It is too early to tell if the benefits of decentralised finance outweigh the negatives, but research shows growing adoption across many industries.
Decentralised finance has been grabbing headlines, from specialised media to daily news broadcasts. Some have gone as far as claiming that it will change the financial world for good as it does not rely on banks or other financial intermediaries, instead using contracts and exchanges based on certain technologies.
In May 2020, the total value locked in decentralised finance was less than $1bn; nine months later it rose to more than $35bn, driven by the Covid-19 pandemic encouraging more people to turn to digital channels and solutions.
The reason we are all talking about decentralised finance right now is that digital innovation is further pushing this phenomenon through the use of blockchain and distributed ledger technologies. These are increasingly employed to enable the internet of value: the establishment of all distributed ledger platforms and applications, based on digital networks of nodes enabling the transfer of valuable assets, in the absence of trust and without the presence of a central body.
This has been the case not only in the financial sector but also, for instance, in the food and pharmaceutical industries. Research by the Blockchain and Distributed Ledger Observatory of Politecnico di Milano University highlights that the number of international projects based on these technologies grew by 59% in 2020, compared with 2019.
Essential elements
At the core of decentralised finance are two essential elements: decentralised provision and actor disintermediation.
Decentralised provision can occur at three different levels. These include decentralised record-keeping, where financial data exists in multiple copies on different public servers that are not owned by the provider and accessible to everyone. The importance of this is stark when you consider that data is frequently touted as the new oil.
At the core of decentralised finance are two essential elements: decentralised provision and actor disintermediation
Further, there is decentralised governance, where decisions concerning the supply, characteristics and evolution of the service are made by its user community. Lastly, decentralised risk-taking, where the different kinds of risk related to the financial services in use are taken by the user without any guarantee from the provider — an activity at the core of the financial industry.
In terms of impact on existing financial actors, we have observed the reduction or change of role for some actors, and the reduction of the number of the actors involved. By analysing 127 decentralised finance initiatives, we have registered a reduction in role (or elimination) for central banks, banks, insurance companies, asset managers, payment processors, stock exchanges, bookmakers, auditors and rating agencies.
Wide impact
The impact of decentralised finance is, therefore, incredibly broad, affecting many different business areas not only in financial services and processes — such as lending, insurance, asset management, savings, payments, trading and exchanges, fundraising and crowdfunding — but also all those at the edges of financial services, such as gaming, prediction markets, know your customer and identity, and decentralised contracting. Decentralised finance is certainly bringing both tangible and intangible benefits to the industry, at the macro- and micro-level, by improving accessibility, transparency, security and interoperability. But we can’t ignore the risks that decentralised finance brings, concerning system concentration and jurisdictional uncertainty, in particular.
To date, we can’t say with certainty which benefits or risks will be the most impactful, and the research of the Fintech and Insurtech and the Blockchain and Distributed Ledger Observatories of Politecnico di Milano will try to shed some light on this aspect. However, if we look at the total value locked in decentralised finance during 2020, we can see an unquestionable and strong evolution of this phenomenon.
Filippo Renga is director of the Fintech and Insurtech Observatory at the School of Management of Politecnico di Milano. The Politecnico’s Valeria Portale, Giacomo Vella, Alessandro Faes and Laura Grassi contributed to the research mentioned in the piece.
