Opinion: DeFi – the decentralized financial market landscape

10 Jan, 2021 04:53
source: Hong Kong International Finance Review

Singularity Financial Hong Kong January 10, 2021 – DeFi: The Decentralized Financial Market Landscape (Source: Hong Kong International Finance Review. This paper was written on August, 2020.)

About the authors: 1) Yi CUI, Fullydata Technology Chief Technology Officer, Fintech Product Designer; 2) Kriangkai Pookayaporn, Chief Investment Officer of Sripatum University, Dean of Sripatum University, International College, CEO and Founder of MIT KUA CHEROEN CO., LTD. (Non-bank Financial Institution); and 3) Wenjie Xu

Since the rise of Bitcoin in late 2008, Satoshi Nakamoto’s white paper has revealed the new technology that can change the world completely. Blockchain has evolved its capacity in the past ten years and integrated into many applications in our life. Immutable, transparent, permissionless, and secure are the most mentioned features that blockchain technology can provide. It was in 2015 that blockchain technology had reached another major milestone. Ethereum blockchain network has become famous in the world.

This smart contract-based blockchain network breaks through the existing cryptography network’s existing limits by offering a turning-completed programming language. As such, the network has been one of the most popular infrastructures that have been used by many developers to contribute their ideas and implementation.

DeFi’s conceptualized framework began to operate on the Ethereum blockchain network in 2019. The initiation of the decentralization finance concept has been argued since the aftermath 2008 financial crisis. It is the ecosystem of interaction between smart-contract and preset protocol. Dapps and smart contracts allow the DeFi ecosystem to be structured similarly our financial ecosystem. The concept has been initializing and developing rapidly over the past two years. DeFi has become more recognized by our society in such a short period.

Centralization and Decentralization, and its Reasons

Centralization is what we all know in the past 150 years of economic development. Human has been using an intermediary to facilitate the transaction. We have been depended on third parties to verifying, settling, and recording our financial activities. We trust someone and believe that they will act rationally as they suppose for our benefit. As such, trustworthiness is the core element that lies behind the intermediary’s success.

It is undeniable that banks and other financial intermediaries have been the a key player in our economic activities. We can argue that the banking industry has been growing as our economy keep expanding. The connection between the two is strongly related. As such, the effect of the 2008 crisis has raised the critical question: Is our banking system is too centralized? Given the economic cost of the crisis, it makes us reconsider our approach to the financial system. The concern is not only in financial related matter but also in a general manner as well, and our nature is leaning toward  someone or something to manage, take responsibility, and lead–for example, government, the president, central bank, or our CEO. Centralization exists as part of our society.

On the other hand, decentralization is the opposite concept discussed recently with the rise of blockchain technology. It is debatable that we need centralization due to our limited technology capability in the past. To understand deeper, Buterin (2017) has suggested the framework of 3 axes to understand the decentralization in software that can be used to apply in other matters. The three axes that describe the issues:

  • Architectural centralization/decentralization refers to the physical infrastructure that uses to support the network or system. If it is large enough, the system cannot be tolerated and broken at any time. For example, business organizations are architecturally designed to lean their responsibility to a single person as CEO or a group of people such as the board of directors. As such, it is undeniable that architectural centralization will generally lead to political centralization.
  • Political centralization/decentralization refers to the individual or organization that can control or govern the system. In this analogy, we can think of the US central’s bank monetary policy committee who set the policy rate to impact the world economy.
  • Logical centralization/decentralization. The ax tries to capture the main fundamental foundation of the object. According to Buterin (2017), this refers to the look of interface and data structure in the system: Whether it looks single or group? We can also think of this as “separation.” Will the object be able to be separated by its own if we cut it into half?

Figure 1 illustrates the framework used to analyzed centralization and decentralization by Buterin (2017). It is noted that this framework is attempting to represent the concept from a different perspective. As such, it is debatable whether it suits the subject.

As described in figure 1, it is noticeable that traditional corporations such as banks and government agencies fall into three centralization axes. Each subject is highly dependable on a small group of people who has the decision power. Also, it is architecturally engineered as a centralized organization. Moreover, our perception perceived this as a genuinely individual organization. There cannot be a two-supremacy power in one administration.

On the other hand, taking the English language as an example shows that people speak English worldwide. It is developed in a different area with a different accent. English grammar is, instead, the standard rule that is developed and commonly accepted and used. Moreover, there is no infrastructure required for language to exist; it is somewhat inherent in human beings (Buterin, 2017).

At first glance, blockchain may commonly be perceived to be genuinely decentralized. Buterin (2014,2017) suggested that blockchain technology is politically decentralized since there is no single governance authority. In terms of architecture, a blockchain network cannot be tolerated given that it runs through a vast large network and is too costly to reengineer the blocks and reverify the consensus. However, blockchain is logically centralized, given that it is only one commonly agreed state and  acts like a single computer.

