The FED's DeFi Report Summary

The Coin Bureau recently dropped a video explaining the details of the report. We loved the video so much that we decided to summarize it in a thread.

Sep 27, 2022

Last month, the FED released a report on DeFi detailing the transformative potential and associated risks

@coinbureau recently dropped a video explaining the details of the report. We loved the video so much that we decided to summarize it in a thread

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INTRO

Cryptocurrency's purpose is to disrupt the existing financial system

This makes DeFi protocols direct competitors to the commercial and central banks

That's why the report published by the Federal Reserve about #DeFi is very significant

REPORT OVERVIEW

The FED's report is primarily about DeFi's transformative potential and associated risks

The report begins with an important statement that the DeFi products and services are conducted without a trusted central intermediary like a bank

Surprisingly, the authors seem to consider #Bitcoin as the first DeFi protocol since it was possible to send and receive $BTC payments in a trustless manner

They also point to the proliferation of smart contract #cryptocurrencies as the precursor to the explosion of DeFi

The authors then present two potential outcomes for DeFi adoption:

DeFi evolves to become interoperable or even integrated with the existing financial system
Or it evolves to become its own financial system which would be the preferable outcome for #Crypto

However, they are unconcerned about either possibility due to the financial stability problems that the DeFi poses since there is a lack of regulation around DeFi

To put it another way, they are saying, "We can't control it, so it's bad regardless of what it becomes."

BLOCKCHAIN BASICS

The second part of the FED paper is about the basics of blockchain

They acknowledge that the Bitcoin blockchain is the first blockchain when the first Bitcoin block was mined in 2009!

They also turn to the topics of smart contracts and here's the issue:

They acknowledge the fact that oracles are required to make most DeFi protocols work

This could be a problem since they may target popular oracles like @chainlink to impose regulations on DeFi

DEFI PRODUCTS AND SERVICES

The authors say that many dApps provide discreet services rather than complex bundles of products

This might be b/c central banks are obsessed with the idea of a one-stop shop for their upcoming central bank digital currencies (CBDCs)

They also mention new protocols that offer a combination of several products in an attempt to become a one-stop shop for financial services

This could also be a hint that they might start going after those kinds of DeFi protocols more aggressively

What's even scarier is that the authors single out @MakerDAO to discuss governance in DeFi

This is scary b/c MakerDAO is mostly collateralized by @circlepay's $USDC

And the FED has the power to freeze everything if they wish to

Apart from the speculations, the authors appear to be 'somewhat' supportive of DeFi as they offer some suggestions for how it could be improved:

The introduction of more real-world assets
The creation of more robust stablecoins
The introduction of CBDCs

BORROWING & LENDING

The authors then talk about borrowing and lending protocols

What's odd is that the authors specifically mention that "Fees are often denominated in a platform's governance token"

They conclude that "Lenders may earn an interest rate that exceeds rates offered by banks on sovereign currency denominated deposits"

This might be a problem for DeFi since it creates competition for the big banks and the FED has the power to save the big banks

PAYMENTS & ASSET MANAGEMENT

The authors define the payment-related DeFi protocols as the ones that are designed to solve issues with efficiency, interoperability, and privacy to provide a better user experience

They also touch on the Bitcoin Lightning Network

They also explain that the asset management DeFi protocols automatically redirect any crypto deposited into them to wherever they will earn the highest yield

And guess who's on top of their list? It's @LidoFinance

This is scary b/c it might be a clue that they are potentially foreshadowing regulatory scrutiny for Lido

And this could be very bad for @ethereum since it has transitioned to the proof-of-stake consensus model

DEFI BENEFITS

In this part they discuss the benefits of DeFi:

When opposed to TradFi, blockchains execute transaction settlements more quickly
All transactions on blockchains are publicly viewable. This makes it easy for investors and regulators to assess market participants' status and any potential risks they're experiencing
The third benefit of DeFi the authors identify is "Auditability".

Blockchains allow us to check the accuracy of financial statements from individuals and institutions and make it possible to assess the security of the smart contracts that make up the DeFi protocols
Cryptocurrency's censorship resistance.

The authors seem to reference this by noting that dApp creators can decide which transactions to accept or reject

This is only beneficial for the governments since they can order the dApp to impose sanctions

DEFI RISKS

The authors then go on to list all the risks of DeFi:

DeFi is still small relative to the financial system that it seeks to replace, but the rapid growth of DeFi could pose future challenges to financial stability

They say that the current developments in DeFi have the potential to trigger a DeFi version of a financial crisis possibly with spillovers to the traditional financial system
They also point to DeFi's high leverage and illiquidity as an area of concern
The consensus protocols of the blockchains are corruptible if more than 50% of the hash power or stake is by a single entity or set of coordinated entities
An error in a smart contract code is eventually exploited, and this often results in a massive loss of funds
The conditions of a smart contract must be predetermined and are thus permanent. This means that it's not possible to write a smart contract whose terms and conditions can be easily changed like a real-world agreement
Transaction ordering problems. From transaction fee competition to minor extractable value
Liquidity issues. Many DeFi protocols need large amounts of liquidity to function properly. The absence of liquidity can cause serious issues such as price slippage
The authors go on to say that the governance of dApps is flawed and is quite centralized in practice

What's wild is what the authors suggest as a result of this risk:

Financial regulators should gain authority over finance conducted on blockchains, and they should have similar authority over on-chain protocols controlled by centralized groups
The final risk that the authors touch upon is the correlation between the DeFi and the TradFi ecosystem

They begin by saying that it's more than likely that crypto will exist alongside TradFi

And because of this, stablecoins like $USDT possess a huge risk to TradFi

A run on $USDT or any other stablecoin could create serious issues for both crypto and the traditional financial system

WHAT DOES IT MEAN FOR CRYPTO?

The authors once again reiterate that DeFi is growing rapidly and therefore requires regulation ASAP

The authors also specified the concerns arising from the governance of the code used in dApps

This again suggests that crypto projects with centralized governance mechanisms could soon come under fire

It is clear that the folks at the FED are perfectly aware of the crypto industry and its risks

This awareness also means that the FED knows where to impose stricter regulations on the DeFi sector

However, the FED report is certainly bullish for the crypto sector

Just the fact that $BTC & $ETH are mentioned in a report from the central bank proves that crypto is slowly taking over the world

Hence, during the next bull market, we could hit the critical mass required to create a parallel system that can't be crushed by regulations!

See the full video here:

See the full FED DeFi Report here.

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