Bank of America analysts question whether DeFi could potentially be more disruptive than bitcoin in a report.
They said DeFi could be a radical challenge to modern finance, but it still has a long way to go.
The analysts break down the five issues that are keeping DeFi from domination.
Decentralized finance (DeFi) is a radical challenge to modern finance, Bank of America analysts say in a new research report released on March 17.
"DeFi is, we think, the most fundamental challenge to modern finance that we've encountered," Bank of America analyst Francisco Blanch wrote.
This analysis is part of a wider report looking at bitcoin, its portfolio position and its challenges. The team found that the main reason to invest in bitcoin was for price appreciation. But they also highlighted the worrying energy implications of cryptocurrency mining.
The outlook for decentralized finance was more positive with analysts questioning if it could be more disruptive than bitcoin.
What is Decentralized Finance (DeFi)?
Decentralized finance seeks to replace a range of centralized and regulated banking institutions with decentralized systems and products, which are typically built on the Ethereum blockchain.
Modern finance currently works on the basis that there are trusted entities acting as central points for providing services and functions, Blanch said. In turn, these entities are then regulated to provide consumer protection,
Decentralized finance aims to remove the middleman and leverage blockchain technology to enable complex financial use cases directly between parties.
Many DeFi applications are being built on Ethereum, which was developed by Vitalik Buterin in 2013.
"Ethereum basically allows you to program anything, but usually its most talked-about feature is 'smart contracts', which can solve a wide range of issues," Blanch said.
Ethereum is similar to bitcoin in that it is validated with a proof-of-work algorithm. There is currently an ambitious project to upgrade to Ethereum 2.0, which will instead leverage a proof-of-stake algorithm, making Ethereum more environmentally friendly and improving its performance.
The DeFi boom
Decentralized finance boomed in 2020, alongside bitcoin's 300% surge in price.
In assessing DeFi's usage, one of the measurements is "value locked". This represents the quantity of ether, the native Ethereum cryptocurrency, and other coins posted with the smart contracts that make up a particular service.
The analysts "crudely" compare value locked to assets under custody for a custodian.
Value locked has grown rapidly in 2020.
DeFi use cases
One of the most well known use cases for Ethereum is smart contracts, which underpin most decentralized finance products. Developers are able to program a self-executing smart contract on the Ethereum network that outlines the conditions under which an asset, or money, can move.
The contract is completely transparent to both parties and the self-executing component means it does not need an intermediary party.
In the report, the analysts had strong views on smart contracts. They said they are not "smart" because they only follow orders and have no legal status, unless both parties agree to be bound to the outcome of the contract.
"In our view, smart contracts are neither smart, nor contracts," Blanch said. "They are, typically 'if…then' statements, a staple of computer programming."
Assets can be represented as digital tokens. The asset could be the US dollar, or something non-monetary, like a piece of art, real estate or music.
The analysts highlight that once an asset is tokenized, it can move easily around the Ethereum network and change hands.
However, to enable broad-base use of smart contracts that represent assets, there needs to be a way to settle in US dollars, Blanch said.
One way to do this is through stable coins, digital currencies backed to the fiat currency, such as the US dollar. However, many stable coins have their assets verified by external entities, which makes the process more centralized.
The DeFi community currently has a stable coin Dai trying to resolve the issue. Dai is decentralized, crypto-collateralized stablecoin that aims to maintain a stable value relative to the US dollar.
One of the most exciting opportunities in decentralized finance is the ability to combine many traditional exchange functions into one.
"DVP takes place via a so-called "atomic swap", with ownership of two different assets occurring at the same time," Blanch said. "Transaction and settlement are the same thing. Given that custody also occurs on chain, at least three functions of a traditional exchange are merged into one."
The same could be done with traditional assets, if investors were to tokenize conventional equity, Blanch said.
There is exploration into lending where investors pay, or receive, interest for lending, or borrowing cryptocurrency, derivative contracts and asset management opportunities.
Five issues facing DeFi
The analysts conclude there is a significant amount of innovation in the decentralized finance space. However, at the moment, there isn't a material challenge to mainstream finance.
"We believe that one of the best defenses against being disintermediated by DeFi would be mainstream finance grasping these opportunities," Blanch said.
Here are the 5 reasons the analysts don't believe DeFi can present a material challenge yet.
1. Size and scalability
Decentralized products represent around $35 billion right now. The analysts note this is minuscule in comparison to mainstream finance and the space could face challenges as it continues to grow.
"Nobody reasonably could claim that DeFi has at present been fully stress-tested," Blanch said. "How hack-proof would DeFi be if the numbers involved were larger? We simply don't know."
The analysts question how Ethereum technology could cope with higher usage and flows.
"Ethereum may be more scalable than Bitcoin, but it, too, faces constraints in terms of speed, block size, the price of ether and so on," Blanch said. "Solutions to scalability typically involve moving activity off chain, with the chain being used for settlement finality. This tends to undermine some of the core characteristics of DeFi, including transparency, decentralization and the lack of dependencies on third-party entities."
2. Credit creation
Credit creation is a key motor of modern finance, Blanch said. But decentralized finance is currently unable to do this.
"The various loan products there are typically are simply reworkings of the traditional margin loan concept, except that rather than turning an asset into cash, they turn one kind of coin into another, whilst locking up more of the first coin," Blanch said.
3. Smart contracts
The main argument for smart contracts is they are transparent. The analysts take issue with this.
"Confronted with a piece of DeFi code, we would have no confidence at all in our ability to predict that it would do," Blanch said. "A system which requires its users to be PhD-level programmers is not going to find widespread adoption, we'd assume."
Experts make mistakes in coding, even with oversight and reviews from their peers. The analysts question how this can be resolved. In the traditional finance world, if there is a glitch a consumer can complain to a legal entity, or regulator. In this scenario, it's on the consumer.
4. Mining concentration
Mining has become a commercial enterprise.
Bitcoin was originally envisioned as having validation distributed among thousands of computers. Now, the four largest mining pools typically account for around a half the total hashpower.
This means several unregulated entities may materially influence the system, Blanch said.
Ethereum is moving to a proof-of-stake system. However, the analysts believe this will still end up with an oligopolistic collection of entities having large influence over how the system works.
"We have not seen that many people worrying about this, but it worries us," Blanch said.
5. Exchange speed
The analysts said a distributed ledger could be a sensible custody solution and that a distributed ledger central bank rail would make settlement much more straightforward than it is at present.
But, they also note there are benefits to centralized and regulated exchanges, highlighting that distributed ledgers are to slow to trade mainstream assets.
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