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Wharton: The Opportunities and Dangers of Decentralizing Finance

Wharton | Jun 10, 2021

decentralized finance opportunities and risks - Wharton:  The Opportunities and Dangers of Decentralizing Finance

Decentralized Finance — or DeFi — has experienced explosive growth in the past year. But in order for DeFi to fulfill its promise as a disintermediated ecosystem that helps rather than harms, “now is the time to evaluate its benefits and dangers,” write Wharton legal studies and business ethics professor Kevin Werbach and David Gogel, a recent Wharton MBA graduate, in the article that follows. Werbach is author of the book The Blockchain and the New Architecture of Trust and leads Wharton’s Blockchain and Digital Asset Project. Werbach and Gogel recently collaborated with the World Economic Forum to create the Decentralized Finance (DeFi) Policy-Maker Toolkit,  providing guidance to regulators and blockchain watchers everywhere.

Intermediaries have always played essential roles within financial markets, facilitating trust, liquidity, settlement, and security. Yet these benefits come with costs. Intermediation contributes to slow settlement cycles, inefficient price discovery, and limitations on market access. Financial services markets tend to be highly concentrated, with a few powerful intermediaries exercising significant control and extracting substantial rents. Since the 2008 Global Financial Crisis, there has been increased attention on structural inequalities and hidden risks of the financial system. Recent controversies such as the GameStop short squeeze, in which retail investors were blocked from trading during a period of volatility, also cast a spotlight on the shortcomings of legacy financial infrastructure.

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Until now, however, intermediation was a necessary feature of finance. Even peer-to-peer fintech lending platforms such as Prosper and cryptocurrency exchanges such as Coinbase retain an important central role. This is the environment in which Decentralized Finance (DeFi) has emerged.

DeFi is a developing area at the intersection of blockchain, digital assets, and financial services. DeFi protocols seek to disintermediate finance through both familiar and new service arrangements. They use stable-value cryptocurrencies known as stablecoins as assets, blockchain ledgers for settlement, and software-based smart contracts to execute transactions automatically.

The market experienced explosive growth beginning in 2020. According to tracking service DeFi Pulse, the value of digital assets locked into DeFi services grew from less than $1 billion in 2019 to over $15 billion at the end of 2020, and over $80 billion in May 2021. Novel business models such as yield farming — in which holders of cryptocurrencies earn rewards for providing capital to various services — and aggregation to optimize trading across exchanges in real-time are springing up rapidly. Innovations such as flash loans, which are either repaid or automatically unwound during the course of a transaction, open up both new forms of liquidity and unfamiliar risks.

Despite its scale and potential significance, DeFi is still early in its maturation. Now is the time to evaluate its benefits and dangers. As with everything in the cryptocurrency world, hype around DeFi is sometimes out of control. Extraordinary — and unsustainable — short-term returns warped investor expectations and attracted bad actors as well as innovative builders. Most DeFi activity is still speculative and conducted by relatively sophisticated cryptocurrency holders. As mainstream usage grows, risks and regulatory considerations will loom increasingly large.

“DeFi will ultimately succeed or fail based on whether it can fulfill its promise of financial services that are open, trust-minimized, and non-custodial, yet still trustworthy.”

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DeFi is a general term covering a variety of activities and business relationships. We define four requirements: financial services; trust-minimized operation and settlement on a blockchain; non-custodial design; and systems that are open, programmable, and composable. We then identify six major DeFi categories — stablecoins, exchanges, credit, derivatives, insurance, and asset management — as well as auxiliary services such as wallets and oracles (external information feeds). Most resemble traditional financial services, at least on the surface. However, they operate without intermediaries. Many incorporate cryptocurrency-based incentive structures to aggregate capital, maintain efficient pricing, and participate in governance decisions.

Within and beyond the categories described here, DeFi is evolving rapidly. Developers are experimenting with new services, business models, and combinations of DeFi protocols. Technologies are maturing. Services are moving to decentralized management and governance of protocols. Tools are emerging to simplify the user experience on and across DeFi services. A significant aspect of ongoing DeFi development will involve the composition of financial primitives as “Money Legos” which can be reassembled in new and dynamic ways.

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