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Bank of Canada Publishes Analytical Notes on DeFi

DeFi | Oct 19, 2023

Bank of Canada DeFi Network and TVL - Bank of Canada Publishes Analytical Notes on DeFi

Image: Bank of Canada

The Bank of Canada staff released analytical notes on Decentralized Finance (DeFi) including the innovation, its potential, and challenges.

The Rise of DeFi

  • The cryptoasset industry has seen exponential growth, with the market value peaking at US$2.9 trillion in 2021.
  • Initially, cryptoassets like Bitcoin were designed for decentralized payments using blockchain technology. However, the focus has now shifted to offering a broader range of financial services, known as DeFi, primarily on the Ethereum blockchain.
  • DeFi operates in a multi-layered structure, with the blockchain at the base layer recording and settling transactions. On top of this, developers create various cryptoassets, including native tokens, stablecoins, and non-fungible tokens (NFTs). Ethereum also supports an application layer offering financial services like lending and asset management.

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  • The emergence of DeFi was partly driven by the inefficiencies and high costs in traditional finance. For instance, cross-border payments in the traditional system involve multiple currencies and a limited number of correspondent banks, leading to cost and time inefficiencies. Securities settlement also demands reconciliations across various ledgers.
  • DeFi can potentially revolutionize the financial system by enhancing service offerings, boosting competition, and increasing transparency. A unified ledger can minimize frictions in the traditional system and expand the range of financial services.
Bank of Canada DeFi Architecture - Bank of Canada Publishes Analytical Notes on DeFi

Image: Bank of Canada

What Makes DeFi Unique?

  • DeFi provides financial services without traditional intermediaries by utilizing smart contracts on blockchains.
  • Smart contracts act as custodians in the absence of trusted parties. For instance, in a collateralized loan, a borrower locks a digital asset into the contract as collateral, which is released upon repayment. If the borrower defaults, the smart contract liquidates the collateral to repay the lender.
  • DeFi offers a range of services, including decentralized stablecoins, exchanges, lending protocols, and asset management platforms.

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  • One of the standout features of DeFi is its "composability." Smart contracts, being open source, can be combined like Lego bricks to develop new products. This allows for the creation of innovative solutions, such as combining an exchange contract with a lending contract to create a smart contract for margin trading. This composability accelerates the growth of the DeFi system and enhances the interconnectedness across its applications.

Challenges Facing DeFi

  • Limited Tokenization: Only tokenized assets can interact with smart contracts, and few real-world assets have been tokenized.
  • Centralization concerns: While DeFi aims for decentralization, there's a noticeable concentration within the system. Most sectors within DeFi have multiple service providers, known as protocols. However, a significant portion of the value is locked into a few key protocols. Operational or financial shocks to these major protocols could have system-wide implications.
  • CeFi platform risks:  Though they offer financial services using cryptoassets, differ from DeFi as they are managed by people instead of smart contracts. This introduces custodian risks and reduces transparency. The recent failures of centralized platforms like Celsius and FTX underscore the risks tied to these unregulated CeFi entities.
  • Price manipulation, bad actors and rug pulls:  Exit scams and fraudsters

Regulatory Implications

  • The Bank of Canada expressed concerns that while DeFi currently poses limited risks to financial stability, its ties to the real economy might grow. Vulnerabilities in DeFi mirror those in the traditional system, such as run risk with stablecoins and leverage associated with lending.

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  • DeFi introduces new, blockchain-specific challenges, including potential points of failure when blockchains interact with each other or the real world, and amplification channels like flash loans that allow malicious actors to secure vast funds without credit checks or collateral requirements.
  • The anonymous and borderless nature of public blockchains complicates regulatory oversight.

Conclusion

In conclusion, while DeFi holds promise for future monetary and payment systems, it also introduces new risks. Policymakers and regulators are tasked with finding a balance between promoting innovation and mitigating these risks.


NCFA Jan 2018 resize - Bank of Canada Publishes Analytical Notes on DeFiThe National Crowdfunding & Fintech Association (NCFA Canada) is a financial innovation ecosystem that provides education, market intelligence, industry stewardship, networking and funding opportunities and services to thousands of community members and works closely with industry, government, partners and affiliates to create a vibrant and innovative fintech and funding industry in Canada. Decentralized and distributed, NCFA is engaged with global stakeholders and helps incubate projects and investment in fintech, alternative finance, crowdfunding, peer-to-peer finance, payments, digital assets and tokens, artificial intelligence, blockchain, cryptocurrency, regtech, and insurtech sectors. Join Canada's Fintech & Funding Community today FREE! Or become a contributing member and get perks. For more information, please visit: www.ncfacanada.org

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