Balancing the Goals of DeFi with Traditional Finance: A Risk Management Perspective

Transcript

foreign [Applause] so yeah thanks for the kind introduction and welcome us from my side I'm with the Lucerne University of applied science we're based in the crypto Valley in North coits you see our nice campus in here so I'll invite you to come to Central Switzerland and I want to talk a little bit about um defy decentralized finance and traditional finance and these are the wrong slides because these slides are for Sunday for the workshop

so perhaps somebody can change this and uh while we get the new slides just a short question for me who of you um have bought some D5 products tokens wow that's cool um who is new to the blockchain industry no newbies or nobody wants to uh to get exposed in this In This Crowd and and who uh developed his or her own smart contract wow okay then we can speed up the

beginning when I get the slides um um yeah while we're waiting just a couple of um words for myself um as I mentioned I'm working for Lucerne University of applied science beside this I'm also president of tech Institute Association we're offering blockchain certificates so if you want to have a look into this we just uh two days ago launched our collaboration with edx and also offering a blockchain milks and I'm also involved in ditas which is focusing on self-sovereign identity and

tomorrow we we also have a panel discussion here so it's always the bad thing if you have two presentations and on the same topic so if you if you're interested in getting your hands a little bit dirty on this topic and also discuss with us then I also invite you on Sunday at 12 for the workshop there we we have a more interactive topic but um yeah so so let's get started I um I think um if

I want to go through the first slides and what I want I want to present in in this short presentation here is um to to think about risk management um in defy and I know risk management D fights a little bit different than in traditional Finance but what I also experienced is that a lot of people when they come to D5 think well now it's everything is completely different and we do things other than that old Banks uh the traditional Finance but I'll think that we can learn a lot from how risk management is done in traditional finance and also think about how can we

use the features of blockchain which which are I think the most important is immutability so that you um you have your lecture and once uh information are there they cannot be changed another feature is the distribution so you have a distributed a decentralized database stored on different sites you always have to look about uh even if something is distributed could be centralized so how is the influence of um of certain parties on this whole ecosystem another feature are smart contracts so automation

transparency especially when you look at permissionless blockchains like ethereum then it's it's always the question about uh here we go now I can go to this slide we already had immutability distribution and programmability or smart contract so the the topic of transparency as mentioned in permissionless environments and solid anonymity most people think about real blockchain I'm Anonymous on a blockchain um you're not

um you're just behind an address and there are a lot of companies that track those addresses so um yeah don't think that you uh while you're behind this address and nobody knows who you are that you are really Anonymous Europe's autonomous like having eBay number and finally a consensus protocol different consensus protocols but there has to be in consensus to in order to get information on the blockchain and with those features we can span up a lot of possible use cases and why I'm really curious about the teams what they come up in which area in which use case area

they come up and D5 is just one of those aspects um so when we go to a definition of decentralized Finance then yeah it's decentralized it's based on a blockchain or distributed Ledger technology normally permissionless um it's run with smart contracts so autonomous nobody can interfere we'll see if it's really nobody um then it's self-managed so you're as a user interact with the system um it's not something that somebody on

behalf of Youth acting so you can yeah decide in which product you want to invest and then directly go into it you have no restrictions on trading hours so it's 24 7. this is a Advantage but also can be a risk um we already had transparency low fees compared to traditional funds products and as I mentioned solid anonymity um I think when you there are a lot of protocols out there that claim that they are decentralized Finance but are at least centralized finance and just a short graph of a of a paper

um you really have to go through and is there really nobody that can interfere and when I think of interference also is there for example in the smart contract a functionality that you can stop trading and somebody can use this functionality then it's not really decentralized um are there there any um governance structures that can interfere with with this product so all those checks you really have to do and um since a lot of you already know a little bit about smart contracts I can go fast

over this slide just as a short reminder smart contract the term was defined just before we already had blockchain so by Nick Sabo in 1994 as a as a computerized transaction protocol and he compared a smart contract with a vending machine so when you go to SBB station and just get some drink out of the vending machine you also have a this automated contract that's uh that run by the machine and in our case the smart contract is run by the blockchain notes stored on the blockchain

immutable cannot be changed and therefore tamper-proofed it is it runs on on events so once it is called then it executes itself stores the updated data on the database on the blockchain and and then wait for the next event we're still in the stage that smart contracts are not legal contracts so just as a short reminder normally you have to have a normal contract beside if you really want to use this as a as a legal agreement there are

a couple of initiatives in in this direction but still in most countries it's it's not a real contract and it's also not smart but it can take custody over goods and that's is especially in the D5 area where we can Implement a lot of different products uh you can go to D5 llama and scan to the categories I think stable coins are most um known then decentralized exchanges or tax automated market makers a lot of um those

decentralized Finance products and the the borders between those categories are not really clear because you have the smart contracts and with the smart contract you can develop whatever you like so you can have slight variations between those and some of the products perhaps make not much sense some of the products are only for speculation as some of the products are really useful when we look at regulation we're still in the wild west scenario even that we have some uh legislation on it but um there are a lot of uncertainties

and people yeah just do what what they do and they come up with new products um also you have to think about which country are you in um at the moment this is highly watched by the supervisors because the amount of transaction volume is rising um there is just a new report from the financial stability board on decentralized finance I can send it to you if you like you can also get it on the internet and um so at the moment they think as D5 not as a systemic risk but they have it on the watch list

and as I mentioned regulation in the financial space um also that we have anti-money laundry and all this stuff for kyc is still a country-specific thing and in D5 we are just out in the internet and everybody on the whole world can interact with those contracts so there we are on the one hand side we're Global we're so edonymus and when you think about kyc there is some some problems um as I mentioned the legal understanding of a smart contract and what we see is that a lot of products

