Assessing and managing risks in Decentralized Finance

By Noah Walters

What is Decentralized Finance?

Decentralized Finance, known as “DeFi” in the crypto space, are types of financial products and services that leverage blockchain technology to replicate their traditional counterparts, making them accessible to almost anyone by eliminating the need to go through traditional financial institutions like banks or brokerages. Generally, the objective shared by DeFi practitioners is to eliminate the need for human discretion from financial contracts, and encode the rules for behavior into highly automated, publicly available systems.¹

DeFi applications that exist today tend to fall into four main categories: (1) decentralized exchanges (DEX), where traders interact through a strictly software-based middleman rather than an institution that facilitates a transaction, (2) lending and borrowing platforms, where central intermediaries are not needed to hold funds, and transactions are completed on a peer-to-peer basis, (3) programmable decentralized derivatives, and (4) automated financial processes.²

Benefits of DeFi according to supporters

DeFi is attractive to consumers because it can facilitate the process of disintermediating financial services, which could allow for open and cheaper access to financial services while reducing risks and delays that stem from traditional intermediaries. DeFi enables the provision of financial services anywhere for anyone, regardless of ethnicity, age, cultural identity, or jurisdictional differences. This “borderlessness” of DeFi can help tear down financial sector silos, greatly promoting innovation, and result in the development of vibrant financial ecosystems accordingly.³ The transparency offered by blockchain technology can also provide for an efficient auditing process to demonstrate solvency and proof of reserves.⁴

Bridging the gap between DeFi and traditional finance

While DeFi aspires to create independent financial services infrastructure on the basis of code rather than legal enforcement, key components of the DeFi system still rely on traditional financial market infrastructure to bridge the gap between fiat and crypto. A critical example of the connection between the decentralized and traditional systems can be found in stablecoins, which are fiat-denominated tokens circulating on public blockchains that purport to be backed by commercial bank dollars held at financial institutions.⁵ These stablecoins are useful for DeFi transactions because they introduce a connection to fiat collateral. However, considering stablecoins often derive their value from underlying dollar instruments, the protocols that rely on stablecoins also depend on the issuer of the underlying instrument and the financial institution where that instrument is held.

Takeaways

Therefore, while DeFi adds distance between the end user and the traditional financial system, someone, somewhere will be accountable to a regulator. Accordingly, stakeholders in the DeFi space should strive to comply with regulatory guidelines, not only to mitigate their own legal risk, but to manage their relationships with counterparts in traditional finance that may consider them a liability and refuse business. As many participants in the cryptocurrency space may already know, legal soundness is often not enough to bridge the gap with traditional financial institutions (FI), often things as simple as opening a bank account boil down to the FIs own risk appetite, which may effectively determine a company’s fate.

That is why it’s so important that you consult counsel with not only a deep understanding of the technologies and both decentralized and traditional financial sectors, but an understanding of the operational risks associated with the launch of DeFi protocols, applications, and associated governance tokens.

For more information on how to reduce risks and exposure to liability please reach out to Noah Walters.

[1] Nic Carter and Linda Jeng, “DeFi Protocol Risks: the Paradox of DeFi” (2021) at SSRN – “DeFi Protocol Risks: the Paradox of DeFi” (plu.mx) [Defi Protocol Risks]

[2] Chen, Yan & Bellavitis, Cristiano. (2020). “Blockchain Disruption and Decentralized Finance: The Rise of Decentralized Business Models.” Journal of Business Venturing Insights 13 (June 2020). 10.1016/j.jbvi.2019.e00151.

[3] Defi Protocol Risks, supra note 1.

[4] Ibid.

[5] It is important to note that not all stablecoin projects are backed with fiat reserves. For more information on this subject please refer to our article on “The Stablecoin Cryptocurrency System” here.