DeFi: Cryptoasset Buffet (re)opens For Business – Technology

If cryptocurrencies aimed to disrupt payments and
initial coin offerings (ICOs) did the same for venture capital, the
latest crypto-craze goes after the core banking business: lending
and deposit taking.

What is DeFi?

Decentralised Finance – or DeFi for short – is the latest
buzzword from the world of blockchain and cryptoassets. According
to Binance Research, a research arm of the leading crypto exchange,
DeFi stands for “[a]n ecosystem comprised of applications
built on decentralised networks, permissionless blockchains, and
peer-to-peer protocols for the facilitation of lending/borrowing or
trading with financial instruments”1.  DeFi
projects and businesses aim to replicate existing financial
services in a peer-to-peer, decentralised, accessible,
interoperable and transparent way, while simultaneously eliminating
the need for traditional financial intermediaries, such as banks,
securities exchanges and other financial
institutions.2  Enabling technology for DeFi is of
course blockchain or, more generally, distributed ledger technology
(DLT) with its promise of “decentralisation of trust” and
(at least theoretically) open access to users and developers alike.
While still small in comparison to the traditional financial
sector, DeFi has already attracted non-trivial amounts of
crypto-capital: USD 11.03bln worth of value has been locked in Defi
as of mid-October 2020, according to DeFi Pulse, an industry
monitor.3

The narrative behind DeFi is very similar to the one for
cryptocurrencies generally: through disintermediation – eliminating
various middlemen taking a piece of each transaction – DeFi
decreases transaction costs and improves financial inclusion by
giving access to financial services to previously
“unbanked” segments of the global population. In
addition, since DeFi runs on open (permissionless) protocols -
typically Ethereum – which operate without formal institutional
gatekeepers, anybody with the appropriate skills can build on the
platform and experiment with new business models. This facilitates
innovation and (arguably) enables more efficient capital
allocation. 

What is really going on?

Reminiscent of the 2017 initial coin offering (ICO) boom, the
world of 2020 DeFi features an incredible diversity of
projects.4 Most fall into one of three broad
categories: 

1.    Decentralised (collateralised)
lending;

2.    Decentralised marketplaces, typically
decentralised cryptoassets exchanges (DEXes); and

3.    Other decentralised financial services, such
as asset management, derivatives issuance and insurance.
  

With the possible exception of DEXes, decentralised
(peer-to-peer) lending seems to be the killer app of DeFi, with USD
4.21bln worth of value (and growing) locked in as of mid-October
2020.5 While DeFi lending comes in many flavours
(custodial and non-custodial, protocol- or platform-based,
etc.6), its core use case is enabling holders of liquid
cryptoassets (such as Ether and Bitcoin) to earn interest from
their holdings. Borrowers, on the other hand, may wish to borrow
cryptocurrency to take short positions in it (i.e. betting on the
decline in their value) or to acquire token utility or governance
rights.7 Platform providers often earn income from
interest rate spreads (i.e. the difference between the received and
paid interest) or from transaction fees. Lenders de facto deposit
their excess liquidity, meaning that they lock in their assets for
the term of the loan. The practice of staking one’s assets in
exchange for a return – which is at the core of many DeFi
applications – is widely known as “yield farming”. To
balance out the risk, borrowers must typically provide collateral
(in the form of a different cryptoasset) against their borrowings,
sometimes as high as 150 % of the loan value (which somewhat
reduces the appeal of DeFi for the truly unbanked, who may not have
any excess capital to pledge).  

The rate of innovation as well as sheer variety in the DeFi
space is extraordinary even by crypto standards. If you thought
animal-themed projects such as Dogecoin and CryptoKitties were
whacky back in 2017 during the ICO era, wait until you hear of
SushiSwap (and its visionary-to-villain creator “Chef
Nomi”),8  YAM Finance and its clone
Spaghetti.Money (which attracted USD 200m in staked assets within
24 hours of launch9) and PieDAO. Tongue-in-cheek
references to food and farming are a common theme in DeFi and these
types of projects – fusing games and memes with finance – have
already been nicknamed “Weird Defi”.10 
Nevertheless, the amounts involved are no laughing matter.
 

