, the Wharton Blockchain and Digital Asset Project identified six major DeFi service categories: stablecoins, exchanges, credit, derivatives, insurance and asset management. Then there are auxiliary services such as wallets and oracles.

Incentive structures in DeFi services

As DeFi protocols usually require crypto asset holders to lock up their assets to serve as liquidity or collateral to a protocol, most DeFi services incorporate token-based incentive structures to compensate those who immobilise their crypto assets by contributing them to the benefit of the protocol. The most common mechanisms are:

• lock-up yields (interest payments);
• liquidity mining (interest payments in the form of tokens issued); and
• yield farming (automatic movement of crypto assets to optimise returns from lock-up yields and liquidity mining).

In addition to the economic benefit of immobilising crypto assets, the tokens issued in connection with liquidity mining and related mechanisms often provide governance rights for the DeFi service, allowing those who contribute to the protocol to be in a position to vote on proposed changes to it or defined parameters.

General risks

Despite all the potential benefits of DeFi services, they also come with risks. The Wharton Blockchain and Digital Asset Project devised a risk-mapping framework to serve as a starting point for policy considerations and identified five major risk categories: financial, technical, operational, legal compliance and emergent.

Legal risks

DeFi will no doubt be used by some to bypass laws and regulations. The marriage of financial instruments and anonymity opens the door for money launderers or those seeking to avoid embargos and sanctions. It also enables financial services to be offered without having to meet the regulatory requirements that have been set up to protect consumers and ensure a fair and secure market.

Financial regulation and DeFi

In a decentralised world, the most difficult challenge for lawmakers will be to decide what kind of regulations they should go for. Possible policies could be warning and information duties to make sure consumers are well enough informed, opt-in rules where providers could choose to become subject to regulations in return for protections, the issuance of guidance or expectations to familiarise people with high standards and, of course, completely prohibiting certain activities.

"In a decentralised world, the most difficult challenge for lawmakers will be to decide what kind of regulations they should go for."

Regulation at different stages

As the name suggests, DeFi applications run in a decentralised way and therefore are not controlled by certain individuals but rather by everyone. During the lifecycle of a DeFi service, however, there may be times when it is controlled by someone or at least by a smaller group of individuals and only really becomes decentralised later on. This has also been identified by the Wharton Blockchain and Digital Asset Project, which has come up with a four-stage lifecycle of a DeFi service from centralised to decentralised. The stages usually are: i) development, ii) publication, iii) deployment, and iv) operation. This lifecycle could be crucial for policymakers, as it is much easier to apply regulation at stages one to three. Once a DeFi service becomes fully operational and decentral, the number of possible policy actions becomes limited.

Future outlook

It is fair to say that DeFi is a significant development not only within blockchain technology itself, but also within traditional financial markets, and contributes to an increasingly digitalised world. DeFi still has a long way to go, and while it provides lots of opportunities, it also comes with many risks and challenges. It remains to be seen how regulators and policymakers will tackle these to provide fair conditions for all market participants while not hindering innovation and technological progress.

author: Dominik Tyrybon