due to this lack of Regulation they think about self-regulation because normally if you want to invest in such kind of product and you build up a company around it then you don't want to be in the wild west and tomorrow The Regulators says well it's it's illegal you don't want to do this so a lot of people thinking in the industry think about how can we self-regulate it and how can we also show that we or people or users can trust in US I mentioned I want to look also on the traditional finance and I don't know if

you're aware but on the traditional Finance also especially after those crisis we had recently and years before the bits or the the Basel committee came up with um a categorization of financial risks and Basel II was mainly three categories the credit risk Market risk and operational risks now after the financial crisis 20089 they came up with battle 3 and added additional risks like liquidity risk or counterparty risk and um not only the risk categories and that

the banks have to hold money for for potential risks like eigen capital and we were at the moment we're in Switzerland just in this discussion about Credit Suisse and should we rise this from 13 to 20 percent um but beside those this pillar one we also have have supervision and we also have this kind of of Market discipline and so the question is can we learn from what happened at the traditional finance and I want to just come up with some of the

the challenges which are different in D5 space compared to the traditional Finance so first of all we as in the name it's decentralized so we don't have a centralized control um another important difference when you look at the products in in traditional Finance you have a lot of products that have some kind of maturity date so an execution date somewhere in the future when you look at decentralized finance and I just turn out staking but the other products usually don't have a maturity date so

you can execute it whenever you want and there the reasons or the that that's the reason why for example A Bank Run is much faster than in the traditional fines where you have some kind of of bounding of a product to a date in the future execution date in the future um we don't have any supervision from the regulator um perhaps companies supervise their own products and have some kind of possibility to stop execution of of the product but there is no official supervision and since we operate 24 7

well this supervision has to be somehow automated otherwise there has to be some somebody with a kill switch and waiting for something happening um we have co-transparency yeah we can look into the code um and that's I think also on one hand side a problem because um when you ask the people who deal with decentralized Finance products and say well um did you really analyze the smart contract and what happens there and what could happen normally people say no

while I read some description what this smart contract will will do and perhaps it's based on a on a standard esc20 token or whatever but um I just want to invite you to have a closer look so for example if you look at the teeth stablecoin which is an ec20 table coin there is a stop functionality or pause functionality so somebody can stop trading teaser on the ethereum network and a lot of those smart contacts has some kind of built um suspension mechanisms and and it's always the question who is able to

execute those suspensions and is it a dial behind it or is it one person or is it a group of person and what is their financial motivation on this um since the smart contacts are executed autonomous there is no no safety net if you don't have really an implementation in this and um well we uh challenges from from a risk perspective also is the usability because um I think the whole blockchain Space lacks on a really good usability and I don't mean usability for technical people I think we will know how to deal

with the wallet but when you go out and and want to go into public and ask somebody on the train station so well how do I handle or how do I buy a D5 product and and how do I sell it I think there are the limitations so the user group is a little bit small for this and mostly experts um in a in a research project we're just looking into this and also combining or combining traditional and finance and decentralized finance and we divided the risks on the systematic risks risk which I as a defy developer cannot influence

so the whole Market risk but also some technological risks like protocol risk so if something happens to the ethereum blockchain I as a provider of a smart contract of a D5 product I cannot do anything against this or if I rely on oracles and those oracles have some some errors then I also depend on this and the other side is the the unsystematic risks where we uh so with these risks I could handle or I I should handle I should look and to governance of the product I should look into

are there some requirements for example from finma that I have to provide the prospectus for my product because it's as a security token um I should do a audit of my smart contract from some companies I should look about reputational risk what happens if there is a in social media suddenly a cell announcement or some kind of bad reputation and everybody is going to sell my product thank you potential Solutions I think were at the beginning of this whole and um I'm really looking forward also

perhaps for uh results from from the hackathon but also from the industry in regards of risk management I think we can learn from traditional risk management it's not that we do have to do the same thing but we can learn because this industry is a couple of years old they had their mistakes in risk management but also their their gains and I think a lot is about automation about automation of the protocols about reporting about transparency about bringing the governance into a decentralized area not on a centralized that a couple of of wallets can can

manipulate or can can change the structure um as I mentioned the the topic of maturity date especially when you think of a bank run and also how can we incentivize liquidity providers because when you look at the D5 protocols you always need some liquidity yeah that's the the whole aspect around it because you don't have a central bank that provides liquidity so you have to have liquidity providers and how can you incentivize them to stay in a protocol if something goes wrong and not pull out their their money and what we will see is the topic of kyc

know your customer and this whole kind of identity where is the origin of the money anti-money laundry topics I think these there has to be developed something in regards of this so coming to an end I have six takeaways for you um just still we're on the wild west but D5 is on the watch list um I think self-regulation from my point of view makes sense but we really have to go in this direction and and check how can we or how can the industry uh self-regulate

then I think we have to find a balance between traditional finance and define it's not all traditional fines it's not all decentralized Finance but I think the truth is somewhere in between um and uh when you look at papers in the decentralized finance area a lot of them are focusing on the technology risks I think there are a lot of other risks in this space Not only errors in smart contracts but those errors are one of the biggest risks and the other I think is the whole topic of reputation so what we've seen

in a lot of those protocols that we have this kind of bank run that there is some bad publicity and people pull out their money and then the whole system collapse and yeah um since it's a new industry um I think it's it's important to get innovation in this space I'm also looking forward to all of you all of your Solutions and not only look at the short gains or speculation but also on a long perspective and with this also risk management with this thanks for attending and sorry for the slides and looking forward for the break

for some interesting discussions thanks [Applause]