Decentralised Finance (DeFi)

Background

From barter to currency. From currency to plastic cards, checks and other financial products. From bank books to digital accounts and wallets. From digital accounts to cryptocurrencies. Throughout human history, society has seen the intangible concept of money manifest into various mediums. It is therefore only reasonable that one asks – what does the future hold for financial services?

Economic development as we know it has been centralised by financial intermediaries that have been validating, settling, and keeping record of all financial activities. A centralised model of this kind, one facilitated by financial entities such as banks and financial advisors, has been the De facto operating model for a long part of human history, and is still very much the case at present.

However, what the last 20 years of financial crises have taught us is that this centralised model may not be as stable as was once thought. Exemplifying this point is the 2008 Global Financial Crisis whereby the excessive risks taken by large financial institutions exposed inherent vulnerabilities that meant governments were forced to make enormous bailouts, with taxpayers footing the bill. Exposing such frailties in the system highlights the importance of learning from those mistakes and improving operating models to focus on Risk and Capital adequacy.

Other key issues affecting our current banking system include friction, inaccessibility, and regulatory uncertainty. Not all of us are fortunate enough to be included in the current financial system as it is, nor are we all able to play on level playing field.

This is where technology comes into play and where an innovative technology “Blockchain” was born; a technology that is a paradigm shift and removes the need for intermediaries and third parties in the value chain.

Newton’s Third Law of Motion states, “For every action, there is an equal and opposite reaction.” What recent technological advances in the banking space have proven, namely through the establishment of Decentralised Finance (DeFi), is that a reaction of this kind was always inevitable. A solution to bridge the gaps, to level the playing field, and to make banking services accessible to everyone was, as Newton puts forward, “the equal and opposite reaction.” DeFi aims to grant users more opportunities, and access to a wider range of financial solutions, without restrictions and without friction.

Technology Underpinning Decentralised Finance?

Distributed ledger technology (Blockchain)

To delve into the notion of DeFi, it is best we first understand what blockchain is. Blockchain is essentially a categorised database that is shared across the nodes of a computer network. Its purpose is to store information in a digital format, guaranteeing fidelity and security of the recorded data, and eliminating the need of third parties or intermediaries.

Blockchain differs from the usual databases as it does not store data in tables, it collects data in groups called blocks. Each of these blocks has a limit to their capacity to store data. Therefore, once one block reaches its limit, it is closed and linked to the formerly filled block: forming a chain of data that builds up the blockchain.

What is interesting about this is that structuring and collecting data in this manner makes for an irreversible timeline. Once a block reaches its full capacity, it becomes unchangeable, and therefore permanently a part of the timeline. A result of this feature is that each block will have its own timestamp, indicating the exact moment it was added to the blockchain.

This technology has facilitated the newly formed peer-to-peer monetary exchange we now know of as cryptocurrencies. The most popular ones being Bitcoin and Ethereum.

Having said that, we can move on to exploring how the blockchain acts as a facilitator of DeFi. The whole notion behind DeFi is that it enables users to gain access to and employ financial services without having to rely on a bank or any other centralised entity. Enabling this new type of intermediation of financial services, are the Decentralised Applications (dApps). dApps are software programs that use blockchains to transfer data and payments, with the majority being used on the Ethereum platform.

Decentralised Finance (DeFi)

DeFi deploys a financial landscape that is built using blockchain technology. The three pillars of the banking system DeFi focuses on include:

  •  Payments and clearing
  •  Accessibility
  •  Centralisation and Transparency

DeFi is mostly open-source and based on an Internet protocol pile that leverages Smart Contracts instead of intermediaries. Smart Contracts are code stored on a blockchain platform that performs a predetermined set of actions, covering the terms of agreement and the necessary functions of the DeFi service. It is important to note that for DeFi, it is usually the case that collateral is locked into a Smart Contract.

Therefore, Smart Contracts can be seen as facilitators of financial transactions and are key for DeFi dApps to work as designed. Moreover, once deployed the Smart Contract is recorded on to the blockchain for the public to see. This makes DeFi inherently transparent as it enables all the transactions to be auditable via blockchain browsers.

What are the opportunities?

DeFi is in its infancy due to the ongoing development of the ecosystem as a whole. However, this presents an abundance of financial opportunities in terms of new product and service development. More specifically, leveraging the DeFi ecosystem and infrastructure could improve operational efficiency by altering traditional processes in the following way:

  •  Payments and Clearance System: Cryptocurrencies such as Ethereum could negate the need for intermediaries, enabling the process to be quicker and the transfers to be processed on a lower fee than traditional banks
  •  Lending, Borrowing and Saving: Smart Contracts will oversee the management of deposits, paid interests and lending, based on what was stipulated by the market in the terms of agreement
  •  Transparency: Transactions are open to the public. Smart Contract governance ensures that anybody with programming knowledge can review and analyse the governing logic, therefore enabling transparency
  •  Accessibility: DeFi seeks to create borderless, censorship-free, and accessible financial services for all. DeFi protocols do not favour one person over the other, they aim to democratise the financial field for everyone

What are the risks?

DeFi is no different from other emerging technologies, there are some obstacles to overcome. Be it around regulatory uncertainty, scalability, security, technological risks, or the governance of dApps. However, that is not to say that they cannot be explored and managed.

At present, DeFi is still in development with regards to Anti-Money Laundering (AML) and Know Your Customer (KYC). The system in its current state lacks the guidance and frameworks required to deal with issues of AML. Institutions such as the Financial Action Task Force (FATF) are exploring how to guide institutions that are interacting with DeFi and the corresponding technology in terms of how to manage the AML/KYC requirements. However, due to the complexity that surrounds DeFi, it will still be the case that certain aspects, regulatory speaking, will still need to be clarified.

Another risk that DeFi poses is that of cybersecurity. Cybersecurity may become an issue due to weaknesses in Smart Contract source codes, increasing the risk of hacks. It must be noted that Smart Contracts by nature tend to mitigate such risks, however, there have been cases whereby users have had their assets withdrawn or private keys stolen.

How can TORI help?

  • TORI can help you with Digital Transformation, pursuing a cost-effective approach to this innovative model. There are many ways to execute digital transformation and there is no one-size-fits-all approach
     
  • TORI can help you to develop a PMO (Programme Management Office), to ensure that the cyber security ecosystem is fit for purpose and sufficient for your Blockchain Platform. TORI provide an independent assessment of your security maturity and compliance with standards, to identify gaps in your layers of defense
     
  • TORI can provide training, manual source code reviews, and pen testing to help protect your business applications and infrastructure
     
  • We can assist you with Building a Digital Future around FinTech and Ecosystems, based on unlocking hidden knowledge and patterns in customer behavior, market trends, operations, and risks. Dealing with complex and new risks and by remediating past deficiencies, to develop enhanced operating models, and optimising transaction monitoring systems
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