"Cryptocurrencies and Decentralized Finance (DeFi)" Makarov, Igor and Antoinette Schoar Flashcards
What are the main functions of the financial system?
*Allocating resources to their most productive use
*Moving capital from agents with surpluses to those with deficits
*Efficiently moving wealth across time and states
What is the problem with the traditional system?
Relies on a set of intermediaries (banks, brokers, exchanges etc.).
Problematic, because this centralised position can lead to outsized economic rents and considerable inefficiencies.
How are transactions facilitated in the blockchain?
Blockchain uses Distributed Ledger Technology (DLT), where multiple validators jointly decide which transaction is admissible.
Two types of ledgers: permissioned (with a centralized body) and permissionless (set of independent parties, trustless).
How to tackle potential bad actors that try to undermine blockchain?
- Proof-of-work – Get reward by solving a computational problem, need 51% of computational power to undermine the system.
ISSUES:
*Incentive to pool mines to increase probability, more risk for attack
*These concentrated pools can also transfer their power to smaller PoW blockchains to undermine them - Proof-of-stake – Validator stacks coins instead of solving computational problems, reduces power consumption, makes attack less useful
ISSUES:
*Can undermine competitors
*Concentration of validators still high, risk present, but less extensive
How do smart contracts differ from real-world contracts?
Smart contracts are executed atomically (fully or not at all) and have little counterparty risk.
What is the problem with smart contracts?
*Try to define all possibilities before –> Leave no space for mediation afterwards, creating certain risks (can’t sue, void or reverse contract if the counterparty is a minor/drunk/mentally ill)
*Deemed “trustless”, but do require trust in the blockchain itself, as well as outside data (oracles), actions or assets in many cases
What are oracles?
Oracles - off-chain entity that does the query and posts the data on-chain.
2 types:
Centralized (takes data from one source)
Decentralized (takes data from multiple entities and incentivises those nodes)
Oracles can sometimes be prone to malicious manipulations (changing the off-chain data). “The fundamental challenge then is to determine what the truth is”.
What are stable- and non-stablecoins?
The whole crypto universe is divided into stablecoins and, you guessed it, non-stablecoins.
Stablecoins – Tokens designed to maintain a peg to fiat-currencies (off-chain liquid asstets or other crypto)
Traditional non-stablecoins – Have only the function of being a coin
What are the main applications of DeFi?
- Decentralized crypto exchanges (DEXs) – Provide an opportunity to securely trade cryptos
- Borrowing and Lending – Often done through algorithmic stablecoin creation
- Yield farming – A process of trying to maximize returns through a set of different strategies executed by smart contracts
What are the differences between DeFi and the traditional system?
DeFi:
* Anonymus, but implies tax avoidance, money loundering, etc (Traditional: has little data privacy)
- No entry requirements –> more competition –> eliminates excessive rents (T: centralized intermediaries can extract excess economic rents at expense of customers)
- Lower transaction costs (T: Many inefficiencies –> high costs)
- Governance issues, worse with high concentration (T: Governance & decisions made by a small group, can ignore public)
- Loans are overcollateralized –> constraints the efficient use of capital, risk of runs on stablecoins still present (T: Banks can hold a part of the deposits in liquid assets, while lending out the remainder to borrower, risk of runs on banks present)
What are the 3 main goals of the new financial architecture proposed by cryptocurrencies and DeFi?
(1) Prevent the use of funds for illicit activities, money laundering or tax evasion.
(2) Protect participants in financial markets against fraud and abuses.
(3) Ensure the integrity of markets and payment systems and overall financial stability.
As of now, DeFi fully fulfils none.
Why is there an urgency for regulation?
Crypto might soon become too-big-to-regulate.
Why could enforcing KYC and AML regulations be a problem in crypto?
A part of crypto value might rely on the fact that the industry does not have to comply with KYC or AML regulations; enforcing those might cause outrage among investors and lead to significant losses.
Authors argue it can be for a greater benefit tho.
What are the suggestions for regulating DeFi?
Best place to start the regulating is the level of developers and validators, who control the network protocol.
Potential regulations:
*Separate entities to do KYC
*Private keys for customers based on their financial sophistication
*A permissioned ledger, that aims to maintain most of the functions, while adding security
What do the authors conclude about DeFi?
Crypto and DeFi provide interesting technological possibilities, but lack the stability and security to outright replace the current financial system.
There are ways to regulate DeFi, which would preserve most of the features of the blockchain architecture, but support accountability and regulatory compliance, adding KYC and AML requirements.
