Decentralized Finance: Features of development
Decentralized Finance (DeFi) is a new form of financial products and services operating on the basis of “Permissionless Blockchains” using “Smart Contracts.”
Sergey Andryushin, Doctor of Economic Sciences, Professor, Chief Researcher, Institute of Economics of the Russian Academy of Sciences
Decentralized finance differs from traditional centralized finance (CeFi) in three ways:
First is the degree of transparency. Any user of the DeFi ecosystem can check the rules (software and digital codes) by which financial products and services function in a decentralized ecosystem.
Second is the form of control. DeFi has public control, which prohibits censoring, moving or destroying the crypto assets of users of a decentralized network without their consent.
Third is the level of availability. On a decentralized network, anyone with their own computer, internet connection, and DeFi platform can create and move crypto assets, products, and services.
As of December 1, 2022, according to estimates by the world’s largest digital panel DefiLlama, the capitalization (Total Value Locked, TVL) of DeFi has decreased by more than 4 times – from $180.67 billion (December 1, 2021, when the peak value was recorded) to $42.57 billion. The greatest development of the DeFi market can be seen in the USA, Vietnam, Thailand, China, the UK, and India. In this respect, Russia ranks 15th in the world.
Architecture of DeFi
At the heart of DeFi is blockchain technology, which allows participating parties to work within the rules of smart contracts that fulfill the terms of the contract automatically as a result of certain technical specifications (proprietary standards) adopted by the community. For example, the Ethereum blockchain uses the ERC-20 standard for interchangeable tokens, and ERC-721 for non-interchangeable tokens.
On the basis of these standards, protocols of products and services or various scenarios of operations with tokens are developed. The execution of scripts is determined by the functionality embedded in smart contracts connected to the protocol. Smart contracts are codes in the blockchain that are automatically executed when trigger events predetermined in this code are reached. Adaptation of the relevant protocols for users is carried out at the level of applications – user online interfaces that convert the basic protocols into accessible services for making transactions and tracking the execution of smart contracts.
Connection to applications and protocols takes place through platforms that provide the ability to select and manage various DeFi services, products and services, connecting the two sides of the platform: liquidity providers, and consumers of products and DeFi services. Currently (as of December 1, 2022), the vast majority of DeFi services operate on such leading blockchain platforms as Ethereum (57.3%), BSC (12.89%), Tron (10.37%) and Polygon (2.52%).
Products and Services of DeFi
DeFi’s products and services include payments and transfers, lending and borrowing, insurance, asset management, stablecoins, exchanges, derivatives, and ancillary services such as wallets and oracles. Lending and borrowing are among the largest product segments of DeFi. According to various estimates, their volume ranges from 40 to 123 billion dollars. The leaders in this are currently the Compound, MakerDAO, AAVE, and Anchor platforms.
As the number of DeFi users grows, the value of the products and services created on the network increases significantly. This is due to network effects that qualitatively distinguish DeFi from traditional centralized finance (CeFi). CeFi is an alternative to the DeFi model of organizing finance using smart contracts executed on the basis of blockchain technology, but with financial intermediaries.
Risks of DeFi
The absences in DeFi of a central bank as a lender of last resort, and of an adequate capital buffer, narrow the financial maneuverability of DeFi participants, making them more vulnerable to the risk of default. In the DeFi ecosystem, there are a number of other specific risks, such as the risk of the vulnerability of smart contracts, errors in the operation of information exchange systems between blockchains and the outside world, risks of concentration of protocol management, errors on the side of oracles, loss of users of their keys, and the lack of technological and financial literacy.
DeFi also inherently has in full measure the same risks that are present in the field of traditional centralized finance (risks to financial stability, reduced effectiveness of monetary policy, distortion of competition, weakening of consumer protection), which require the development of additional approaches to minimizing these risks.
Regulation of DeFi
Due to its novelty, an established approach to the regulation of the DeFi ecosystem has not yet formed in international practice. It is difficult to regulate due to the absence of centralized intermediaries in the ecosystem, as well as the presence of compatibility of services, programmability of processes, anonymity (pseudonymity) of users, and the global nature of transactions. Among regulators at all levels, contentious questions remain about possible approaches and principles of regulation, the problems of regulatory arbitration, and which body should be responsible for regulating this sphere: the central bank, or regulatory and supervisory authorities in the financial market.
Currently, the prevailing point of view in international practice is the need to regulate DeFi based on the principle of equivalence of regulation (similar activities – similar risks – similar regulation). At the same time, monetary authorities are also considering soft regulation (based on self-organization) of the DeFi sphere, as well as private initiatives of individual ecosystem participants to optimize and license DeFi protocols within the framework of the rules of the already existing regulation of the financial market.
DeFi in Russia
In November 2022, the Bank of Russia published two key reports – “Decentralized Finance” and “Development of the Digital Asset Market in the Russian Federation” – devoted to topical issues of the issue and circulation of digital assets, as well as the development of the Russian financial market on a new technological basis. The reports noted that within the framework of DeFi, digital financial assets (DFA), utilitarian digital rights (UCP), central bank digital currency, tokenized currencies in non-cash form, as well as secured stablecoins, can be used as crypto assets.
The Bank of Russia notes a gradual increase in the demand of Russian market participants for new technological innovations. Thus, the use of these innovations is recorded in such areas as document management (Rospatent, Dixie), loyalty programs (Sberbank PJSC), corporate voting (NBFC JSC National Settlement Depository) and mortgage accounting (Rosreestr and DOM.RF). In 2022, the first operators of information systems (Atomize LLC, Sberbank PJSC, Lighthouse LLC) were registered within the framework of DeFi, and VTB Bank (PJSC) issued the first bank guarantee on the MasterChain platform to Rostelecom PJSC.
DeFi has huge potential – associated with network effects, flexibility, programmability and compatibility, which make DeFi products novel and in demand. Currently, the activities of the main participants of DeFi are mainly focused on speculation, the use of Flash Loans, and efforts to obtain a guaranteed Risk Free Rate of Return.
However, as the macroeconomic situation normalizes in the world generally and Russia specifically, the share of the capitalization of DeFi in financial markets will increase rapidly (currently, the share of DeFi in the global financial market is small – according to IMF estimates, less than 0.001% of the total volume). This will require international regulatory organs, state authorities, and developers of DeFi product services to introduce additional mechanisms and standards in order to minimize all types of risk in the process of implementing these new technological innovations.