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Demystifying DeFi: Professor Christine Parlour talks decentralized finance

Photo credit: imaginima for iStock/World Map Courtesy of NASA

If you haven’t been paying attention to the explosive growth of decentralized finance, otherwise known as DeFi, now is a good time to start.

DeFi refers to the rapidly expanding ecosystem that enables the provision of financial products and services—including trading, lending, borrowing, insurance, and more—without the involvement of traditional financial institutions. It is an open-source system built on top of permissionless blockchains—meaning that anyone can use them or build on it. What’s more, DeFi is built on public “smart contract” platforms or blockchains, which can automate financial processes, like loans or payments, without intermediaries (one example is Ethereum).

According to DeFi Pulse, the total value of currency at play in DeFi ecosystems shot from $10 billion in 2020 to $93 billion in 2022. What once had been considered a kooky corner of the online world has now caught the attention of the biggest players in traditional finance.  In October 2021, for example, Bank of America launched its own digital asset research division.

Christine Parlour, a professor and the Sylvan C. Coleman Chair in Finance and Accounting at Berkeley Haas, has focused much of her recent research on DeFi, fintech, and market microstructure. She also co-taught a recent MOOC (massive open online course) about DeFi that enrolled over 2,800 students from 30 countries.

We asked Parlour to break down what DeFi is, what makes it better than traditional finance systems, what’s behind its recent exponential growth—and why we all should be paying attention.

KG: What are the origins of decentralized finance, and how do you explain the exponential growth over the past couple of years?

CP: To some extent, DeFi’s roots go back to 2008 after the financial crisis, when people started feeling grumpy about traditional finance and Bitcoin emerged. There were bank bailouts while people were hurting. There was just this sense that maybe there could be a better way of designing the financial system from the ground up.

As with any new idea, it just took time for people to understand what they could do based on the idea of a blockchain. Over time, we had the ICO (initial coin offering) craze and that was a little bit like a lottery. Once we had this plethora of cryptocurrencies, suddenly people wanted to use and trade them—this gave rise to decentralized trading venues and decentralized lending platforms.

And now, people in traditional finance—who we used to call “Wall Street’”—have started to look at these venues very carefully. They have realized that there could be substantial cost savings associated with doing things on a blockchain.  Transactions that previously required substantial human intervention could be automated. They’re starting to innovate and think a lot about how they can integrate with this new development.

It’s moving quickly. And it’s moving in all sorts of different directions at the same time.

Do you agree with those who say DeFi will “democratize” finance?

At the moment we are not quite there. It is still difficult for most people to access the DeFi world—some of it is not very user friendly. Also, based on some of my work, I am starting to think that sometimes systems can end up with unusual concentrations of market power.  Time will tell.

What do you point to as some of the big benefits of DeFi?

At the moment, pretty much all financial services are offered in silos. DeFi opens the possibility of letting many, many more participants offer different bundles of financial services. That increases the rate of innovation. Secondly, it gives people more control over all matters relating to their financial health.

How so?

Most of decentralized finance is based on some form of blockchain technology. The way to think about a blockchain is it’s essentially a public computer that anyone can see operating and anyone can check information on at any point in time. This would be like a traditional firm that is totally transparent, so you can see exactly what they’re doing, what things cost, and so forth. This ultimately gives everyone more control over their finances.

Building on this public resource of different blockchains allows completely new and cheaper ways of trading. A concrete example is Uniswap, which is one of the more successful decentralized finance platforms. It allows people to buy and sell cryptocurrencies, but they could be trading any kind of asset: stocks, bonds, chickens.  And Uniswap allows them to do it in a way that is cheaper and really takes away the advantage from professional traders.

There’s also been a huge amount of movement in payment systems—not so much in the U.S., but certainly in other parts of the world. Some of these payment system innovations have been very successful, widely adopted, and make everyone better off. They often involve lower fees than we’re used to, they’re safer than cash, they offer an ability to send money over large distances. Unbanked or underbanked consumers are the main beneficiaries of some of these changes.

Are there personal privacy benefits?

Yes. When it comes to activities within decentralized finance, you are what we call “pseudo-anonymous.” No one knows how old you are, your gender, your educational background—and all of this information usually goes into things like credit scoring. That’s just not relevant in DeFi.

Does that anonymity also have some downsides—such as allowing bad actors take advantage of people or engage in criminal activity?

Because of this pseudo-anonymity, DeFi operates on collateral. So, you don’t rely on reputation or a brand name, you rely on collateral.  This means that lenders, for example, can be confident that that they will be repaid.  As to criminal activity, an important regulatory discussion is how to ensure that “bad actors” don’t use these new systems.

What are some of the big questions you have as a researcher?

I think we all want to understand, is the new system better than traditional finance? Is it working? Who benefits, who loses? If there are cheaper ways to transfer and store money, unbanked people could be better off. Some banks and traditional financial institutions could be worse off, losing customers if they don’t adapt.

We have a pretty good idea about how the legacy financial system works, so let’s just try to understand what the parameters are within DeFi. There’s a whole range of questions in particular around blockchain and the role of AI. What is the difference is between a human taking an action and a machine taking an action. When is that better? When is that worse?

The good thing about any blockchain is that there’s a huge amount of information available, because you get all the transaction data. The data are a little bit difficult to work with, just because it’s not in a nice and obvious format. There’s also a bit of a learning curve, so there aren’t that many people working in this area, but hopefully over time, more researchers will realize just how important it is.

You have a new working paper comparing Uniswap (and other decentralized exchanges) to centralized exchanges. What did you find?

When we first looked into Uniswap, we thought, ‘Oh, this is nuts! Who would design a system like this?’ But it turns out Uniswap has been really successful, and it’s been successful for a very specific reason. It’s designed so the costs and benefits of posting orders are mutualized. Unlike traditional trading, you’re not competing against the next guy who’s doing the same thing as you are. Essentially you are  sharing any costs and sharing any benefits.

What are some of the biggest concerns you have right now about the state of DeFi?

What’s moving very slowly is regulation. I think in general, we all agree that understanding what the regulatory environment is going to be is helpful, and regulators want to encourage innovation. But we’re not quite there yet. That adds a risk for innovators and also for consumers. We are used to being in a highly regulated financial system, and DeFi is the Wild West.

What’s coming next? 

I think we’re going to see this become more accessible for retail adoption. We’re starting to see some of the apps allowing people to trade cryptocurrency.

Another thing to expect, as I mentioned, is huge growth in payment systems, which can have a big impact on welfare—especially for the developing world.

Overall, it’s worth being informed about DeFi, because it’s not going away.