Examining the Rise of Decentralised Finance: Trends, Challenges, and Opportunities (2024)

ARX Series 8 December 2020

Practitioner's Brief

Eric Anziani Igor Mikhalev Piotr Zembrowski CFA

The Rise of Decentralized Finance: Disruption or Opportunity?

Watch the Webinar

Decentralised finance is a system that sees centralised financial intermediaries, such as banks, credit card providers, and clearinghouses removed from the equation. Instead, all interactions are conducted on a peer-to-peer basis using “smart contracts.” These are self-executing agreements governed entirely by code and hosted on the blockchain.

The key advantage gained from the removal of financial intermediaries is value. After all, one of the main ways that many financial services companies make money is through intermediary fees. As Mikhalev puts it, “DeFi is a novel way of approaching and rethinking traditional financial institution flows and value chains.”

The survey results indicate broad agreement on this matter, with 70% of respondents thinking that efficiency gains are an essential driver for DeFi adoption. Furthermore, institutions can directly participate in DeFi protocols to earn liquidity fees (this is the key attraction for retail investors).

While the advantages of a DeFi system can seem evident on the surface, implementing it is easier said than done. There are critical points to understand — such as how the system is governed and structured.

In the context of blockchain, cryptocurrencies, and DeFi, governance refers to how a system both reaches and implements decisions. In the traditional centralised ecosystem, the answer is easy: it’s all in the hands of the centralised players — whether central banks or other financial institutions.

For a decentralised system, it’s not so simple. There must be a mechanism that allows stakeholders to participate and reach some sort of consensus. Typically, the number of “votes” each participant gets is proportional to the number of tokens they hold.

This governance process can happen in one of two ways: on-chain or off-chain. On-chain means everything occurs on the blockchain underlying the DeFi protocol and all changes are implemented automatically. Off-chain means the decisions are reached using a separate blockchain (or some other voting system) and decisions must be implemented manually.

This governance is the “secret sauce” behind DeFi – and this is why it is unique and so disruptive.

After governance, the second key component of DeFi to understand is the layered structure of a DeFi protocol. Broadly speaking, each protocol has four bands:

• The settlement layer is the underlying blockchain network that powers the DeFi protocol. Right now, the vast majority of DeFi protocols run on Ethereum, as it is the most dominant smart-contract platform.
• Next is the asset layer, where the various crypto tokens are issued. These include the native token of the underlying blockchain (which would commonly be Ethereum and the token of the individual DeFi protocol.
• Higher still is the application layer. This is where we see hands-on DeFi-based applications. Most development activity within the DeFi space is concentrated here, and it is where most innovation is expected in the near future.
• Finally, we have the aggregation layer, which houses the tools that allow the protocols to connect to other protocols and wallets.

This stratified structure is what gives DeFi its flexibility. As Mikhalev notes, “Central banks around the world continue to develop CBDCs (central bank digital currencies), so there is a possibility that DeFi protocols may be able to be built on top of these CBDCs.” This would be a significant boost for the DeFi space. According to a Bank of International Settlements survey, 86% of central banks are now exploring the advantages and disadvantages of CBDCs.

While DeFi holds great disruptive potential for the financial industry, there are very real limitations holding it back from greater adoption. Mikhalev and Anziani group these into five categories:

• Scalability: A big trade-off to decentralised governance are scalability bottlenecks. This is a problem for cryptocurrencies as a whole, but it also affects DeFi. The upcoming transition to Ethereum 2.0, however, should mitigate some of the scalability issues.
• Security: Smart contracts are not perfect. If improperly coded, backdoors can be maliciously exploited. Some people who have “locked in” their funds (to DeFi protocols) have had their assets stolen through such exploits. As Mikhalev observes, “The decentralised nature of the ecosystem, coupled with the fact that most protocols are transparent and open-source, mean that protocols can quickly learn from such exploits and quickly adapt.”
• Network Concentration: Most of the DeFi world currently runs on the Ethereum blockchain. This exposes the entire DeFi space to concentration risk.
• Limited Liquidity: DeFi’s growth may have been explosive, but it is still a drop in the ocean compared with the wider financial world. Liquidity is thus limited, which makes it challenging to attract significant market participation.
• Regulatory: DeFi (and cryptocurrencies) are attractive partly because of their permissionless and borderless nature. As the space grows, however, so too has regulatory attention. Interestingly, more than 60% of the webinar’s audience, including mainly financial professionals, believe that DeFi should be regulated by national or global regulators. Only 25% think it should be self-regulating or remain a complete “buyer beware” space. Should onerous regulations be implemented, it could stifle innovation.

Another issue highlighted by the presenters is accessibility. The long-term use case for DeFi is that it can help the world’s unbanked population access financial services. At present, it is even more difficult for this population to access DeFi compared with the traditional alternatives.

Why? Because right now, you need to own cryptocurrencies to access DeFi protocols. And to obtain digital money, you need a bank account to trade on the various centralised crypto exchanges.

By comparing the size of the DeFi space with the broader financial system, the presenters believe that DeFi has barely scratched the surface of its full potential. Still, they acknowledge that many of its limitations will have to be overcome first. Scepticism around this space abounds: the survey results show that 42% of respondents’ companies think blockchain is overhyped.

It is still too early to tell whether DeFi will remain for the long term. Mikhalev points to possible innovations, such as using prediction markets as a source of information for decentralised credit risk management as well as the potential of decentralisation as a whole to benefit our traditional business models.

In his view, the broader benefit of decentralisation is its ability to foster collaboration without necessarily undermining competition. He notes that in today’s world of top-down “winner-takes-all” business models, such a balance is virtually impossible. With decentralisation, the DeFi ecosystem could be a torch that helps us see the path ahead.

For more on DeFi, see the in-depth report jointly researched by BCG and Crypto.com: “The Sudden Rise of DeFi: Opportunities and Risks for Financial Services.”