DeFi is a financial system implemented within the crypto industry and represented by many decentralised platforms, which are interconnected to a greater or lesser degree.
At the core of decentralised finance is the idea of replacing the traditional system of financial organisations (banks, investment funds, exchanges, and so on) with one on the blockchain, based on the principle of decentralisation. It is a system of financial applications built on blockchain networks that aims to replicate some of the functions of the traditional financial system in a seemingly open way, eliminating traditional financial intermediaries and centralised institutions. The current number of DeFi users in the EU is estimated to be 7.2 million, but only a fraction (less than 15%) seems to engage regularly in DeFi activities. The main use cases of DeFi appear to be staking, lending and borrowing, and exchanging crypto-assets.
Euro-denominated so-called stablecoins remain negligible in DeFi markets.
It represents 4% of the total crypto-asset market and is managed by the people who use crypto assets themselves and, unlike the world of fiat, doesn’t have a central governing body. At this stage, I shall list some of the main advantages of decentralised finance. To start with, there is more accessibility, such that anybody with an internet connection anywhere can connect to and take full advantage of DeFi, where users interact with each other directly without intermediaries, while the smart contracts monitor compliance with all the terms and conditions of transactions. Another advantage is conditional anonymity, yet, of course, everything and everyone can be tracked with enough effort, but for the most part, a crypto wallet is all you need to connect to and use the system.
Furthermore, DeFi is a system of financial applications built on blockchain networks that aims to replicate some of the functions of the traditional financial system in a seemingly open way, eliminating traditional financial intermediaries and centralised institutions. It is financial activity whose rules are expressed in smart contracts on a public ledger, so that users can trade, lend, borrow, provide liquidity, or earn yield directly through code using a self-hosted wallet, rather than opening an account with a firm that holds their assets and determines the terms. Many DeFi products route through hosted wallets, smart accounts with vendor recovery, or curator vaults. If the token is a MiFID financial instrument, MiCA rules do not apply at all. DeFi in the economic sense is “finance expressed as public smart contracts”.
MiCA treats a CASP (a crypto-asset service provider) as a legal person or other undertaking whose occupation or business is providing one or more crypto-asset services to clients on a professional basis, and that is authorised to do so. CASPs provide the various services to clients: custody and administration of crypto-assets on behalf of clients; operation of a trading platform for crypto-assets; and exchange of crypto-assets for funds or for other crypto-assets.
Furthermore, they execute orders for crypto-assets on behalf of clients and place crypto-assets via receipt and transmission of orders for crypto-assets on behalf of clients. They also provide advice and portfolio management on crypto-assets.
Moving on, let us discuss MiCA (Regulation (EU) 2023/1114). This is the EU single rulebook for crypto-assets that are not already financial instruments, deposits, funds (except e-money tokens), insurance products or securitisation positions. It applies to persons who issue or offer crypto-assets in the EU, seek admission to trading, or provide crypto-asset services. The main uses of DeFi appear to be staking, lending and borrowing, and exchanging crypto-assets. Euro-denominated so-called stablecoins remain negligible in DeFi markets, so that a majority of surveyed EU banks do not engage in crypto-asset issuance or service provision. So far, the adoption of technologies related to crypto-assets is low among EU banks. EU investment funds providing exposure to crypto-asset markets or the blockchain sector represent a very limited portion of the EU fund universe (0.02%).
One may ask: what are the main vulnerabilities of this system? Its anonymity or pseudonymity, due to the use of self-custodial wallets, can challenge the enforceability of the regulatory framework. Another weakness is that it can facilitate fraudulent activities and obfuscation of funds of crypto-assets. Because of this, there are a number of consumer protection concerns and a need for high levels of digital/financial literacy to understand risks. Users need to effectively safeguard private keys, with particular care regarding self-hosted wallet use. To mitigate such weaknesses, all crypto-asset service providers must be authorised in one member state and can then passport across the EU.
By definition, a CASP is a crypto-asset service provider under the EU’s Markets in Crypto-Assets Regulation (MiCA). It is a company (or other undertaking) whose business is providing one or more listed crypto-asset services to clients on a professional basis, and that is authorised to do so in the EU.
In summary, DeFi is a financial system implemented within the crypto industry and represented by many decentralised platforms, which are interconnected to a greater or lesser degree.
