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The initial proponents of Decentralised Finance (“DeFi”) opined that DeFi, as opposed to Centralised Finance (“CeFi”), could innovate the financial system by providing easier methods of payments and other financial services. The reasoning was based on the notion that transactions without a centralised intermediary in the financial system entail a simpler economy with less regulatory burdens. In fact, the laws governing finance in Western countries (irrespective of their Common Law or Civilian Law traditions) are largely based on CeFi principles.

In May 2023, the European Systemic Risk Board (“ESRB”), an EU body under the European System of Financial Supervision, provided a short analysis on CeFi and said that: “CeFi refers to services that are run by centralised intermediaries. They are often the main access points between fiat currencies and [other] assets.”¹

 The Malta Financial Services Authority (“MFSA”) defines DeFi by saying that: “DeFi is an emerging form of decentralised and autonomous financial services powered by smart contracts.”² The MFSA elaborates that DeFi enables quasi-anonymous individuals to effortlessly access decentralized financial services, mirroring the functionalities of the traditional financial system while bypassing intermediaries.

Whilst the differences between CeFi and DeFi might sound too technical and meaningless for the end-user, the legal underpinnings are contrasting. In DeFi, trading takes place “through decentralised peer-to-peer digital asset exchanges”³ which gives less data to a centralised institution which might use such data for its own benefit. Moreover, the “non-custodial nature”⁴ of such exchanges allows the investors/users to retain more control over their investment. Such flexibility is not given by operation of the law but through the inapplicability thereof.

The assumption that financial services can thrive in the absence of intermediaries oversimplifies the complexities of the financial ecosystem. The traditional CeFi model, which is highly intermediated, did not come into existence by chance; it evolved to fulfil certain essential roles and functions.

Intermediaries often serve as a buffer between investors and the volatile markets, offering guidance, diversifying risk, and ensuring the enforcement of regulatory standards. They contribute to the efficient allocation of resources, provide easier access to financial services, and play a crucial role in the prevention of financial crimes such as fraud and money laundering. Their regulatory compliance efforts also contribute to the overall trust in the financial system.

The role of a central intermediary as a ‘backstop’ during market turmoil is a pivotal aspect of the current financial system. Such intermediaries, in the event of adverse market conditions, can absorb shocks, stabilise the market, and ensure the smooth operation of the financial system. Regulatory developments post-financial crisis have increasingly emphasised the establishment of robust default procedures for financial institutions and market infrastructures. This has been aimed at minimising the potential impact of a significant institution becoming insolvent.

The collapse of a substantial institution within the financial system can trigger a domino effect, leading to widespread market instability. In this context, the role of central intermediaries in the traditional CeFi model becomes all the more crucial. CeFi intermediaries can step in to contain the risks, manage the default of the failing institution, and mitigate the repercussions on the wider financial market.

The post-2008-crisis regulatory focus has led to the development of resolution regimes aimed at ensuring that financial institutions can fail in an orderly manner without causing systemic risk or requiring public funds. Taking the EU as an example, Directive (EU) 2019/879 of the European Parliament and of the Council of 20 May 2019 amending Directive 2014/59/EU as regards the loss-absorbing and recapitalization capacity of credit institutions and investment firms and Directive 98/26/EC (commonly referred to as BRRD2) lays out a process for managing the failure of significant banks, mitigating the impact on the financial system and economy.

On the other hand, the DeFi space, being inherently decentralised, lacks such central backstops. The absence of intermediaries leaves DeFi systems vulnerable to potential shocks, and there is no clear recourse or bailout mechanism if things go wrong.

Yet, the DeFi movement promises to bring about numerous benefits that the traditional CeFi model struggles to provide. At its core, DeFi offers a more inclusive system, enabling anyone with an internet connection to access financial services, thereby bridging the gap created by the CeFi systems for unbanked or underbanked individuals.

Moreover, through the use of new technologies, DeFi can provide a higher level of transparency and resilience. New technologies which ensure that transactions are auditable have the tendency to minimise the chances of fraud. This level of transparency can, in theory, increase market efficiency and minimise information asymmetry, a frequent issue in traditional finance.

Despite the innovation brought about with DeFi, the ESRB notes that “CeFi would most likely remain the most important segment […] and gain market share from traditional counterparties. Despite the emphasis on decentralisation, the current CeFi domination in digital-asset markets shows that people prefer convenience over complicated, self-custodial decentralised services”⁵

Furthermore, the introduction of the MiCA Regulation⁶ which was published in the OJ earlier this year gives more room for DeFi to coexist (rather than replace) CeFi. The reason being that non-traditional currencies are put under the mantle of a robust framework which enhances investor protection whilst promoting more stability in the EU’s financial system.  CeFi and DeFi’s coexistence could accomplish a further movement in the direction of convergence if the European Central Bank were to initiate the public issuance of its own digital currency.

Footnotes:

1. ESRB, Systemic Implications and Policy Options < https://rb.gy/furgi > page 57
2. MFSA,https://www.mfsa.mt/wp-content/uploads/2022/11/FinSights-Decentralised-Finance.pdf page 1
3. Ibid page 3
4. Ibid page 4
5. Ibid supra no.1, page 57
6. Regulation (EU) 2023/1114 of The European Parliament and of the Council of 31 May 2023 on markets in crypto-assets, and amending Regulations (EU) No 1093/2010 and (EU) No 1095/2010 and Directives 2013/36/EU and (EU) 2019/1937

Disclaimer: This document does not purport to give legal, financial or tax advice. Should you require further information or legal assistance, please do not hesitate to contact Dr. Mario Mizzi

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CeFi and DeFi’s Coexistence appeared first on Mamo TCV.