Decentralized Finance (DeFi) is more than just a crypto buzzword. Despite being around for only a handful of years, it has transformed legacy financial infrastructure as we know it—shifting the power away from central institutions and into the hands of individuals.
DeFi operates in a multi-layered structure, according to Canada’s central bank
What started as a niche interest among crypto enthusiasts has now grown into a multi-billion dollar industry. Even the Bank of Canada finds DeFi hugely appealing.
On October 17, Canada’s central bank published a staff note, highlighting the developments that led to DeFi’s meteoric rise. Additionally, the staff note also throws light on the challenges and risks associated with its use.
According to the Bank of Canada, DeFi comprises multiple layers, with blockchains like Ethereum placed at the bottom, or the “settlement layer.” Crypto assets constructed by developers – such as native tokens (e.g., XRP), stablecoins, and non-fungible tokens (NFTs) form the second or “asset” layer. Meanwhile, financial services offered by blockchains — including lending protocols and asset management — are on the top or “application” layer.
Bank of Canada weighs DeFi’s pros and cons
The staff note was sanguine about certain features of the DeFi technology—especially its “composability,” which enables the apps and services in the ecosystem to interact with each other. According to the Bank of Canada, DeFi can reshape the traditional financial system in the following three areas:
Frictionless financial services offering: Not only does a decentralized ledger-based system automate workflows, that were previously manual and time-consuming, but it also expands the scope of financial services.
Open competition: Owing to its decentralized nature, the door to the DeFi ecosystem is open to anyone who wants access. This, in turn, raises the bar for competition, and the end user gets to choose between a number of products.
Transparency: A majority of DeFi applications are built atop the Ethereum blockchain—and therefore, are required to provide a complete record of all transactions. Furthermore, DeFi has also brought about the rise of decentralized autonomous organizations (DAOs), which run mainly on smart contracts. The decentralized nature of DAOs sets them apart from the traditional hierarchy of a corporation.
DeFi’s trajectory over the last few years
The Canadian central bank noted that DeFi was on top of its game in 2020—having gained immense popularity. In the next few years, it became an indispensable part of the crypto economy, with the total value of crypto assets locked into DeFi contracts skyrocketing. However, the numbers have declined since the catastrophic collapse of Terra, Celsius, and FTX.
Regulatory hurdles stifling innovation in DeFi space, says Bank of Canada
Although the DeFi revolution has profoundly impacted the way businesses operate, the DeFi ecosystem still has several vulnerabilities—such as hacks and exploits. Per the staff note by Canada’s central bank, the DeFi system is grappling with three main challenges: the lack of real-world tokenization, the high density of interconnection within, and its reliance on unregulated centralized finance infrastructure.
“Despite its innovations and possibilities, the overall economic benefits of DeFi remain limited,” the Bank of Canada wrote in its staff note. Moreover, it said regulatory hurdles are smothering innovation in the DeFi space and preventing it from realizing its full potential.
A hotbed for crypto Ponzi schemes
Todayq News reported last month how the rise of DeFi is fuelling a surge in “cross-chain” criminal activities. Several DeFi platforms have been hacked in recent months—including Euler Finance. The rise in crypto Ponzi schemes has prompted regulators worldwide to tighten the noose around the DeFi space.
For instance, French lawmakers are contemplating expanding the purview of existing crypto laws to include DeFi projects. Hong Kong Securities and Futures Commission has also unveiled plans to regulate the DeFi sector.