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Finance

Monopoly free and open to critique: with decentralized finance, this could be the future of our financial system

Published 9 April 2021 in Finance

Aave is a liquidity protocol that connects people who want to earn a yield on their digital assets with those who want to borrow these assets and pay that yield. How do you think decentralized finance (DeFi) will impact the financial system as we know it?

DeFi expands the application of cryptocurrencies and enables complex financial activities such as market making, synthetic assets, hedging, lending and trading derivatives. Bitcoin, as a simple bearer asset, can’t do that; by design its functionality is limited. You could say that DeFi delivers the promise of “the Internet of Value” that Bitcoin promised.

DeFi is a technologically and economically decentralized system. From the technology point of view, the system is not centrally located on servers. It is non-custodial, which means that users own private keys to access their assets directly. The custody is not handed over to a third-party. The systems are run on a public blockchain, not on a set of servers nor on a “cloud” controlled by a company.

From the economic point of view, the power and control over decision making is distributed across a large number of participants and over time this influence over decision making becomes wider and less and less concentrated. This is known as decentralized governance.
DeFi can make the global financial system much fairer. In traditional systems, monopolists may control the technology and intellectual property, create regulatory or other anti-competitive moats around the business and thus gain the power to lock everyone else out and charge economic rents in excess of their economic contribution.

In DeFi, power is distributed, systems are open source, technology and data are transparent and innovation is continuous and open, meaning no rent-seeking monopoly can exist.

This transparency aspect is essential in DeFi. In the traditional financial system, credit scoring, decision-making and resource allocation are opaque. This creates the potential for consumer harm, as seen in the case of the UK PPI debacle, the German Wirecard disaster and the recent failure of Archegos that used the same collateral for multiple total return swap contracts.

In the radically open and transparent system we call DeFi, anything can be challenged, such as opaque, unfair or buggy products.

Aave dealt with a few billion dollars in flash loans last year. What are some of the attractions?

DeFi allows for inefficiencies in the financial system to be detected and eliminated almost instantly. One way of doing so is by flash loans, which Aave created to allow market participants to eliminate inefficiencies without acquiring a lot of capital for a long period of time.

A flash loan allows anyone to borrow an unlimited amount of liquidity from the protocol for the duration of one Ethereum block and Ethereum protocol guarantees that the loan will be returned – plus interest – in the next block.

You can’t default on a flash loan. Since the term of the loan is so short, and you can’t default, you can get very creative eliminating market inefficiencies.

There are often certain bugs or issues in newly released protocols that haven’t been properly tested. Many people want to earn high yields on protocols that offer incentives and so they rush in with liquidity. If there is a bug in the code, the flash loans can be used to expose them by exploiting arbitrage opportunities. There is no limit to developers’ imagination about what they can do here.

Aave has a staking mechanism. Tell us how that works.

In a proof-of-stake protocol, staking allows participants to post a bond and thus become eligible to propose the next block in the blockchain. If the staker breaks the rules of the protocol, the bond they posted can be slashed and, if they behave correctly, they earn a reward.

Stakers secure proof of stake blockchain. In Aave’s case, stakers secure the protocol in a slightly different way. Aave tokenholders protect the protocol from insolvency i.e. the risk of having insufficient collateral if the market moves are too adverse, say.

To avoid such a scenario, stakers provide insurance equivalent to a third of the total staked value. So, for USD1.5 billion staked approximately 500 million would be the copay, meaning the amount that can be sold off to recapitalize the protocol. For staking, Aave token stakers receive additional Aave.

How could government regulation and censorship impact DeFi?

Technically it is possible for the government to control the distributed finance ecosystem. However, DeFi’s aim is not to allow unregistered money transfers and avoid governments – quite the opposite; the goal is to have an open, transparent system for consumers that is more inclusive and less risky overall. Regulation has proven to be a massive catalyst for the crypto- and digital-asset industry and will become so for DeFi as well.

Aave is an Open Source and Non-Custodial liquidity protocol. Ajit Tripathi is an IMD MBA 2010 alumnus. This interview was carried out by IMD MBA alumni.

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