The Decentralization concept has been argued to offer some benefits that may increase overall economic benefit. From a computer science point of view, it is argued that it can reduce the fault tolerance given the dependency on centralization. Secondly, Secondly, it is attack resistance because given it is costly to attack the whole network. Thirdly, it is collusion resistance because of anonymity, which is expensive to collude (Buterin,2014).  Moreover, from a business perspective, decentralization is a trustless requirement concept. There is no need to put the responsibility on one person or organization. It is also less likely to lead to failure in operation given its diversification nature. Transparency is also increased, give the decentralization structure such as peer network. Furthermore, it can increase efficiency in process and operation because of diversification in governance.

The Reason Behind the DeFi

The rise of Bitcoin and the initiation of the Ethereum network leads to significant development in tokenization. According to CoinMarketCap (2020), there are 6,537 Cryptocurrency with a total market cap of $361 billion traded in the world. Crypto asset has gained its popularity so quickly because it is claimed to be securely stored forever. However, it brings up another problem, crypto storage is not free, financially, and technically, which can be explained as follows:

  • Fee: The first thing brought by asset storage is a fee. There are charges for users who transfer crypto assets in and out. Charges go to the miner when moving in and out of a wallet. Executing smart contract has a price, too, according to its complexity (Blummer, 2019).
  • Dilution: Dilution is a problem too for cryptocurrency. There are always new coins generating, which will attract assets and dilute previously owned crypto.
  • Cost of mining: Miners do not work on blockchain for free, especially when they face real-world costs. According to the calculation mentioned in Skvorc (2018), storing data on the blockchain is more expensive than a traditional centralized system. Miners will need to use their distributed coins with real-world money to pay for their real energy/electricity and gas bills. This will lead to more supply of crypto in the market and potentially brings the price down.

With an approximate BTC calculation, it depreciates about 2.1% per annum for merely holding the BTC (Young, 2019).  To add and preserve value for crypto assets is the problem of the current cryptocurrency market faces.

Stages of DeFi services

DeFi services aim to rebuild traditional financial services with a decentralized architecture. Figure 2 is a review of previously offered financial services by the industry. They can be categorized into TradFi, CeFi and DeFi stages.

  • Traditional Finance (TradFi): Centralized organizations are run as a business with a clear top-down decision-making organizational structure. Think of banks, hedge funds, almost all corporations, and so on. Under this model, customers have to trust people running the business to be ethically responsible and execute business’s services.
  • Centralized Finance (CeFi): Legacy financial architecture. Centralized finance is digitalized but still requires the user’s trust organization. The organization still has custodial responsibilities. Coinbase, Binance, and a vast number of firms offer CeFi services in the cryptocurrency space.
  • Decentralized Finance (DeFi): Advocates of the DeFi approach argue that the “trust in people” element should be eliminated and replaced by technological solutions, which have become available thanks to the rise of blockchains, smart contracts, and decentralized applications (DApps).

Layers of DeFi services

The potential capability of the Ethereum network allows Ethereum to be used as the platform for DeFi. It is the only infrastructure that can support DeFi’s fast-growing and unknown size super-structure (Hoffman, 2019).  Figure 6 illustrates the layer of the DeFi environment and the Dapps on the Ethereum blockchain network. Figure 3 and Table 1 explain and summarize the layers.

Table 1: Description of the DeFi Layers

Layers Function / Utility The Ethereum economy
Layer 0 Ethereum The ETH Staking Rate
Layer 1 MakerDAO The Stability Fee

The Dai Savings Rate

Layer 2 Lending + Borrowing The Dai Volume-Weighted Average Borrow / Supply Rates
Layer 3 The Application Layer ETH Locked in DeFi
Layer 4 Liquidity Transaction Volume of Assets

Source: Hoffman,2019

Challenge of DeFi Ecosystem

Given that DeFi is a relatively new ecosystem, the progress has revealed some limits that persist and challenge the sustainability of the ecosystem. We analyze and categorize the challenge into three aspects: implementation, platform, and fundamental aspects.

In term of implementation, DeFi is emerging and become hot recently, but some challenge issues may reduce the value of DeFi as described below:

1)Trust and trustless. Decentralized finance can be vulnerable to fraud as well as to the proliferation of untested financial innovations. It seems every DeFi project is under control by the developer team while there is no regulator. Meanwhile, the user is not identified. This means they are relatively easy to fraud and doing illegal business. This leads to question the trustworthiness of platform DeFi.

2)The volatility of the digital currency. Even though we now have a stable currency that is pegged/backed by the real asset. However, market liquidity is still low because of the low participant due to its unique recognition. With the increase in regulation and acceptance in the future, the cryptos’ volatility might decrease and make it behave more like money.

3)The usability. When the market is hot, everyone wants to ride the bull wave. When the technology sounds promising, everyone wants to make a profit from it. This implied that DeFi might follow the path of technology push rather than market pull. Many innovations lack business insights, or the project is not severe enough to consider all the aspects: e.g., why the investor should put the money into it. The current DeFi ecosystem seems to struggle to onboard people to join as much as possible, given its usability concern.

