Speaker: David Piesse – Research Board at International Insurance Society
Following the recent $40 billion TerraLuna crypto crash, where a bank that was running on cryptocurrency collapsed the entire blockchain, DeFi risk mitigation has become imperative.
Cryptocurrencies are based on technological change and hence, carry long-term risks. However, the future of finance is expected to improve over time, as the current financial system and the DeFi system converge, and the technology is debugged. It’s still early days, as DeFi is not yet regulated.
DeFi: An Overview
Now, DeFi is best described as a new technical architecture for the next generation of the global financial system. It’s built on decentralized technology, using programmable instruments called smart contracts, which are different from legal contracts. A smart contract is a coded agreement between two parties that eliminates the middleman from the transaction. By removing the middlemen from the traditional financial system, it creates new intermediaries as well as risks in the digital world.
DeFi will enable all financial services to work 24/7 by creating instant settlements and payments, asset tokenization, programmable money, and interoperability while opening an arbitrage. Therefore, regulation is needed to take advantage of the current market where there is currently no central authority.
There is also a great paradox on whether to have a centralized digital currency or decentralized finance. For instance, China only wants a centralized digital currency, whereas America favors a decentralized approach with regularization, and other countries are looking to develop a more hybrid model. But soon, DeFi will get connected and be linked to the institutional finance world.
How will Financial Services change with DeFi?
- Stock Markets and Financial Institutions will be available 24X7
- No central order books
- Immediate settlement instead of days
- Beginning of the end of the SWIFT system in its current form
- Reduction in the cost of global remittances
- Decoupling of the state and networks on currency supply
- Hedges against inflation using tokenomics (i.e., using econometrics based on digitalized tokens rather than econometrics as we know it today)
- Bitcoin becomes reserve and limited edition – similar to gold
Current benefits of DeFi
The existing benefits of DeFi are the same as blockchain. It offers transparency, fraud protection, cyber protection, self-custody, and programmability. It also allows people to link together different blockchains (interoperability), provides audit trails for every transaction, and tracks everything that happened to an asset through its lifetime.
All these blockchain benefits are combined with the same components of the traditional financial system, such as savings, borrowings, banking, insurance, and asset trading. Only, it’s done on a decentralized basis.
Within a decade, most financial services will employ digital tokens as tokenization continues to move at a rapid pace.
Smart contracts are a combination of the law and regulation with code. And there is a major convergence between digitized smart contracts in DeFi and parametric insurance because smart contracts function like parametric triggers. For example, an earthquake epicenter or Richter scale acts as a trigger and is used to pay an insurance claim. Similarly, in DeFi, that trigger is used to pay to make claim settlements, except that it’s automatic. There’s no human involvement.
Smart contracts use the underlying blockchain’s computational power. They’re triggered by an event on the blockchain (real-time) or an Oracle, which is a piece of data coming from outside, like inflation, exchange rate, etc. As a result, cyber security is critical when having an outside trigger.
Value is created on a smart contract by collecting, lending, borrowing, trading, and paying out money. So, a good smart contract should have natural language and arbitration. While regular audits and debugging must be done to mitigate risks.
- Interactions with the traditional finance system
- Operational risks from underlying blockchains
- Smart contract-based vulnerabilities
- Governance and regulatory risks
- Scalability challenges
- Custodial risks – lost/ stolen keys
Fortunately, we can ride insurance on the back of all these things as long as the standards are met and risks are proactively managed. De-pegging insurance is now in place as well, and when the pegging goes on to a stablecoin, there is insurance to cover a spread. Likewise, insurance is evolving after the recent crypto events, and it’s proving beneficial.
Currently, market volatility is the biggest risk when working with the traditional finance system because it’s decoupled and based on market-driven trends. But in the DeFi protocol market, stablecoins are the main source of liquidity, and more attention should be paid to the smart contracts that are stablecoins.
- No central administrators, relying on economic incentives only
- New intermediaries and relying on end users
- Consensus issues – forking
- Cyber risks and hacking – flash loans
- Direct access to trade on protocols needs smart contract auditing
- Gas fees / PoW (Proof-of-Work)/ ESG/ miners fork threat/ private broadcasting
- Smart contract Ponzi schemes
- Inflation bugs – inflated coin supply – rollbacks
Smart Contract risks
- They are essentially code, not legal contracts, and could be rendered unspendable
- Wallets and custodial risks were first to surface
- Bugs in deployed contracts
- Algorithms managing large capital pools with no human oversight
- Fear of withdrawing profits with no recourse
- Frozen tokens when stablecoins and collateral are involved
- Oracle attacks – data provenance – triggers
- Wrongful liquidations and flash loans
- Reserving with liquidity pools
Governance and Regulatory risks
- Administrative keys
- On-chain governance token models – voting power
- Tainted liquidity from blacklisted parties entering the system
- Pseudo-equity and regulatory risk
- 20th-century regulations and 21st-century technology
- Insurance reserving – actuarial issues
- Oversight required – Bug remediation, technical audits
- Economic audit and governance stewardship
- Layer 1 – base protocols like Ethereum, where the settlement happens.
(If the settlement is too slow, Layer 2 is created, which gets hold of more software architecture that speeds up transactions and makes the settlements.)
- Settlements, sidechains, and interoperability
- NFTs – all competing finite pools of blockspace
- High gas fees
- Trapped funds in UTXO
- Sharding – breaking a blockchain into small chunks to make it more efficient
- Smart contract liability at a protocol level and staker level
- Stablecoin de-peg cover
- Leverage parametric smart contracts as risk management
- Monitors assets in real-time – data integrity – AI
- Claims procedures on chain – parametric triggers
- Dynamic financial analysis aligned with regulation compliance
- Reinsurance structures DAOs
- Mutual vs. Peer to Peer
How will DeFi fare in the future?
With the growing focus on ESG, DeFi often turns a green portfolio red because of the power consumed by Bitcoin miners. But there are ongoing shifts in the DeFi world to become greener. For instance, Ethereum PoS reduces power consumption considerably when compared to Bitcoin.
Today, DeFi and components represent the most significant shift in financial services since the ‘big bang’ in the 1970s. Except, they are much larger and more impactful as they rewrite the financial world, not just digitize existing functions. It also involves the future of money because it removes paper money from circulation and changes reserves to tokenomics instead of economics.
While the risks do seem numerous, they are temporary and will be gradually eradicated because they are technology-based and not human-based. Furthermore, blockchain enables truth over trust through cryptography, leading to reduced fraud.
Thus, once DeFi matures, it’ll be a much sounder, safer system than the one it is today.