As decentralized finance continues its triumphant march—although the road is sometimes bumpy—some important questions remain about its nature. How to protect DeFi applications from crashing under extreme loads? Is it really decentralized if some people have a lot more governance tokens than others? Does an anonymous culture compromise its transparency?

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A recent report from the EU Blockchain Observatory and Forum clarifies to these and many other questions related to DeFi. It consists of eight sections and covers a range of topics from the fundamental definition of DeFi to its technical, financial and procedural risks. The report, prepared by an international team of researchers, draws some important conclusions that we hope will reach the eyes and ears of lawmakers.

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The researchers highlight the potential of DeFi to improve the security, efficiency, transparency, accessibility, openness, and interoperability of financial services over the traditional financial system, and propose a new approach to regulation — one that is based on the activities of individual entities rather than their overall technical status. The report says:

“As with any regulation, measures must be fair, effective, efficient and enforceable. The combination of self-regulation and enforcement of supervisory regulation will gradually lead to a more regulated DeFi 2.0 emerging from the current nascent DeFi 1.0 ecosystem.”

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Cryptooshala spoke with one of the report’s authors, Lambis Dionisopoulos — a researcher at the University of Nicosia and a member of the EU Blockchain Observatory and Forum — to learn more about the most intriguing parts of the document.

Cryptooshala: How should regulators deal with the information asymmetry between professionals and retail users?

Lambis Dionysopoulos: I would say that regulatory intervention is not required for this. Blockchain is a unique technology in terms of the level of transparency and sophistication of the information it can provide to anyone for free. The trade-offs to achieve this level of transparency are often significant, to the point that decentralized blockchains are often criticized as inefficient or redundant. However, this is necessary to provide an alternative to the current financial system, the opacity of which is the root of many evils.

In traditional finance, this opacity is given. The daily saver, philanthropist, or voter cannot know if their funds are properly managed by the bank, if their favorite cause is supported, or knows who sponsored their politics and how much. DeFi lifts the veil on financial magic by encoding every transaction in an immutable ledger accessible to all.

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Today, tools like blockchain explorers allow anyone to track the flow of money in the blockchain economy, get insights into the applications and services they use in the space, and make informed decisions. It is true that those who have the means and advanced knowledge can and do use this system better. However, as the DeFi ecosystem expands, I am optimistic that new tools will emerge that will make more advanced information available to everyone. My optimism is based on two factors: first, it is comparatively easier to create such instruments in DeFi; and secondly, inclusiveness and openness is the spirit of the DeFi space. The role of regulators should be to facilitate this.

CT: The report categorizes DeFi as “radical innovation” while fintech typically “supports innovation.” Could you explain these definitions and the difference between them?

LD: Maintenance or incremental innovations are improvements to existing products or procedures to better serve the same customers, often also to generate higher profits. Fintech is a prime example of this. Significantly, with e-banking, customers can open accounts faster, initiate online transactions, and access electronic statements, reports, and management tools.

Revolut and Venmo make it easy to split an account or get pocket money. All of these amenities are often welcomed and sought after by consumers, as well as companies that can find ways to monetize them. Central to sustaining innovation is the notion of linearity and certainty, meaning modest changes that result in modest improvements in how things are done, as well as added value.

In contrast, radical innovations such as DeFi are non-linear—they are discontinuities that defy conventional wisdom. Radical innovations are based on new technologies—they can create new markets and make new business models possible. For this reason, they also involve a high level of uncertainty, especially in the early stages. The notion that everyone can be their own bank and that openness and composability can transcend walled gardens are examples of how DeFi can be seen as a radical innovation.

CT: Is there any evidence to support the hypothesis that DeFi can help those who are and lack banking? It seems that DeFi is popular primarily among tech-savvy people from developed countries.

LD: The notion that DeFi is popular among banking and tech-savvy people is both true and short-sighted. For traditional financial service providers, the availability of their services to individuals is a cost-effectiveness issue. Simply put, most of the planet is not worth their “investment”. Someone more suspicious might also add that depriving people of access to finance is a good way to keep them in line – a look at those who are unbanked may confirm this horrifying theory.

