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Introduction
DeFi is the abbreviation for Decentralised Finance: it consists in the possibility of developing and using totally disintermediated financial services. Instead of operating through a regulated intermediary, as it happens with traditional finance, or with the not qualified Centralised Exchanges, which both play the role of “men in the middle”, we deal with platforms that are totally governed and controlled by smart contracts. There is no doubt that the birth and subsequent evolution of DeFi are closely linked to Ethereum. In fact, as indicated in our previous analysis “Digital & Crypto Assets”, this protocol allows the development of decentralised applications (based on smart contracts) that have led to the explosion of the DeFi phenomenon we are experiencing today.
Main Features
Analysing the practical use of blockchain technology, DeFi is one of the main protagonists. Thanks to smart contracts, it is possible to replicate and develop financial services that are regulated through this technology. Most of the DeFi platforms are based, as mentioned above, on the Ethereum blockchain, even though, after just 5 years from the birth of this sector (first developments in 2017 with explosion of the popularity of protocols in 2019), applications and services on other protocols are already being developed, which introduce new characteristics and different degrees of efficiency.
Currently, the financial services offered by DeFi can be classified into:
- LOANS: One of DeFi’s most popular uses is cryptocurrency lending. It is an extremely liked way to generate passive income for cryptocurrency holders by receiving an interest from the cryptocurrency borrower. The management of the risk associated with the lending activity is delegated to a smart contract that sets rules, limits and collateral in order to guarantee the lender, the payment of the agreed interest and the repayment of the capital. All this takes place in a completely decentralised way on the DeFi platforms enabled for this service.
- DEX, Decentralised Exchanges: these are platforms that allow users to buy, sell or exchange cryptocurrencies and tokens in a totally disintermediated manner. Smart contracts created especially for these activities apply rules, execute operations and securely manage funds when needed.
- Decentralised DERIVATIVES: a derivative is a financial contract between two or more parties, the value of which is determined by the performance of a specific asset (underlying). Through DeFi, it is possible to create and guarantee an infinite variety of derivatives using smart contracts capable of
regulating exchanges, without the need for intermediaries. - Decentralised ASSETS: tokenization concerns assets of a different nature, from works of art to real estate up to luxury yachts. NFTs (non-fungible tokens) represent a huge innovation, as they allow representation and therefore the possibility of making liquid instruments that are not liquid
by their very nature. Furthermore, it is possible to develop smart contracts dedicated to asset management and automated strategies such as periodic rebalancing based on technical indicators and oracles.
The following table shows the individual services offered by DeFi and the main platforms with relative value in USD locked on them:
| Service | Main Platform | Locked (value in USD) |
|---|---|---|
| Lending | Maker | 7.90B |
| Dex | Uniswap | 7.04B |
| Assets | Convex Finance | 2.88B |
| Derivatives | dYdX | 636.4M |
| Payment Systems | Flexa | 212.4M |
The value of DeFi over time
The development of the DeFi ecosystem begins in early 2017. By September of the same year, existing DeFi protocols had already accumulated approximately $1 million in invested assets. At the end of 2017, the value of assets in DeFi had reached $45 million. The development of these protocols has generated two categories of users within the cryptocurrency market: holders, i.e., those interested in maintaining their possession of cryptocurrencies aiming at appreciation over time, and DeFi adopters, i.e., those interested in using services and decentralised financial protocols, in order to obtain passive income and profits.
The Boom
In June 2019, the equivalent of $570 million in crypto assets was present on the DeFi protocols.
This growth progression demonstrates that DeFi is not a random and sporadic phenomenon, but a set of technologies and services destined to grow, becoming a disruptive and innovative segment of the global financial sector.
At the beginning of 2020, the value of assets invested in DeFi services exceeded $1 billion. However, following the crash of the cryptocurrency market in March 2020, the dollar value of the assets used in the protocols fell by about 50%.
Subsequently, the interest in the DeFi sector has made it possible that the resources employed in it were involved in a further upward trend which, from October 2020, has increased the value of this segment to over 11 billion dollars.
2021 was certainly the year of the “boom” for the DeFi sector: in fact, as can be seen from the graph of DeFi Pulse (the reference website for data on DeFi), the dollar value of assets “blocked” in DeFi protocols hit 80 billion.
Such rapid growth resulted from the combination of a series of events involving the entire cryptocurrency sector:
- The increase in the price of bitcoin (which reached its all-time high of $ 63,729) has brought great enthusiasm (Fear Of Missing Out) to the world crypto and consequently to the DeFi landscape.
