Decentralised Finance (DeFi): What you need to know & Looking forward
What you need to know
The phrase ‘Decentralised Finance’ (DeFi) is neither legal nor technical. Nonetheless, it is increasingly being employed in talks concerning the future evolution of finance and its regulation. The following terms are commonly used: I decentralisation; (ii) distributed ledger technology and blockchain; (iii) smart contracts; (iv) disintermediation; and (v) open banking. While decentralised systems like Bitcoin rely on distributed ledger technology (DLT) and blockchain to support token-based ecosystems, DLT and blockchain are not the only ways to accomplish decentralisation. Furthermore, many distributed ledgers (including the majority of distributed ledgers maintained by big financial intermediaries) currently use a hierarchical, centralised governance architecture, limiting access to only permissioned users. In turn, decentralised may not always imply dispersed. Similarly, disintermediation is not required for decentralisation; rather, disintermediation may be one (side) result of decentralisation, given that the costs of centralised infrastructure may be difficult to recuperate in a world where services can be delivered on a distributed or decentralised basis. As a result, we define DeFi as the decentralised supply of financial services using a combination of infrastructure, markets, technology, methodologies, and applications. Decentralised supply of financial services entails the provision of services by various players, intermediaries, and end-users distributed across several countries, with interactions facilitated and, in many cases, enabled in the first place by technology.
Many people see decentralisation as an attractive ideal, with the possibility to replace the regulatory state with technology. We adopt a different approach here: rather than debating the possible benefits of DeFi, we strive to determine what is actually happening and the regulatory consequences that may result. We examine DeFi as a real-world reality rather than a desired ideal, and we strive to comprehend the mounting issues this trend provides for financial regulation. One issue is the challenge to established mechanisms of governance and regulation.
In summary, DeFi necessitates close regulatory scrutiny. In situations where DeFi results in new forms of technological reliance, regulation must focus on the re-concentrated portion of the value chain to ensure effective oversight and risk control: in this framework, regulation is required to support decentralisation, much like regulation is required to support securities markets and other financial services. In other cases, regulation will be required to safeguard markets and participants against predation by non-decentralised systems, such as when a player in one market attempts to use technology for regulatory arbitrage.
In more forward-thinking ways of thinking, regulation may insist that compliance requirements and real-time supervisory access be embedded in the very technology that allows for decentralisation, potentially decentralising both finance and its regulation in the ultimate expression of RegTech: not only ‘embedded supervision,’ as Auer suggests, but ‘embedded regulation.’
Looking forward
A variety of preliminary findings are possible in the future.
Increasing processing, storage, and bandwidth capacity provide the possibility for financial decentralisation, while AI, blockchain, cloud, and data offer the technological framework for DeFi.
Simultaneously, by connecting multiple small actors, decentralisation may facilitate the creation of efficient scale in terms of data and liquidity pools, which has previously justified regional or global clustering of services in financial centres and the pooling of both through large balance sheets. As a result, decentralisation may jeopardise part of the bundling activity provided by intermediaries. This tendency is most likely only partial. In other words, decentralisation will likely result in more diverse and competitive financial services ecosystems, as well as a reduction in the importance of financial hubs, which is a good thing, but it will not eliminate the significant data advantages enjoyed by the largest tech platforms, such as Aladdin’s Blackrock in the US or Ant Financial in China.
However, DeFi in its purest form cannot operate meaningfully inside a well regulated environment, given that decentralisation is not a panacea — quite the contrary. The ‘tragedy of the commons’ is the dilemma with pure DeFi. When everyone owns something, nobody owns it, and nobody has a direct stake in preserving or enhancing its state, as Aristotle said about children and Milton Friedman adapted for the broader economy. Wherever there is technical and economic decentralisation, incentives to invest in the long-term growth of a technology or business model may vanish: this is one of the key areas of the economics profession, which is increasingly emerging around ideas of system design.
DeFi also presents concerns of accountability and enforcement in the context of both public and private ordering. The problems of establishing standing to suit, defining the appropriate legislation and jurisdiction of regulators, supervisory bodies, and courts, and ascertaining how many clients or counter-parties are situated in a particular area all weaken the rule of law in financial services. But, to some extent, it is one of the primary goals of DeFi.
In reality, both economic and legal factors are likely to explain why efficient DeFi can never be total, but only partial: where parts of the financial services value chain are decentralised, there will be a re-concentration of a different (but potentially less regulated, visible, and transparent) part of the value chain, with cloud computing and BigData pools providing a vivid example. In this way, real-world DeFi has the potential to enhance concentration effects elsewhere in the financial system while also introducing new dimensions of cyber risk due to tech reliance and interconnectedness. As a result, DeFi poses serious problems to the rule of law. If DeFi is to be fully realised, the rules that govern it must be entrenched in the system. This is the ultimate potential for RegTech, as well as the possibility of creating better markets through technology. Aside from that, the law must adapt to the issues of DeFi. Tools include those designed to improve competent authority cooperation, improve tech risk management, mandate data and reserve localisation, mandate RegTech to strengthen financial supervision and enforcement, and mandate open data and open access to services where data economies naturally lead to re-concentration, as in other forms of core infrastructure.
These technologies may need the government playing a prominent role in monitoring and perhaps managing the core underlying systems: ironically, realising the DeFi dream may necessitate government action. Given that DeFi will result in re-concentration somewhere along the value chain, this re-concentration permits, justifies, and necessitates management over DeFi systems, with DeFi supervision focusing on these new point(s) of failure.
If you’ve enjoyed and want to read more from me follow this link here: https://itstomrobertson.medium.com/membership
