4th September 2022 > > Decentralised Finance.

tl;dr

The Federal Reserve has issued a research paper on the topic of Decentralised Finance (DeFi).

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BTC threatening to make a new low for 2022 has spawned another new word – Septembear – though as you can see, market fears over gas supplies are beginning to moderate:

Curious Cryptos’ Commentary – Decentralised Finance (DeFi)

The Federal Reserve has published an internal research piece about DeFi, which can be found here:

https://www.federalreserve.gov/econres/feds/files/2022057pap.pdf

It titles itself as “Decentralized Finance (DeFi): Transformative Potential & Associated Risks” which is a cheeringly positive approach from the start.

At 33 pages long I suspect I cannot persuade many of you to read this document, however useful such an exercise might be. But fear not, let the CCC provide you with a summary of its main points and conclusions.

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The paper opens with a definition of DeFi, and a comparison with CeFi (Centralised Finance) more commonly referred to here as TradFi (Traditional Finance), and it hints at the problems inherent in supervising DeFi protocols and dApps (Decentralised Applications), without providing any clear answers.

It then continues with a decent explanation of blockchain technology, smart contracts, and DeFi products and services, with a focus on collateralised loans and uncollateralised loans, aka flash loans, which are made and repaid within the same block.

Section 4 “Risk implications of DeFi” is a useful reference point stating that:

“The ability to build large leveraged positions and to conceal trades to some extent, combined with the novelty of the financial products allowing such leverage, have been common elements in the history of financial crises of the past century. If DeFi products become sufficiently widespread, a sparking event that undermines confidence in the levered positions might generate a financial crisis.”

It is good that the researchers state quite clearly that the risks presented by DeFi are not new in any sense but are the same risks that all new financial products present.

This section goes into significant detail about operational risk, and how blockchain technology can both mitigate and increase operational risk. The blockchain trilemma is nicely explained, followed by some interesting comments regarding dApp governance and blockchain’s inherent resistance to censorship. A couple of apposite quotes for you:

"If control (of dApps) is widely dispersed, the supervisors may not find anyone who they feel can remedy regulatory concerns.”

“An important feature of decentralized blockchains is that they are typically resistant to censorship. That is, to be included on the blockchain, a proposed transaction merely must comply with the blockchain protocol.”

The eagle-eyed amongst you will immediately be thinking about the Tornado Cash situation (see CCC 10th, 12th, and 16th August). In summary, a dApp has been taken down by the authorities, and some wallets that interacted with Tornado Cash have been censored. This regulatory overreach (in my opinion anyway) is being challenged by this research paper, which is overwhelmingly positive news.

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The report finally concludes with this statement:

“In addition, under the scenario in which public blockchains evolve to provide a full range of services denominated in cryptocurrencies, supervisory authorities (including the Federal Reserve) may lack the necessary tools to ensure compliance with laws and regulations. Policies considered well in advance and thoughtfully may reduce the scope of the inevitable financial stability disruptions stemming from DeFi.”

This is a neat summary of the exact stance taken by the CCC with regards to legislation and regulation of the crypto industry.

Let us hope the lawmakers act on this advice.