DeFi recalls the risks of unbridled financial engineering

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The writer is the author of ‘The future of money: How the digital revolution is transforming currencies and finance ”

Decentralized finance, or DeFi, is the next frontier in finance. New forms of financial intermediation are using blockchain technology to open up access to finance and bypass inefficient and cumbersome traditional institutions like commercial banks. DeFi even helps bypass government oversight and regulation. In China, for example, a nationwide ban on investing in cryptocurrency is pushing traders towards DeFi.

While there is no doubt that technology is opening exciting opportunities, this kind of unbridled financial engineering also opens the door to new risks.

At first glance, DeFi may seem like a more secure way to transact. The system is characterized through transparent digital registers kept on multiple computers, so there is no centralized point of failure. Its governance is also decentralized: control belongs to the members of a network rather than to a central authority. Trust is achieved through public consensus: community members must themselves agree on the validity of transactions, rather than relying on third parties.

In principle, these features make DeFi invulnerable to hacks of particular computer nodes or to embezzlement by individuals or institutions. DeFi also allows “composability without authorization”. This means that a developer can easily connect multiple DeFi applications based on open source technology to create new financial products and services, without having to apply for permissions.

Several innovative DeFi products are already available. Flash loans, for example, allow you to borrow without collateral, use that money for a transaction, and then return the borrowed amount, all for a small fee. A flash loan is initiated, executed and completed in the blink of an eye, using a simple computer code. They have many uses, ranging from helping arbitrage price differences between markets, to increasing market efficiency. As they are instantaneous, the risks of default and liquidity are reduced.

Then there are smart contracts, which allow financial and other assets to be traded using computer code without a lawyer or escrow agent involved. Computer tools can do rigorous work economic risk assessments smart contracts and specific DeFi products. The open source nature of applications allows security and other weaknesses to be discovered and eliminated.

Always, sophisticated hackers were able to take advantage of vulnerabilities in DeFi products. Malware can exploit the larger “attack surface” created when combining multiple applications. They are also more vulnerable to software bugs and users who do not fully understand the risks.

The absence of a central authority responsible for controlling bad behavior also carries risks. Researchers from Cornell University discovered that automated bots could handle certain transactions upstream, for example, by executing open orders at an unfavorable price before they could be canceled when prices change. With no one to report this flaw to, the researchers published a blog post detailing the risk, assuming the community would protect themselves. Instead, a cottage industry of robots emerged to exploit the idea before the loophole could be closed.

It should be remembered that while DeFi may rely on libertarian ideals such as its own rule of law, with the community creating and enforcing rules in the general interest of stakeholders, in reality, nascent blockchain systems are vulnerable. the capture of governance by small groups of stakeholders, who could bend the rules in their favor.

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Additionally, although blockchains are stand-alone, they still need information about prices and asset ownership to execute certain transactions. For example, chain pork futures contracts must have access to pork prices from commodity exchanges. Computer programs called oracles get this information off-chain and pass the on-chain information to the real world. These oracles are vulnerable to technical risks, including hacks and even issues with external data providers.

Given all of this, regulators are in a dilemma – even the open-minded ones who see DeFi’s potential but worry about the risks to financial stability. They can now only intervene at the point of intersection of these products with the institutions they supervise. As decentralized finance increases in size and scope, regulators will need to pay attention to the risks that accumulate in these markets and their spillover effects into traditional financial markets.

Updated regulatory frameworks that encompass DeFi will ultimately be needed, although they should strike a reasonable balance in the innovation-risk trade-off. At a minimum, naive retail investors swept away by the technological crash must be protected against excessive risk-taking.

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