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Finance: no more middlemen?

Julien Prat
Julien Prat
Researcher at CNRS, CREST and École Polytechnique (IP Paris)

Can you explain the con­cept of decen­tralised finance, or “DeFi” as it is now called?

Decen­tralised finance pro­vides access to finan­cial ser­vices such as cred­it or asset exchanges (main­ly cryp­to-cur­ren­cies). Unlike tra­di­tion­al finance, there are no bank­ing or legal inter­me­di­aries. Exchanges are man­aged between pri­vate com­put­ers thanks to the blockchain, which makes it pos­si­ble to gen­er­ate con­tracts that are self-exe­cut­ing under cer­tain con­di­tions (e.g. repay­ing a loan at reg­u­lar inter­vals or com­mit­ting to sell an asset at a giv­en price). This is what we call “smart con­tracts”. They replace banks for trans­ac­tions and the legal arse­nal (reg­u­la­tors, lawyers, courts) that was pre­vi­ous­ly called upon in case of breach of con­tract. The blockchain is neu­tral, unal­ter­able and allows to trace in all trans­paren­cy all the steps of a con­tract. It is an open book shared by all.

A plat­form like Uniswap records an aver­age of more than $1bn-worth of trans­ac­tions per day1.  Does this mean decen­tralised finance is tak­ing off?

Com­pared to tra­di­tion­al finance, it’s tiny, but these vol­umes are mas­sive and con­tin­ue to grow. So, we can indeed talk about a take-off, espe­cial­ly for lend­ing pro­to­cols (Com­pound, Aave), decen­tralised exchanges (Uniswap, Curve) and “sta­ble­coins” (Mak­er). This suc­cess is part­ly dri­ven by the explo­sion in cap­i­tal­i­sa­tion of cryp­to-cur­ren­cies, which is still close to $2tn2.

But isn’t decen­tralised finance only for cryp­to-cur­ren­cy holders?

Yes, only cryp­to-cur­ren­cies can be trad­ed. Exchanges of reg­u­lat­ed assets, such as stocks, are not pos­si­ble for rea­sons of non-com­pli­ance with the leg­isla­tive frame­work. It is impor­tant to under­stand that the clas­sic mar­ket works in reverse to the cryp­to-cur­ren­cy mar­ket. In mar­ket finance, we know the iden­ti­ty of the play­ers (thanks to “know your cus­tomer” pro­ce­dures for iden­ti­fy­ing cus­tomers), yet their oper­a­tions some­times remain opaque. In decen­tralised finance, iden­ti­ties can be pseu­do­nymised, but all oper­a­tions are transparent. 

What does “DeFi” promise to achieve?

To take an extreme case, the ini­tial ver­sion of Uniswap was only 300 lines of code. Hence, decen­tralised finance is acces­si­ble to the mass­es as opposed to the costs of enter­ing tra­di­tion­al finance, which are very high (licens­ing, ini­tial cap­i­tal, lawyers). If these costs come down, it will stim­u­late com­pe­ti­tion and access to com­plex finan­cial prod­ucts that are today reserved for the rich­est. This democ­ra­ti­sa­tion is the strong promise of DeFi. That being said, it is not with­out dan­ger. Most reg­u­la­tors believe that one should not give too easy access to finance because small hold­ers could risk los­ing out if they lack full under­stand­ing; this is what we some­times see with hyper-sim­pli­fied stock trad­ing mobile apps like Robinhood.

What are the obsta­cles to large-scale adop­tion of “DeFi”?

In addi­tion to the reg­u­la­to­ry hur­dle men­tioned above, the indus­try also has to over­come tech­no­log­i­cal bar­ri­ers. The main one is scal­ing up to a much larg­er scale. Despite the rel­a­tive­ly mod­er­ate num­ber of exchanges, there is already some con­ges­tion on the Ethereum blockchain. There are often too many trans­ac­tion requests com­pared to the val­i­da­tion capac­i­ty of Ethereum. Fur­ther­more, min­ing is struc­tural­ly slow com­pared to the thou­sandths of a sec­ond required for an exchange in cen­tralised finance. An inter­op­er­a­ble net­work of mul­ti­ple blockchains and sidechains will like­ly be required to devel­op DeFi. This is a sig­nif­i­cant tech­no­log­i­cal chal­lenge, but many devel­op­ers are work­ing on it and giv­en the dynamism of the sec­tor their inge­nu­ity should not be underestimated.

Doesn’t decen­tralised finance encour­age risky speculation?

As finance does in gen­er­al, I would say! That being said, there is a spec­u­la­tive fren­zy around cryp­to-cur­ren­cies. If we look fur­ther ahead, we can hope that this spec­u­la­tion will fall back to make way for sol­id mar­kets based on blockchain tech­nol­o­gy, with an inter­me­di­a­tion cost lim­it­ed to the remu­ner­a­tion of the net­work infrastructure. 

What is the risk of a cryp­tocur­ren­cy mar­ket reversal?

It should not be over­looked. In a con­text of high val­u­a­tion of finan­cial assets, we can indeed fear a vio­lent rever­sal of the cryp­to-cur­ren­cy mar­ket. What’s more, there are doubts about the resilience of sta­ble­coins3 to such a sce­nario. It is easy to imag­ine a bank­ing pan­ic sim­i­lar to the one suf­fered by mon­ey mar­ket funds dur­ing the 2008 cri­sis; except this time cen­tral banks will prob­a­bly refuse to save sta­ble­coins by exer­cis­ing their pow­er of lender of last resort. Hence, it is becom­ing urgent to build tools to antic­i­pate sys­temic risks in DeFi, a task we are active­ly work­ing on in our research chair.

Can the high ener­gy con­sump­tion of blockchain slow down – if not pre­vent – its development?

As we face the accel­er­a­tion of glob­al warm­ing, we can­not imag­ine DeFi rely­ing on Bitcoin’s proof of work and its exces­sive car­bon foot­print – which cur­rent­ly accounts for 0.3%-0.5% of the world’s elec­tric­i­ty con­sump­tion [LIEN VERS ARTICLE DE JEAN-PAUL DELAHAYE]. The future will prob­a­bly be found in proof-of-stake, which uses much less ener­gy. In proof-of-work, the min­ers in charge of updat­ing the blockchain must solve an ener­gy-inten­sive cryp­to­graph­ic prob­lem. Where­as proof-of-stake, instead of select­ing min­ers based on their amount of work, the pro­to­col uses the amount of cryp­to-cur­ren­cy they hold. The idea is that min­ers who hold cryp­to-cur­ren­cies native to the Blockchain also have an inter­est in it work­ing properly.

Proof of stake has already been test­ed, in par­tic­u­lar by Tezos, a blockchain co-found­ed by a poly­tech­ni­cian, Arthur Bre­it­man, and whose research cen­ter Nomadic Labs is one of the spon­sors of our chair. We are con­duct­ing work to for­mal­ly estab­lish and, as far as pos­si­ble, improve the robust­ness of the proof of stake.

Interview by Clément Boulle
1https://​info​.uniswap​.org/#/
2https://​defipulse​.com/
3Un sta­ble­coin est une cryp­to-mon­naie qui réplique la valeur faciale d’une mon­naie fidu­ci­aire, comme le dol­lar ou l’euro.

Contributors

Julien Prat

Julien Prat

Researcher at CNRS, CREST and École Polytechnique (IP Paris)

Julien Prat is Head of the academic chair “Blockchains and platforms”. His research covers information economics, contract theory and labour economics. His current projects focus on the optimal design and financial implications of decentralised systems.