The advantages and challenges of DeFi and DAOs

Blockchain technology is having a growing impact on the financial services sector, both in terms of the use of the technology and the digital assets that blockchains are able to create. Cryptocurrencies, digital assets, CBDC, stablecoins, decentralised finance (DeFi), non-fungible tokens (NFTs) and peer to peer (P2P) transactions are some of the use cases being adopted. And, at the frontline of changing how finance and banking is transacted, is DeFi.

Source: Logo of Defi DAO

DeFi is a blanket term for financial exchanges and systems of ledgers that are not controlled or run in a centralised fashion. The fact that they are decentralised is a strength since they act as disintermediate trades. Through DeFi, participants can:

· loan - without all the hassles of paperwork.
· lend - lend out digital assets and earn yields (similar to earning interest)
· trade - similar to the traditional financial system, digital assets can be bought and sold
· derivatives - users can take positions on certain assets.

However, this makes it a challenge for regulators to regulate - after all, who is responsible in the event of failure? DeFi can also relate to other things, such as protocols that rely on collective consensus and shared databases and can describe, for example, an organisation established as a decentralised autonomous organisation (DAO). These organisations are increasingly being used to minimise risks because they offer (at least in theory) a very transparent form of governance since their rules and operations are usually freely available and then codified. Furthermore, DAOs usually use smart contracts which can then automatically execute trades (depending on certain criteria being met) without the need for human intervention. And in addition to this, DAOs are organisations where stakeholders, such as leaders and participants, act as the governing body thereby removing the need for other intermediaries - so they can be used for resource allocation, decision-making, charity, etc. In essence, DAOs are systems established and run via pre-agreed code that attempt to make decisions through collective action and consensus without the need for an intermediary or a governing body. In a sense they could be seen as having similar characteristics as cooperatives which, themselves, have their roots in Scotland as far back as 1761 -although it was not until 1864 that the Rochdale Equitable Pioneers Society was established by 28 artisans and the first true business co-operative was created. Fundamentally, DAOs and cooperatives are designed to be run by a group of individuals for the benefit of that community and, because there are no third parties taking fees, the profits are, in theory, greater for the members.

Rochdale Equitable Pioneers Society

Source: ICA.coop

The fall of some centralised finance organisations such as Terraforms Labs, Celsius Network, VoyagerDigital, Three Arrows Capital, BlockFi and, in2022, FTX, has rocked confidence in the cryptocurrency ecosystem although, despite this turmoil, most DAOs and DeFi protocols have continued to function. Security of clients assets has become a greater concern and we have seen a growing interest in how securely digital assets are being stored i.e. their custody. There have been calls from organisations such as the FBI which has warned members of the public to steer clear of cryptos. In other jurisdictions, such as Australia and the UK, regulators are finally trying to offer clarity or ( as in the case of the UK) appeal to foreign investors as a place to hold and trade cryptocurrencies. Another concern that DeFi, and to a lesser extent DAOs, have faced are the growing transaction fees since many of the initial decentralised platforms were built on the Ethereum blockchain. The Ethereum transaction fees/gas fees have been expensive and the blockchain itself arguably had poor ESG credentials given that it was based on proof of works. This has now changed and the Ethereum blockchain is now run on a proof of stake, which Ethereum claims uses 99.5% less energy.

Ethereum blockchain was not only the first blockchain to commercially scale smart contracts, core to many DAOs and DeFi protocols, but can offer solutions to help allay users’ privacy of data concerns - such as zero knowledge technology which, according to the publication, Blockworks, “will significantly improve scalability and performance for blockchain networks.”Decentralised exchanges (DEX) are “experiencing serious growth” fuelled by their use of automated market markers (AMM) - another trend to watch out for in 2023. According to DeFi Llama, trading volume across all decentralised exchanges reached$11.93 billion in November 2022, a sharp jump from the $2.92 billion recorded on November 7th. Indeed, Bybit (which is the world’s third most visited exchange) has announced it will integrate a DEX app, furthermore reporting a huge increase in trading from $2.8 billion to over $ 13 billion. However, whilst DeFi and DAOs position themselves as the solution to traditional highly centralised command and control financial institutions, they do still have a number of drawbacks.

The advantages of DeFi:
· permissionless
· immutability
· transparency
· saving applications
· lending and borrowing applications
· not reliant on human intervention - ‘fat finger’ errors

The challenges of DeFi:
· scalability
· liquidity risks
· how to regulate them/who is accountable or responsible in the event of mistakes (not insurmountable as Swarm are the first licensed DeFi platform globally)

The advantages of DAOs:
· accountability
· transparency
· neutrality
· equal stakes
· autonomous structure

The challenges of DAOs:
· vulnerability from smart contract code
· time in reaching consensus
· the concentration of voting power
· how to regulate them

DeFi and DAO adoption in the world is on the rise and centralised exchanges such as FTX have revealed the potential risks users face. In Argentina, crypto enthusiasts are using Defi to navigate the crippling inflation. According to a study, India, China, Vietnam, Thailand and the US saw the most activity in DeFi. Fuelled by its young population, DeFi is revolutionising how finance is done, especially with the arrival of Nimbus in India. Patronage of Defi services and retail investors has also increased since the Supreme Court ruled out the Royal Bank of India ban on crypto transactions. In Thailand, PwC believes that “DeFi is disrupting the landscape of financial services, creating new investment opportunities while attracting app development companies, financial institutions, and commercial banks seeking to leverage its potential.” Globally, DeFi and DAOs can strengthen financial institutions, reduce financial fraud and strengthen monetary policy but they do potentially present regulators with the challenge of requiring a different style of regulation. DAOs and DeFi may seem similar at first glance, but they are both different in their unique ways. DAOs provide a decentralised governance structure for communities to thrive whereas DeFi offers financial freedom and innovation to all. So, whether you are a fan of the classic or prefer something a little more adventurous, both DAOs and DeFi are likely to meet at some point as the community that comes with DAOs will give the decentralisation in DeFi more weight.

WebThis article first appeared in Digital Bytes (15th of February, 2023),
a weekly newsletter by Jonny Fry of Team Blockchain.