In our article, we provide a deeper analysis of how proposed regulation in the blockchain space affects the code- and confidence-based architectures which so far have underlain decentralized financial services (DeFi).

We start from the fact that traditional financial institutions and novel blockchain-based DeFi rely on fundamentally different sources of trust and confidence. The former rely on heavy regulation, trusted intermediaries, clear rules (and restrictions) on market competition, and long standing informal expectations on what banks and other financial intermediaries are supposed to do or not to do. It is a complex and multi-layered trust infrastructure of regulation, competition, supervision and oversight. 

Blockchain-based decentralized financial services rely on technological constraints to provide confidence in the outcome of rules encoded in protocols and smart contracts. The ecosystem is trying to obviate the need for institutional, regulation- and market-based trust by building ‘trustless’ systems, where trust does not rely on any third party operator, but rests solely in the technological infrastructure. These systems come with the promise—which yet has to be properly fulfilled—to replace trust with confidence in the way the blockchain architecture enforces rules, rather than to trust banks, regulators, markets, etc.

However, despite the solid safeguards and guarantees which code can offer, DeFi currently suffers from issues which don’t seem to have immediate, purely software-based solutions. Buggy, exploitable smart contract code on the one hand, widespread fraud, price manipulation, insider trading on the other are risks which can only be addressed with more traditional trust-enhancing mechanisms, such as code governance and anti-fraud regulation. In fact, to have confidence in the technological infrastructure, one needs to trust the ability, benevolence and integrity of a multiplicity of actors, such as the developers responsible for coding the platforms, the miners in charge of maintaining the technical infrastructure, and the market players capable of manipulating the value of the associated crypto-assets. As trust comes back into the picture, technology and game theory alone are no longer sufficient to ensure confidence in the proper operations of the system.

What is more, given the risks of bugs or scams in the DeFi space, regulators and trusted intermediaries may need to play a more active role in order for DeFi to gain the trust of the next generation of users. But whether this would improve or reduce the confidence of these systems is an open question. Blockchain innovation was fuelled by a general distrust in the state apparatus and in the financial system, so it is important to ask whether such top-down regulation will be able to achieve its goal, increasing confidence in the decentralized crypto-economy or, on the contrary, whether the willingness, and ability of regulators to extend their powers to this domain will lead to a loss of confidence in such systems.

The regulation of DeFi might thus have divergent implications on the perceived trustworthiness of DeFi applications, depending on corresponding preferences and risk profiles of DeFi users. Those who already trust the public trust infrastructure provided by the state (as most users involved in the traditional financial system do) might feel more comfortable to engage in DeFi because of the greater sense of security and protection that regulation might provide to them—ie in terms of knowing that they will be at least partially protected against the risks of frauds, scams, bugs, hacks or other technological failures. Those who do not consider the public trust infrastructure sufficiently trustworthy (as hinted by a significant portion of existing DeFi users) might instead be discouraged by the appearance of the state and its institutions. The re-introduction of regulation shifts the trustworthiness safeguards away from a low agency, confidence-based technological system towards a more institutional trust-based system. This shift also entails a change in the nature of the risks within the system: there might be less fraud or fewer buggy systems, but at the cost of having the same old trusted middlemen in the ecosystem—those who the early blockchain advocates wanted to bypass at all costs. This may be perceived, at least by some, as an ideologically unacceptable, or in the long term unnecessary tradeoff.

To justify regulation, the added benefits of increased agency, intervention by, and the associated counterparty risk of a third party (such as a court or a regulator) must outweigh the technological and financial risks and harms posed by the current model of DeFi. We conclude that, in order to facilitate the mainstream adoption of DeFi, the trust infrastructure it relies upon needs to step beyond a purely technological understanding of confidence and instead develop a more complex understanding of what constitutes trust and trustworthiness in various components of the ecosystem. In particular, one needs to account for the various social institutions (such as traditional laws and regulations, but also social norms, community rules, etc) and the multiple accountability mechanisms that exist to address the countless ways in which things could go wrong in a system where the stakes are so high.

Overall, the DeFi experiment cannot be held to be either a success or a failure; it is an on-going experiment that helps us explore new technological infrastructures of trust, their strengths and their limitations, as well as their interactions with pre-existing legacy trust architectures.

Balázs Bodó is an economist and socio-legal researcher at the Institute for Information Law (IViR) at the University of Amsterdam.

Primavera De Filippi is a Permanent Researcher at the National Center of Scientific Research (CNRS) in Paris, a Visiting Fellow at the Robert Schuman Centre for Advanced Studies, the European University Institute, and a Faculty Associate at the Berkman-Klein Center for Internet & Society at Harvard University

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