DeFi has the potential to be different. Its global availability does not depend on the decision of the board of directors – this is how the system is built. Anyone with basic Internet access and a smartphone can access the most advanced financial services. Immutability and censorship resistance are also central to DeFi – no one can stop someone from transacting from a specific area or with an individual. Finally, DeFi is independent of the intent behind sending or receiving information. As long as someone sends or receives valid information, they are first-class citizens in the eyes of the network—regardless of their other social status or other characteristics.

DeFi is popular with tech-savvy banks for two main reasons. First, as an emerging technology, it requires a certain level of technical sophistication and thus attracts users with the luxury of acquiring this knowledge. However, active steps are being taken to reduce entry barriers. Social recovery and advances in UX design are just two such examples.

Secondly, and perhaps most importantly, DeFi can be profitable. In the early stages of wild experimentation, early adopters are rewarded with high earnings, airdrops, and price increases. This has attracted tech-savvy and financial professionals looking to get a higher return on their investment. Market shocks (such as the recent UST/LUNA events) will continue to separate the wheat from the chaff, unsustainably high yields will eventually decline, and those attracted by them (and only them) will look elsewhere for profits.

CT: The report highlights the problematic aspects of the pseudonymous DeFi culture. What possible trade-offs between DeFi core principles and user security do you see in the future?

LD: DeFi is not entirely homogeneous, meaning that it can provide different services with different sets of trade-offs for different people. Just as blockchains must compromise security or decentralization in order to increase their efficiency, DeFi applications can choose between decentralization and efficiency or privacy and compliance to meet different needs.

We are already seeing some interoperable DeFi attempts, both in stored stablecoins, central bank programmable digital currencies, blockchain-based securities settlement and more, collectively also referred to as CeDeFi (centralized decentralized finance). The compromise is clearly included in the name. Products with various trade-offs will continue to exist to meet consumer needs. However, I hope this interview will make an argument for decentralization and security, even if it means breaking conventions.

CT: The report states that DeFi has had minimal impact on the real economy so far, with use cases limited to crypto markets. What use cases do you see outside of these markets?

LD: DeFi can directly or indirectly affect the real world. Starting with the first, as we get better at making complex technologies more accessible, the entire DeFi toolbox can be made available to everyone. International payments and money transfers are the first easy fruits. The limitless nature of blockchains, combined with relatively low fees and reasonable transaction confirmation times, makes them contenders for international payments.

With advances like level 2, transaction throughput can compete with that of large financial providers such as Visa or Mastercard, making cryptocurrency an attractive alternative for everyday transactions as well. This may be followed by basic financial services such as savings accounts, lending, borrowing and derivatives trading. Blockchain-backed microfinance and regenerative finance are also gaining momentum. Similarly, DAOs can innovate new ways of organizing communities. NFTs can also be, and have been, more attractive to the wider market.

At the same time, the idea of ​​using concepts developed in the DeFi space to improve the efficiency of the traditional financial system is gaining momentum. Such use cases include, but are not limited to, smart contracts and programmable money, and the use of blockchain’s tamper-resistant and transparent properties to monitor financial activity and implement more efficient monetary policy.

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While each of these individual components is important in its own right, they are also part of a larger transition to Web3. In this regard, I would argue that the real question is not how much cryptocurrency can affect the “real” economy, but how much it will blur the line between what we consider to be the “real” and “crypto” economy.

CT: The report contains a reserved recommendation to regulate DeFi participants based on their activities, rather than using an entity-based approach. How will this regulatory structure function?

LD: In the world of DeFi, entities look very different than what we are used to. They are not hard-coded structures. Instead, they are made up of individuals (as well as organizations) who organize into decentralized autonomous organizations to vote on proposals for how the “organization” will participate. Their activities are not clearly defined. They may resemble banks, clearing houses, a public square, charities, and casinos, often all at the same time. In DeFi, there is no single person who should be held accountable. Due to its global nature, it is also impossible to apply the legislation of a single country.

For this reason, our conventional wisdom about financial regulation simply does not apply to DeFi. The shift to activity-based regulation makes more sense and can be facilitated through individual-level regulation and DeFi entryways. That being said, there are definitely attackers using DeFi as an excuse to sell repackaged traditional financial products, only less secure and less regulated — or worse, outright scammers. Regulatory certainty could make it harder for them to find safe haven in DeFi.