The latest report on decentralized finance is bullish about its probable.
The Federal Reserve Bank of St. Louis is keeping a closer look at Ethereum-based decentralized finance (DeFi).
A February 5 report named “Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets” came with warnings about smart contract security, scalability, and some risk factors, but it is otherwise bullish about the innovation.
“DeFi offers exciting opportunities and has the potential to create a truly open, transparent, and immutable financial infrastructure,”
Fabian Schär, a University of Basel professor who specializes in distributed ledger technologies such as blockchain
DeFi refers to financial services offered without a traditional financial middleman like a bank or lender. DeFi apps, for instance, enable their users to borrow, lend, or trade digital assets on a peer-to-peer basis. Ethereum is a blockchain where most decentralized finance applications are built.
DeFi took off in a big way in 2020. By the beginning of last year, there was less than $1 billion of value locked into DeFi protocols and platforms. As of now, there is over $38 billion according to DeFi Pulse. The growth was triggered by major events, like the airdrop of the UNI governance token to users of the decentralized exchange Uniswap.
Writing for the St. Louis Fed, Schar noted four ways where the DeFi ecosystem may benefit financial infrastructure: accessibility, composability, efficiency, and transparency.
In terms of accessibility, Schär believes that DeFi can level the playing field for access to financial services given that “the infrastructure requirements are relatively low and the risk of discrimination is almost inexistent due to the lack of identities.”
Next, the technology permits the quick transfer of tokens with smart contracts, a game-changer for efficiency, when most bank transfers take days to settle.
Third, as an economist, Schar is captivated by the statistical transparency of the platforms. He highlighted, “The availability of historical (and current) data is a vast improvement over traditional financial systems, where much of the information is scattered across a large number of proprietary databases or not available at all.” It can help cut off potential financial disasters before they occur.
Last, he found that composability “allows for an ever-expanding range of possibilities and unprecedented interest in open financial engineering.”
However, the last opportunity is also a risk. He wrote that composability also leads to increased dependencies. As more products interact and integrate, they become progressively exposed to other products’ vulnerabilities.
For example, when someone locks ETH into MakerDAO to receive Dai stablecoins, then lends those assets out on another platform, where they were put into a liquidity pool that will allow another token to be withdrawn, things start to get murky.
“These ‘token on top of a token on top of a token’ scenarios, which create wrapper tokens, can entangle projects in such a way that theoretical transparency does not correspond to actual transparency,” he stated.
There is also the issue of operational security, with many “decentralized” projects providing admin keys to the creators. These keys are not always securely stored; even if they are, they can be used to siphon funds out of a project. That was the concern back in August 2020 when liquidity protocol Ren revealed that $100 million in assets were held in a single wallet – although the team maintained that the private key details remained hidden.
Also, the smart contracts, although an innovation, are themselves security risks. “If there are coding errors, these errors may potentially create vulnerabilities that allow an attacker to drain the smart contract’s funds, cause chaos, or render the protocol unusable,” Schar claimed, without even citing any of the dozens of smart contract vulnerabilities that had been exploited in the previous year.
A November 2020 report from CipherTrace found that hackers were causing $10 million in DeFi protocol losses each month thanks to smart contract exploits. For instance, Harvest Finance said goodbye to $34 million in a flash loan attack. That is a type of attack that allows users to borrow money, drive down an asset price, grab an asset for less than normal, and then pay back the loan in an instantaneous series of convoluted transactions.
In total, these are problems to be addressed, not insurmountable barriers. “If these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure,” stated Schar.
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