In summary, if the 2017 ICO boom was primarily a capital
formation affair fuelled by regulatory arbitrage, the 2020 DeFi
drive explores other, more sophisticated financial products and
intrudes on banks’ home turf with disintermediated peer-to-peer
lending platforms. This is an attractive, albeit sometimes risky,
proposition for holders of large cryptoassets war chests, as
otherwise idle coins can be put to work earning a return. 

DeFi should not be confused with “Open Banking”,
despite their potentially convergent goals. Open Banking is a
concept where banks – traditionally the exclusive custodians of
customers’ funds as well as, crucially, their financial data -
are compelled to allow access to this data to third-party service
providers.11  This enables the latter to build
innovative (fintech) applications, “democratising” access
to the consenting customers’ bank accounts and banking data, as
if they were essential infrastructure. In the EU, this development
is driven by the Payment Services Directive 2 (PSD2) and is, just
like DeFi in the crypto space, expected to foster innovation in
payment services.   

(Legal) issues and challenges

Despite occasional views to the contrary among tech enthusiasts,
DeFi – just like the rest of the blockchain universe – does not
operate in a legal vacuum. It is inevitable that technology aiming
to disrupt one of the most heavily regulated sectors – finance -
will collide with existing regulation. Here is a high-level
overview of a few of the legal and conceptual issues facing
DeFi: 

  • Licensing issues and regulatory developments:
    Lending – not to mention accepting deposits from the public – are
    regulated and licensable activities across the EU, sometimes
    reserved to credit institutions. The licensing processes are
    administratively cumbersome and impose stringent requirements on
    the prospective applicant. Needless to say, the majority of DeFi
    projects do not bother. Should they? Economically, decentralised
    lending projects often look very similar to core banking business,
    except they primarily operate with cryptoassets instead of fiat
    currency and – arguably – merely facilitate peer-to-peer
    transactions instead of underwriting any risk themselves. The
    latter may not always be the case, however, as many DeFi lending
    operations also maintain liquidity pools. In addition, the argument
    “if it is done in crypto only, it should be okay” is a
    shaky one. A vivid illustration of this is the recent enforcement
    action by the United States’ Commodity Futures Trading
    Commission (CFTC) targeting BitMEX, a leading crypto derivatives
    exchange, alleging that BitMEX has been operating an
    “unregistered trading platform”.12 In the
    EU, the landscape could change drastically for the DeFi sector with
    the eventual adoption of the Digital Finance
    Package.13 The regulation package – currently in
    the legislative proposal stage – introduces, among other things,
    investor protection measures in respect of cryptoassets (including
    a licence for “stablecoin” issuers).

  • Evolution of anti-money laundering / know-your-customer
    rules
    : At least in the EU, AML rules (last amended by the
    5th Anti-Money Laundering Directive) mostly target “fiat
    on-ramps” – i.e. exchanges enabling purchase and redemption of
    cryptoassets for “real” currencies, such as the euro and
    US dollar. This approach assumes that the proceeds of crime take
    the form of fiat currency, and that conversely cryptoassets only
    have value to malicious actors once converted into fiat. This
    assumption may no longer be true, as the cryptoassets and DeFi
    ecosystems develop. Regulators and legislators may therefore decide
    to follow the (crypto-)money and expand stringent KYC requirements
    to crypto-only operators, which may prove impossible to comply with
    for many DeFi teams and may put a quick end to the decentralisation
    utopia.  

  • Jurisdictional challenges and supervisory
    gaps
    : The decentralised and global nature of DeFi (and
    cryptoassets generally) makes it difficult for an individual
    regulator to conduct effective and comprehensive supervision and
    take enforcement action when necessary.14 This may
    cause serious harm for investors or consumers. On the other hand,
    the opposite may occur, where multiple regulators will claim
    supervisory authority over a DeFi operator, resulting in a
    disproportionate regulatory burden or in regulatory paralysis as
    various bodies sort out which one should exercise supervision or
    take enforcement action.  

