05 April 2023

Breugel's Demertzis, Martins: Decentralised finance: good technology, bad finance

• The emergence of cryptocurrencies/crypto assets has allowed the provision of a new form of financial services, including payments and loans, known as decentralised finance (DeFi). Crypto assets currently represent only about 1 percent of total global financial assets and it is unlikely, in its current form, that DeFi will become a substitute for the traditional financial system, for three reasons.
• First, while decentralisation is very innovative, in practice the technology required to replace the role of intermediary is slow and costly in terms of energy use. This has led some crypto networks to adopt more centralised solutions to the problem of verification.
• Second, the automaticity behind the transactions does not allow for any legal recourse. If something goes wrong, there is no way to stop or reverse a transaction once it has been initiated. It is very difficult to imagine DeFi scaling up without the ability to challenge outcomes.
• Third, and perhaps most importantly, DeFi is for the most part self-referential. Crypto assets are exchanged for other crypto assets without being employed in activities that stimulate economic growth by creating jobs or facilitating investment. It is not likely for DeFi to grow enough to replace traditional finance unless it helps growth.
• Nevertheless, the technology that enables DeFi and crypto assets, distributed ledger technology (DLT), is very innovative and has managed to remove the intermediary without compromising the safety and finality of financial transactions. Hence, it is likely that the technology behind crypto assets and DeFi will feed into the mainstream and offer efficiency gains.

1. Introduction

The main objectives of the traditional financial system in its entirety (banks, other financial institutions and investors) are to support efficient capital allocation decisions and to finance productive activity: activity, in the sense that it finances growth through job creation and investment; productive, in the sense that the activity financed is profitable and therefore sustainable.

The emergence of cryptocurrencies has introduced an important innovation into the financial system, which, traditionally, has acted as an intermediary connecting investors, seeking returns on their savings, and borrowers, who seek funding for their projects. Cryptocurrencies enable the removal of intermediaries without compromising the safety and finality of financial transactions. This marks a revolution in how transactions are settled between any two parties. As cryptocurrencies have become more popular and established, crypto financial services, like lending, have also emerged. Given the increasing importance of digitalisation, it is fair to ask whether these digital decentralised services will become established and normalised. Answering that question requires an examination of whether and how the crypto world contributes to the main objectives of the financial system: reducing search costs and financing growth.

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