Finance: no more middlemen?

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. 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