4)DeFi lacks regulators and monitors, which leads to trustworthiness concern, which deters entrepreneurship and innovation. If the firm wants to go for an IPO, they need to satisfy a vast qualifications requirement. Even after the share has already been listed in the market, they also must follow the regulation accordingly. This assured that market integrity investors’ rights are preserved. In the commercial banks, also take responsibility for the money. However, in the DeFi, when the heist happened, no one will take responsibility. Meanwhile, due to less regulation, there is no standardized ICO format rather than the whitepaper. As such, the potential risk is enormous, which leads to fewer investors and deter innovation.

5)DeFi faces the threat of illicit cryptanalysis by quantum computers. When blockchain was first conceived, quantum computers were a distant fantasy, but now they appear increasingly feasible.

6)Financial Crisis in DeFi ecosystem. DeFi protocol ecosystem can lead to excessive leverage given that users typically loan and invest. The complicated and connected layer can unintentionally lead to the excessive leverage position. Since the market might not yet be deep enough to absorb the shock, this may easily trigger the crisis event once the shock happens.

The platform is also another aspect that needs to be considered. Following are the challenges that we found to persist in the ecosystem.

  • Cyber Security and Protocol. Ethereum and Bitcoin have been hacked and lead to the hard fork of the system, demonstrated cybersecurity risk. Moreover, Qin et al. (2020) also found out the weak point in the MakerDao protocol. It is yet to be stable. Moreover, increasing users equals an increase in point of attack. There is no guarantee that this unwelcomed event will not occur in the future
  • Network risk. All the DeFi projects are built based on the Ethereum public blockchain network. Therefore, the crash in the infrastructure is also the risk that needs to be a concern here.
  • Smart contracts and decentralized platforms can be upgraded through achieving consensus among key stakeholders to implement significant upgrades, which is often challenging. When consensus is not forthcoming, progress can stall (Chen et al.,2020).

In the Fundamental aspect, some limits may influence the development and sustainability of DeFi.

  • High requirements on knowledge of users are also another challenge. Given that the protocol is purely the computer code. A high level of knowledge in a computer language is required in order to understand the protocol deeply. This may challenge the growth of the DeFi ecosystem.
  • It is still costly for computation power. Joining the DeFi system, users must use excessive power to store the data and maintain updates, which would increase the costs of preparing, processing, and storing information. This pattern seems not efficient comparing to CeFi. In currently available applications, the combination use of CeFi and DeFi is frequently observed. CeFi is mostly used as the exchange square to unload individual investors from heavy updating workload while still being able to shop in the DeFi world freely.
  • Even though blockchain technology holds the advantage of transparency. However, privacy might be jeopardized, given its transparency and open access environment. As such, there is a cost and benefits consideration of joining the ecosystem.
  • DeFi is using smart contact to implement the whole financial process and stored in the blockchain technology. This might lead to the inflexibility issue that might cost user expense. Moreover, the smart contract itself is the computer code that is filled with the requirement. Implementing it as the real contract may lack the spirit of the law that lay behind the law’s foundation
  • Lack of accountability is another fundamental issue. Given that the whole system is run by code with no one is responsible for it. When something unexpected happened, users cannot find central entities or regulators to account for. It is also not easy to build trust for users to put valuable assets in DeFi. Accountability is still needed to be developed in DeFi ecosystem.

Prospect

The history of money can be traced back to the Bronze age. Currency is later developed and changed its form into paper notes. Those inventions lead to other inventions such as the stock market, future, bond, and many sophisticated financial services and products. Combined with human knowledge advancement, that progress introduced us to the modern financial environment as we know it today.

DeFi is another invention that will be recorded as part of monetary history. With the decentralization concept and technology capability, we found financial services trending toward the peer-to-peer financial ecosystem that might redraw the new picture of the financial world. Decentralized financial services focus on reducing vulnerability brought by a centralized governance structure. Technicality is used to improve efficiency, while produce side product as DeFi vulnerability.

DeFi is preferably in the beginning stage that the real benefits and costs are yet to be known. It is already proved that the concept can be threatened by blockchain folk, currency fluctuation and,  quantum computational power. Blockchain is a technology that provides a comparatively secured environment to centralized database architecture. However, it is not exempted from programmer error and programming bugs. The programming logic might occur the loophole that can be exploited by the attacker and cause damage to the whole ecosystem.

Moreover, facilitating the real economy in the blockchain network is still the first step. Our financial system has grown and passed through many crises that eventually evolved as the backbone of the economy. DeFi is still too young to be tested and observed its potential and capabilities. At this early stage, DeFi is not an enemy or substitute for traditional financial services. It is neither a compliment. In contrast, it is a disruptive innovation power worth attention with conceptual and logic restructuring. The learning curve to DeFi is still long. When digital tokens replace notes someday, to master DeFi, it must master the security of codes and maths.

Reference

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Qin, K., Zhou, L., Livshits, B., & Gervais, A. (2020). Attacking the DeFi Ecosystem with Flash Loans for Fun and Profit. http://arxiv.org/abs/2003.03810

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