European View of DeFi

    16 May 2022

    On May 7, the European Commission (EC), or, more precisely, its division called the Directorate-General for Financial Stability, Financial Services and Capital Markets Union, published a fascinating document called European Financial Stability and Integration Review 2022. Two-thirds of it was dedicated to DeFi, and having examined it, the author of these lines got the impression that the European government finally “discovered” decentralized finance.

    European Financial Stability and Integration Review 2022 reads like a short textbook or guide to DeFi, complete with a concise listing of what about decentralized finance scares Europeans and what hopes it brings.

    At the beginning of the relevant section, the document authors define DeFi as “a newly emerging form of autonomous financial intermediation in a decentralized digital environment powered by software – “smart contracts” on public blockchains”. EC experts acknowledge that DeFi puts smart contracts at the heart of financial services and, in its purest form, performs all transactions on the public blockchain, providing full transparency of the associated data.

     “While still very small compared to the size of the traditional financial sector, DeFi is growing rapidly and increasingly raising questions about its functionalities, opportunities and risks, as well as its relationship to traditional finance and regulation,” the authors write. “The emergence of DeFi can be seen as the next step in the development of crypto asset ecosystems. … [It] is the outcome of further innovation with the use of smart contracts to replicate common functionalities of the traditional financial system in a decentralized setting.”

    Next, the experts explain how smart contracts and the Ethereum network work, how blockchain transactions take place, and what decentralized autonomous organizations (DAOs) are. They point out that the volume of crypto asset transactions in Europe has noticeably grown over the past couple of years, especially in DeFi applications. The leaders are France, the Netherlands and Germany, followed by Spain and Italy.

    The following chapter concerns stablecoins as a means of enabling DeFi. The writers explain that stablecoins, on the one hand, serve as a convenient entry and exit vehicle to the DeFi ecosystem while at the same time allowing holders of volatile crypto assets to retain their market exposure by pledging them as collateral for loans. For those reasons, the rise of DeFi has also fueled an increase in the issuance of stablecoins.

    It also mentions widely used euro-pegged stablecoins: EURS and EURT and sEUR, recognizing that despite the growth, the pool of stablecoins pegged to the euro is negligible compared to those tied to the US dollar. As of December 23, 2021, the EURS circulating supply was €98.8 million, EURT – €103 million and SEUR – €73.8 million.

    The report then goes on to discuss such aspects of DeFi application as global decentralized networks of instant payments; trading and liquidity provisions (here it describes decentralized crypto asset exchanges); crypto asset lending (as the most widely used DeFi feature today); synthetic tokens and derivative financial instruments (derivatives), as well as insurance against risks typical for a decentralized blockchain environment.

    Overall, if you want a brief intro to DeFi, you might as well use the European Commission paper.

    While comparing the potential of DeFi to traditional finance, the report authors conclude that it improves the security, efficiency, transparency, accessibility, openness, and interoperability of financial services. The difficulty with smart contract security, however, is that it depends on the quality of the coding. Smart contract hacks happen regularly, even though the settlement layer itself has never been compromised. DeFi efficiency largely comes from the use of smart contracts and collateral that can reduce counterparty risk. It also stems from its non-custodial nature that makes traditional services such as custody and central clearing redundant. In any case, even though the processing of transactions on a public blockchain is relatively slow, DeFi still offers quicker settlement than traditional securities, the experts say.

    Another point brought up by the paper is that open source DeFi applications encourage innovation by attracting a large developer community that actively contributes to incremental improvements over time. Given the open nature of most DeFi apps regarding copyright protection, anyone can simply copy the existing code and improve it with additional features.

     “Should DeFi ever go mainstream, it could also positively contribute to financial stability, because of its broader risk-sharing characteristics that go together with decentralized governance and liquidity provision. Geographical diversification would constitute an additional risk-sharing element in case DeFi indeed contributes to financial integration,” the EC report indicates.

    A separate section of the document deals with the risks inherent in DeFi. Europeans traditionally fear that DeFi will be used for tax fraud, money laundering and other illicit activities. “The inherent transparency of DeFi applications makes it easy for malicious users to inspect the code on the web and exploit unaddressed bugs to steal user funds148. In case of interconnected DeFi applications, exploiters can also cause them to behave in ways not intended by developers of the individual DeFi applications149. Furthermore, the existence of “admin keys” may pose a vulnerability in case those with access have malicious intentions,” the experts warn.

    The last part is devoted to regulatory challenges in a decentralized environment, and it seems to be the weakest one. The report just says that as the decentralized finance ecosystem continues to grow, it needs to be closely monitored. To do this, regulators must be well informed and ready to consider any necessary intervention. But the authors don’t make clear what type of regulatory action would be the most justified and effective in a decentralized setting.

    In their conclusion, the European government specialists remark that DeFi is often opposed to the traditional financial system, which relies on centralized intermediaries that control access to financial services. But in doing so, DeFi applications replicate or even mimic existing features of conventional finance.

    “More generally, the coexistence of traditional finance and decentralized finance as differently organized financial ecosystems could promote broader financial system diversity that may be good from a risk perspective at system-wide level. As regards broader economic welfare considerations, an open question is whether the DeFi ecosystem could substitute or complement (parts of) the traditional financial system. Although DeFi seems to replicate many of the functionalities of the traditional financial system, its contribution to the financing of real economic activity is so far minimal, if not fully absent. Thus, there is currently a question mark over its usefulness for the real economy, investments and job creation, also in light of the widespread need for collateral. However, the DeFi ecosystem is at a very early stage in its development, and there is no reason to assume at this point that such a link to the real economy may not develop in the future,” the European Commission summarizes.

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