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