While blockchain-based decentralized finance technology has a lot to offer institutional investors, taking full advantage of these tools will require significant technological and regulatory hurdles to be overcome, says Andreas Park, professor of finance at the Rotman School of Management.
“There’s lots of cool things you can do in the DeFi space. There’re genuinely new financial products that are pretty clever. There are also new risks.”
The basic goal of DeFi is to provide financial services that work without restrictions at extremely low costs. On top of simple services, like money transfers and trading, other specialized tools have been developed, most of which rely on Ethereum, a cryptocurrency platform.
“The basic idea of blockchain is that it’s a common, open infrastructure for value or resource transfers,” says Park. “It’s a little bit like a database, but also more than one. It’s programmable — you can store and create assets as financial contracts or simple tokens using the technology. It can be used in any manner you want — you can trade assets, transfer them or put them in an escrow account. You can design new forms of ownership or enable ownership for things that couldn’t be owned before, which, in many ways, is a critical prerequisite for the digital economy.”
Park, who serves as the research director at Finhub, the Rotman School’s financial innovation laboratory, says DeFi technology is already being used to cut down the infrastructure required by the financial sector. A prime example of this can be seen in decentralized trading.
“In centralized finance, if you want to sell a share of ABX, you have to speak with your broker. Then, the broker has to assemble an order and send it to a trading venue. Then, you need to find someone interested in buying what you are selling. The exchange then processes the trade and sends it off to the clearing house, which settles things with the custodial banks, etc. It’s a big process. . . . There are several infrastructures, some decades old, that are jerry-rigged together.”
Beyond just simplifying the infrastructure required to trade assets, DeFi technology can also be used to perform tasks that aren’t possible using existing centralized financial infrastructure. One example of this can be seen in flash loans, which allow for apparently risk-free arbitrage. “Risk-free arbitrage isn’t possible in the normal world,” says Park. “With flash loans, you can take advantage of credit opportunities.”
For all the opportunities available through DeFi technologies, risks still exist. Once published, a blockchain-based contract can’t be altered by its creator. A simple coding error could have devastating results and there are several examples where tens of millions were lost. Human errors can make the DeFi world dangerous in other ways as well.
“Assets are stored under a wallet address, [which is] like an account,” says Park. “You control them with a private key, similar to a password. If you lose this private key or if it gets stolen, that’s it. If it gets stolen, that’s it. Your assets are, potentially, gone. People can even hack your browser and get it from you. There are technologies to prevent that from happening, but those aren’t really customer-friendly.”
For savvy individual investors this risk may be mitigated. For institutional investors, however, an individual person having access to the wallet account adds an extra level of concern. “That can be a major headache for fund managers,” says Park. “At an office, only one person can have access to a security key — and that person becomes a risk. There have been discussions about allowing banks to serve as custody managers.”
Giving banks a role to play in the use of DeFi technology would also require the development of new regulations. Park is concerned that regulators will attempt to mimic the approach taken in regulating traditional financial organizations.
“I’m not 100 per cent comfortable with the conversations about regulating the DeFi space. I worry there’s a lack of understanding. . . . Suppose you apply securities laws to a digital token attached to a piece of code: it isn’t clear who would be held accountable. There’s often no corporate structure that underlies it.
“Policy-makers would like to translate the current world that was developed in the 20th century into this experimental world which is trying to reinvent the finance. But there’s value in this experimental world — it isn’t clear that we want to curtail it [at this point]. We don’t want to miss the opportunity to create something that works better.”