- The birth of the Binance Smart Chain (BSC), a blockchain created by the Binance exchange capable of hosting DeFi services (parallel to the traditional ones developed on the Ethereum blockchain), has allowed access to decentralised finance with very low and accessible transaction costs, even to small users.
- The birth of further blockchains open to the DeFi ecosystem and able to attract new projects and services such as Polkadot, Solana…
Source: defipulse.com
The Risks
The introduction of such disruptive and revolutionary technologies as Decentralised Finance in a such delicate, highly regulated and controlled sector as the financial one, presents a series of topics for discussion and problems of both technical and regulatory nature to be observed and understood carefully.
In addition to the typical risks of new technologies, the exponential growth of the entire sector in recent months must be assessed with great attention.
The apparent formation of such a large speculative bubble on DeFi services suggests great caution, since historically and statistically, the more sudden the increases in value of a market, the more sudden will be the collapse, resulting from the initial outbreak of the trend and the later normalisation of the whole sector.
This phenomenon has already been tested in sectors with a very high content and capacity for technological innovation. In the beginning there is a very strong generalised growth, then an equally aggressive collapse that leads to a subsequent natural selection of the players and technologies present on the market that ensures the survival of the only subjects really useful and functioning.
For instance, we report below a table published in an interesting paper of the World Economic Forum, and in the continuation of the analysis we will identify and explain each risk associated with Decentralised Finance as it is today.
Source: Decentralized Finance (DeFi) Policy-Maker Toolkit, White Paper (2021)
Financial Risks
- Market Risk: It is the possibility that the value of the DeFi business will decrease due to market conditions or negative developments in the DeFi market.
- Counterparty risk: it is the possibility that the counterparty may, for fraudulent reasons, fail to comply with what is defined in the provision of the service. This risk can be mitigated by a professional audit of smart contracts.
- Liquidity risks: it is the possibility that the funds or assets available to realise the value of a financial activity are insufficient, i.e., that there is a sudden mass liquidity withdrawal by the contributors’ community of the protocol.
Technical Risks
The technical complexity and immaturity of the DeFi market increases the likelihood of significant vulnerabilities including:
- Transaction risks: these are limitations or technical problems related to the underlying blockchain network.
- Risks related to smart contracts: risks related either to incorrect writing of the code of the smart contract, or to the presence of fraudulent back doors that allow to control it. This risk can be mitigated by a professional audit of the smart contracts underlying the service.
- Risks of oracles: they involve the potential risk that data external to the blockchain, provided by specific protocols called Oracles, on which a DeFi contract is based, is inaccurate or has been manipulated.
Operational Risks
- Ordinary maintenance, updates and forks of DeFi protocols can create vulnerabilities and technical risks in the event of malfunctions or technical problems introduced following the update.
- Cryptographic key management, a potential problem for all blockchain-based systems. The platforms identify users and their assets through cryptographic key pairs. Since DeFi’s services are non-custodial, they place the burden of key management on their users in exchange for removing dependencies on a centralised system.
- Governance Mechanisms: Potential risks increase for DeFi and other blockchain-based services. Only with proper due diligence of the protocol and the perfect understanding of the mechanisms that govern it, problems of this type can be minimised.
- Dispute Resolution: Once a smart contract has been executed, the output cannot be changed or reversed just because a single player, or government authority, orders it. When participants believe they are entitled to compensation for some system failure or malicious act, arbitrage can be incorporated into DeFi through multi-year or decentralised agreements, through a forecasting market or crowdsourcing mechanism.
Legal Compliance
- Financial crimes related to the absence of anti-money laundering procedures or transaction control systems in decentralised systems.
- Fraud and market manipulation, which generate cases of misappropriation to the detriment of users.
- Arbitrage, the possibility of obtaining profits for some users at the expense of others due to the absence of adequate regulation to protect the parties involved.
Exogenous Risks
- Dynamic interactions between different DeFi protocols interconnected with each other can produce risks which, although not present in the protocol and in the service used, are inherited by other protocols connected to it. A typical example is the oracle’s problems, which are consequently reflected on the protocol that uses its data.
- Flash crashes or price collapses, risks deriving from the price volatility of the cryptocurrencies used in the DeFi service and accentuated by the use of very high leverage, often granted in this type of service, and combined with protocol vulnerabilities.
