Decentralized Finance (DeFi) and Financial Services Disintermediation: Policy Challenges

Decentralized Finance (DeFi) and Financial Services Disintermediation: Policy Challenges

INSIGHTi
Decentralized Finance (DeFi) and Financial
Services Disintermediation: Policy Challenges
July 28, 2021
Decentralized finance (DeFi) is one of the fastest-growing areas within the digital asset industry. Total
value locked (TVL), a common measure of market size for DeFi referring to the value of the digital assets
committed for transactions in DeFi systems, reportedly reached $89 bil ion in May 2021, up from around
$1 bil ion a year before (although that amount has since dropped to about $66 bil ion as of July 26, 2021).
DeFi does not yet have a standardized definition, but the term general y refers to the use of digital assets
and blockchain technology to replicate and replace conventional delivery of financial services—such as
loans, asset trading, insurance, and other services—through central financial intermediaries such as
brokerages, exchanges, or banks. Characterized as financial disintermediation, or “cutting out the
traditional middleman,” DeFi aims to offer financial services through a direct peer-to-peer system that
uses digital assets and “smart contracts,” which are computer programs that automatical y execute
transactions via predetermined protocols. DeFi proponents believe that financial disintermediation could
save transaction costs and revolutionize the operations of the industry; skeptics doubt it wil significantly
displace traditional intermediaries because of scalability and other concerns. In addition, others worry
about the potential harm to investors and market integrity and possible disruptions to the existing
financial system. They argue that the rise of DeFi may require a substantial regulatory revamp to keep up
with the industry should it continue to grow at the current pace.
How Does DeFi Work?
DeFi applications are often built on blockchain-based networks, such as Ethereum. Participants holding
digital assets (e.g., Bitcoin, Ether, and others) typical y send the digital assets to a smart contract address
(some of which are known as liquidity pools, where the assets of many holders are gathered together).
The smart contracts “lock” the assets until the execution of a transaction, such as the lending of the digital
assets to a borrower. As such, TVL is a common measure of DeFi’s market size.
For example, Uniswap, one of the largest DeFi platforms, is a decentralized crypto-asset exchange that
runs on two smart contracts that automatical y execute transactions—one adds new digital assets, and the
other facilitates trades. Uniswap’s trading transactions rely on liquidity pools and automated market-
maker smart-contract protocols that execute trades against the committed assets in the liquidity pool.
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Another important operational aspect is DeFi’s governance structure. The DeFi platforms aspire to
decentralize decisionmaking and control. They often manage changes to smart contracts or other
blockchain protocols using tokens that al ocate voting rights to stakeholders. That practice is not uniform.
Sometimes the developers maintain more control regarding altering the transaction terms, upgrading the
system, and ending the contract, among other actions. Other times, the developers could be unable to
pause the contracts, such as with Uniswap.
What Does Financial Disintermediation Mean?
At a fundamental level, financial intermediaries move money between (i) investors (or savers) and (i )
businesses (or individuals) who need money from loans and investments. Disintermediation means
removing the “middleman” and their related services and connecting (i) investors and savers directly to
(i ) the businesses and individuals seeking funding. The services that financial intermediaries general y
provide can include pooling savings, safekeeping and accounting, providing liquidity, risk-sharing,
information services, underwriting, acting as counterparties, and serving as market-makers, among others.
The disintermediation process could mean that such services would no longer need to exist, or different
methods would replace them in offering similar services. Table 1 il ustrates the differences between the
traditional financial system and DeFi.
Table 1. Comparing Traditional Finance to DeFi

Source: Wharton Blockchain and Digital Asset Project.
DeFi industry practitioners view financial intermediation as unnecessary. They believe the new DeFi
applications can speed up financial operations and expand financial inclusion. Some believe that
traditional financial intermediation contributes to slow settlement cycles and limitations on market access.
They also attribute certain problems of market concentration, inequality, and financial instability to
intermediaries.

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However, some market observers believe that the consequences of DeFi-related disintermediation could
include the absence of entities to “monitor markets for fraud and manipulation, prevent money
laundering, safeguard deposited funds, ensure counterparty performance, or make customers whole when
processes fail.”
DeFi and the Financial Regulatory Framework
The emergence of DeFi chal enges the fundamental thinking of financial regulation in two ways:
1. Access points for financial regulation traditional y focus on intermediaries. Part of the
existing regulatory infrastructure emphasizes the oversight of intermediaries (e.g.,
investment funds, securities exchanges, and banks), which aggregate and channel
industry activities. Without these centralized access points, traditional financial
regulatory infrastructure could be difficult to apply. In addition, even when certain
operators are identified, they may not be able to change or terminate the smart contract
protocols that dictate the terms of transactions, chal enging the precise targeting of
financial regulation.
2. Potential regulatory arbitrage between more-regulated and less-regulated markets.
According to one federal regulator, DeFi-related competition between more-regulated
and less-regulated entities in the same market “can result in the regulated entities
assuming either more risks in order to generate the higher yields necessary to compete
with the unregulated competition, or seeking less regulation for themselves to level the
playing field. Either of these reactions can introduce significant risks into the financial
system.”
The DeFi industry is stil in its early stages. On one hand, some argue that a slower regulatory response
could al ow the industry more time to mature and demonstrate its full potential. Any fast rollout of a new
regulatory framework could risk becoming obsolete if the target is rapidly evolving. On the other hand,
the need to protect investors and market participants does exist. The longer the regulators wait, the harder
it may be to intervene and address potential market manipulation, fraud, and other concerns. Some
observers believe that DeFi’s reliance on blockchain technology and the fact that the underlying
infrastructure is un-owned introduce a new array of risks that may cal for regulatory attention. These
issues are particularly chal enging, because related policy decisions could shape the directions of a
perceived financial services revolution.

Author Information

Eva Su

Analyst in Financial Economics

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