6. Digital and Decentralized Finance Flashcards

Question

“DECENTRALISED FINANCE: ON BLOCKCHAIN-AND SMART CONTRACT-BASED FINANCIAL MARKETS” paper by Schär, F. What is the potential of DeFi technologies?

Answer 1

DeFi technologies have significant potential to improve the current financial system by providing an immutable and highly interoperable financial system with unprecedented transparency, equal access rights, and little need for custodians, central clearing houses, or escrow services. However, DeFi is still in its early stages and has some big inherent issues to address.

Answer 2

The text provides an overview of decentralized finance (DeFi) and its potential to transform the traditional financial industry by enabling greater financial inclusion, lower costs, and increased transparency. It highlights the key features of DeFi, including its use of blockchain technology and smart contracts, as well as the potential risks and challenges associated with this new ecosystem. The conclusion of the text is that while there are still significant challenges and risks that need to be addressed, the growth of DeFi has the potential to reshape the financial landscape, bringing greater efficiency and accessibility to financial services. As the technology and infrastructure of DeFi continue to evolve, it is likely that we will see more innovation and new use cases emerge, further increasing its impact on the financial industry.

Answer 3

Innovations in money and payments and the potential for improving the current monetary system.

Answer 4

The crypto universe is unsuitable as the basis for a monetary system because it lacks a stable nominal anchor and limits scalability, leading to fragmentation. Crypto also relies on unregulated intermediaries, posing financial risks. Central bank money offers a sounder basis for innovation, ensuring services are stable and interoperable, domestically and across borders. New capabilities, such as programmability, composability, and tokenization, can be built on top of central bank digital currencies (CBDCs) without the structural flaws of crypto.

Answer 5

DeFi refers to decentralised finance and its goal is to refashion the monetary system by cutting down the intermediary to lower costs and increase efficiency.

Answer 6

Programmability, composability, and tokenization

Answer 7

It is impossible to scale as fast while maintaining security and decentralization, leading to fragmentation.

Answer 8

It is impossible to scale as fast while maintaining security and decentralization, leading to fragmentation.

Answer 9

To provide the core of the future monetary system and support the smooth functioning of the payment system by providing sufficient liquidity for settlement.

Answer 10

Issuing central bank money, providing means for the ultimate finality of payments, supporting the smooth functioning of the payment system, and safeguarding the integrity of the payment system.

Answer 11

The central bank provides the foundations of the system, while private sector entities conduct the customer-facing activities.

Answer 12

Application programming interfaces to ensure programmability, composability, and tokenization

Answer 13

CBDC stands for central bank digital currencies, and it can streamline a wide array of innovations such as multi-CBDC arrangements, a wider range of financial intermediaries, instant payments, and inclusive design.

Answer 14

Decentralization can be achieved without the structural flaws of crypto.

Answer 15

The ability of smart contracts to automate certain actions, eliminating the middle man in different processes

Answer 16

Composability is the capacity to combine different components in a system, which would allow for complex multi-layered monetary system processes.

Answer 17

Tokenization refers to assets that are "tokenized" and can be transferred and exchanged much quicker and with more efficiency, utilizing the blockchain system.

Answer 18

They pose financial risks

Answer 19

Crypto has to borrow it off-chain from real-world currencies.

Answer 20

A lot of decisions are made through governance tokens with centralized control, and most of the trading occurs on centralized exchanges, creating significant risks of rug pulling or unprofessionalism

Answer 21

It offers a sounder basis for innovation, ensuring that services are stable and interoperable, domestically and across borders.

Answer 22

The financial system performs functions such as allocating resources to their most productive use, moving capital from agents with surpluses to those with deficits, and providing efficient means for moving wealth across time and states.

Answer 23

Intermediaries such as banks, brokers, and exchanges serve as centralized nodes that guard the access to the financial system and provide customers with essential services such as record keeping, verification of transactions, settlement, liquidity, and security.

Answer 24

Blockchain technology offers the possibility of a completely different financial architecture, called Decentralized Finance (DeFi), where record keeping is decentralized, access to the system is anonymous and unrestricted, and any form of intermediation would be built on top of it.

Answer 25

The blockchain architecture can eliminate unnecessary intermediaries and potentially be a significant benefit for the financial system's efficiency.

Answer 26

Challenges include issues with security protocols, the potential for negative externalities on smaller networks, and the added complexity of smart contracts. Proposed solutions include creating economic incentives for decentralization and addressing challenges for consumer financial protection.

Answer 27

It could severely affect market participation of less sophisticated consumers, or these customers would have to find trusted intermediaries to act on their behalf.

