Why decentralised finance should not be the foundation of the financial system of the future?

26, Aug - BLOG

Decentralised finance should not be the finance of the future

The Bitcoin payment system, invented in 2009 by Satoshi Nakamoto, became the basis for the creation of crypto-assets that soon transformed the financial market. These assets include tokens and stablecoins, which were designed to address the problem of high volatility by tying their value to a basket of currencies or assets. In this context, decentralised financial protocols (DeFi) have emerged, offering the provision of traditional financial services in an automated manner without the involvement of intermediaries.

Decentralised finance: what is it?

DeFi, or decentralised finance, is a system based on blockchain technology and the peer-to-peer principle, which operates without a centralised governing body or centralised data repository, making it open and accessible to all. DeFi's main goal is to provide users with access to financial services without the need for traditional financial intermediaries such as banks and brokers.

Here are the key features of DeFi:

1. Native digital nature: DeFi was originally created as a digital system operating exclusively in the online space.
2. Decentralised management: The management of the system is distributed and does not depend on central authorities or institutions, thus ensuring a high degree of autonomy.
3. Openness: DeFi is accessible to everyone, making it public and transparent to participants and users.

Challenges of decentralised finance

The main goal of DeFi is to offer an alternative financial model that does not require the involvement of third parties such as banks and financial institutions. Decentralised protocols are managed through smart contracts, allowing users to exchange digital assets directly. However, despite all the benefits, DeFi brings with it many challenges and risks.

One of the main challenges is the lack of regulation. Because transactions are carried out without the involvement of intermediaries and regulatory bodies, DeFi exposes users to high risks, including loss of capital, fraud, and cyberattacks. Moreover, DeFi can become a conduit for money laundering and terrorist financing due to its anonymity and lack of control over the origin of funds.

DeFi's main services

DeFi offers services such as loans against crypto assets, where the collateral can be cryptocurrencies or NFTs. Users can also exchange, buy and sell tokens on public markets with high liquidity. Staking allows tokens to be deposited to support the blockchain, with liquid staking protocols preserving access to the assets.

Additionally, yield farming for yield and collateral-free flash loans, redeemable in a single transaction, are available in DeFi. Decentralised derivatives are contracts linked to underlying assets and executed on a smart contract platform.

Key risks of decentralised finance

DeFi presents significant risks that are exacerbated by the lack of regulation and high volatility of cryptoassets. These risks include operational, technological and security risks that can have serious implications for users and the financial system as a whole. 

Here are the main types of risks:

•   Blockchain Risks: The scalability of blockchain remains a major concern. This refers to the ability to process more transactions without losing efficiency and improving security;
•   Cryptoasset risks: The rapid development of cryptoassets can destabilise the financial system, creating risks to consumer protection and financial integrity. An example is the volatility of assets such as Bitcoin and Etherium;
•   Decentralised governance risks: In DeFi, the management of protocols is decentralised, but the creators of these protocols can manipulate them to their own advantage, which can harm minority holders;
•   Risks of use: There is a high risk of capital loss in DeFi due to fluctuations in crypto-asset prices, as well as the risk of hacking and fraud. Participation in DeFi requires users to have a thorough understanding of the mechanisms of these protocols;
•   Cyber-attack risks: DeFi protocols are often targeted by hackers who use phishing, routing, Sybil and 51% attacks to gain control of blockchain or smart contracts;
•   Money laundering risks: Anonymity in DeFi can facilitate money laundering and terrorist financing, which is one of the main reasons for increased regulation.

Regulation of decentralised finance

In April 2023, the European Parliament approved the Markets in Cryptoassets (MiCA) regulation, which aims to regulate cryptoassets and provide legal certainty in this area. This regulation introduces a special regime for cryptoassets and divides them into three categories: asset-linked tokens, e-money tokens and other cryptoassets.

MiCA ensures the harmonisation of the regulatory framework for cryptoassets, which should contribute to consumer protection, market integrity and financial stability. However, DeFi is not yet subject to MiCA, which has raised concerns among regulators and financial experts.

The future of DeFi and its regulation

The lack of regulation of DeFi is a major concern given the potential of the sector and the major risks it carries. The European Commission plans to assess the development of DeFi and develop an appropriate regulatory framework to minimise the risks.

Christine Lagarde, President of the European Central Bank, has stated the need for stricter regulation in crypto-assets and decentralised finance. In her view, innovation in these uncharted territories could pose serious risks to consumers and financial stability in general.

Conclusion

DeFi offers innovative solutions for the financial system, but also carries significant risks. Lack of regulation, high volatility and vulnerability to cyberattacks make DeFi a potential threat to financial stability. For DeFi to become a safe and sustainable part of the financial system, appropriate regulations and regulatory mechanisms need to be developed to minimise risks to users and protect the market from instability.