  • Technological centralisation displacing counterparty
    centralisation
    : DeFi can enable decentralised execution of
    transactions and can bring together separate parties without
    nominally placing an intermediary between them. However, whereas
    counterparties get decentralised, the technology bringing them
    together does not. Reliance on a particular platform, protocol or
    provider creates a single point of failure in a very similar way as
    a bank can become a nexus of financial risk. DeFi thus replaces
    single counterparty risk with technological risk (i.e. a serious
    flaw in the protocol’s code, a key developer abandoning the
    project, etc), which is much less regulated and more difficult to
    police.15 The story of SushiSwap is a cautionary
    reminder of the huge amount of de facto control that can vest with
    a single developer over a nominally “decentralised”
    platform.16  

Footnotes

1 Binance Research (Calvin & Etienne):
Lending & Borrowing, Studying the landscape of the (Ethereum)
decentralized cryptoasset lending industry, 6 June 2019, accessible
at https://research.binance.com/en/analysis/decentralized-finance-lending-borrowing
(13 October 2020).

2 Yan Chen, Cristiano Bellavitis: Blockchain
disruption and decentralized finance: The rise of decentralized
business models (2020), Journal of Business Venturing Insights 13
(2020) e00151, accessible at https://www.sciencedirect.com/science/article/pii/S2352673419300824?via%3Dihub
(12 October 2020).

3 DeFi Pulse, accessible at https://defipulse.com/ (12 October
2020).

4 See a list of selected DeFi projects sorted
into high-level sectors at https://defipulse.com/ (accessed 12 October
2020). 

5 DeFi Pulse, accessible at https://defipulse.com/ (12 October
2020).

6 Binance Research (Calvin &
Etienne): Lending & Borrowing, Studying the landscape of the
(Ethereum) decentralized cryptoasset lending industry, 6 June 2019,
accessible at https://research.binance.com/en/analysis/decentralized-finance-lending-borrowing
(13 October 2020).

Ibid.

8   Adriana Hamacher: The Man Who
Saved SushiSwap, Decrypt, 13 September 2020, https://decrypt.co/41606/the-man-who-saved-sushiswap
(13 October 2020).

9 Ogwu Osaemezu Emmanuel: Spaghetti Money DeFi
Protocol Attracts $200M in TVL Under 24-Hours, BTC Manager, 19
August 2020, https://btcmanager.com/spaghetti-money-defi-protocol-200m-tvl-24-hours/
(13 October 2020).

10 Brady Dale: Yearn, YAM and the Rise of
Crypto’s ‘Weird DeFi’ Moment, Coindesk, 31 August 2020,
accessible at https://www.coindesk.com/yearn-yam-cryptos-weird-defi-moment
(13 October 2020).

11 Deloitte: How to flourish in an uncertain
future, Open banking and PSD2, 2017, accessible at   https://www2.deloitte.com/content/dam/Deloitte/cz/Documents/financial-services/cz-open-banking-and-psd2.pdf
(13 October 2020).

12 JD Alois: BitMEX Hit by CFTC Enforcement
Action for Illegal Crypto Derivatives Trading, AML Violations;
Criminal Action Unsealed Simultaneously, Crowdfund Insider, 1
October 2020, accessible at https://www.crowdfundinsider.com/2020/10/167473-bitmex-hit-by-cftc-enforcement-action-for-illegal-crypto-derivatives-trading-aml-violations-criminal-action-unsealed-simultaneously/
(13 October 2020).

13 European Commission communication: Digital
finance package, 24 September 2020, accessible at https://ec.europa.eu/info/publications/200924-digital-finance-proposals_en
(13 October 2020).

14 Dirk A. Zetzsche, Douglas W. Arner, Ross P.
Buckley: Decentralized Finance, accessible at: https://ssrn.com/abstract=3539194 (13 October
2020).

15 Dirk A. Zetzsche, Douglas W. Arner, Ross P.
Buckley: Decentralized Finance, accessible at: https://ssrn.com/abstract=3539194 (13 October
2020).

16 Adriana Hamacher: The Man Who Saved
SushiSwap, Decrypt, 13 September 2020, https://decrypt.co/41606/the-man-who-saved-sushiswap
(13 October 2020).

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