Answer 28

The enforcement of these contracts could lead to undesirable outcomes if there is no provision to reverse the outcome as in traditional contract law.

Answer 29

When both parties to a contract are sure that they do not value any ex-post protection through contract laws.

Answer 30

They cannot be modified once executed.

Answer 31

According to the paper, Bitcoin dominates the group of non-smart contract cryptocurrencies with a market share of more than 90%.

Answer 32

The group of non-stablecoins is a large and diverse group of cryptocurrencies whose value depends on the current investor sentiment and fluctuates widely over time.

Answer 33

The cryptocurrencies that have no other function than being a cryptocurrency are the first generation of cryptocurrencies such as Bitcoin, Litecoin, etc. These cryptocurrencies are built on non-smart contract platforms.

Answer 34

The new narrative for the benefits of the first generation of cryptocurrencies is that they are positioned as the new "gold" — a digital store of value.

Answer 35

Dogecoin was created in 2013 by two software engineers Billy Markus and Jackson Palmer as a parody of a cryptocurrency that was meant to be worthless.

Answer 36

High transaction costs can still make the financial system inefficient.

Answer 37

High cost of banking services and long settlement time of transactions.

Answer 38

The need to cover brick-and-mortar costs and outdated infrastructure.

Answer 39

Centralized intermediaries can have limited incentives to invest in new technologies that could threaten their centralized position.

Answer 40

It has had a positive effect on the incentives of financial industry to upgrade its infrastructure and reduce costs.

Answer 41

Yes, arguments can be made that a permissioned blockchain could deliver a more cost-efficient and robust solution.

Answer 42

Competition can be limited between different protocols because of strong network externalities and miners/validators can earn rent in equilibrium.

Answer 43

No, even if the execution of transactions and smart contracts on the blockchain are automated, the rules governing the blockchain itself and any upgrades to the system must be agreed upon and implemented by its participants.

Answer 44

The major stakeholders in a blockchain ecosystem are the core developers who write and update the code, validators who verify transactions, token holders who are investors or equity holders, and users of the platform.

Answer 45

No, the incentives of stakeholders are not always completely aligned. Users and developers might want fees on the blockchain to be low, while investors and validators want to maximize their financial return.

Answer 46

The DAO is a new form of governance in decentralized finance that tries to avoid placing trust in any actor or institution, including the legal ones. It spreads control over decisions among all interested stakeholders and is done by issuing special "governance" tokens that give holders the power to propose changes to the protocol and vote on them.

Answer 47

No, any DAO design faces the same fundamental trade-offs and issues as traditional organizations. Decision making in a fully decentralized organization can be inefficient, investors with large stakes can capture the control and impose their preference on the system, and the voting system can give more power to participants who may only be interested in maximizing short term profits as opposed to developing the protocol towards innovative use cases.

Answer 48

When banks only hold a fraction of deposits in reserve and lend out the rest to borrowers to expand economic activities.

Answer 49

A banking model where every loan is overcollateralized, removing many of the problems faced by fractional reserve systems.

Answer 50

A potential run on stablecoins, which can occur due to investors' doubts about the quality of the collateral.

Answer 51

The complexity and potential fragility of the system, as they are not fully backed by safe assets.

Answer 52

The ability to establish highly leveraged positions, which can exacerbate volatility and lead to sharp drops in cryptocurrency prices.

Answer 53

Many DeFi protocols facilitate leverage and accept other protocols' tokens as collateral, resulting in a highly complex and potentially fragile system.

Answer 54

DeFi has the potential to reduce transaction costs, but it may also create additional problems, such as facilitating tax evasion or skirting AML laws.

Answer 55

DeFi architecture might have the potential to reduce transaction costs, but it is not an automatic solution to the problem of rents in the financial sector.

Answer 56

The permissionless and anonymous nature of DeFi blockchains provide the opportunity for market participants to circumvent controls in the financial system, and create externalities for the rest of society.

Answer 57

Regulating the DeFi system would rely on a system where validators on the blockchain agree to check if a particular address belongs to a certified entity, and validators would be charged with only processing transactions that involve certified addresses.

Answer 58

The cross-jurisdictional structure of permissionless blockchain ledgers entails a danger that participants will engage in regulatory arbitrage which would undermine the financial system and its stability.

Answer 59

The way the DeFi system evolves has important consequences for liquidity and credit provision to the economy, and ultimately the standing of the US and other global economies. There are also strategic and competitive implications across countries.

6. Digital and Decentralized Finance Flashcards

(83 cards)