BBA-MBA INTEGRATED

TERM - VIII
RESEARCH METHODOLOGY

Individual Assignment

Topic Chosen: DeFI – Illusion to Governance?

Submitted to: PROF. HRUDANAND MISRA

Submitted By:

Name Roll. No.

Jainil Thakkar 197127
 ACKNOWLEDGEMENT
In performing our assignment, we had to take the help and guideline of some respected person,
who deserve our greatest gratitude. The completion of this assignment gives us much Pleasure.
We would like to show our gratitude Prof. Hrudanand Misra, Institute of Management Nirma
University for giving us a good guideline for assignment throughout numerous consultations.
We would also like to expand our deepest gratitude to all those who have directly and indirectly
guided us in writing this assignment. In addition, a thank you to Professor Amola Bhatt, who
introduced us to the Methodology of work, and whose passion for the “underlying structures”
had lasting effect. Many people, especially our classmates and team members itself, have made
valuable comment suggestions on this proposal which gave us an inspiration to improve our
assignment. We thank all the people for their help directly and indirectly to complete our
assignment.

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 UNDERTAKING
I, confirm that all the information provided and written in this report is non plagiarized. I have,
however used secondary resources to gain more knowledge on the topic. Any similarities or
overlapping of phrases or sentences of this report with the sources is mere coincidence and we
didn’t intend to copy or misuse it, it was used only for educational purpose.

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 CONTENTS

Sr. No Content Pg No.

1. General Overview 5

2. Literature Review 7

3. Research Gap 8

4. Research Objectives 8

5. Methodology 8

6. Findings 9

7. Conclusion 11

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 1. General Overview of Research Area

DeFi which is Decentralized Finance is being pushed as a new kind of crypto market intermediation.
Novel automated protocols on top of blockchains — to allow cryptoasset trading, lending, and
investing – and stablecoins that ease financial transfers are crucial components of this ecosystem.

DeFi operates on blockchains and uses automated protocols to deliver financial services without the
use of centralized middlemen. The DeFi ecosystem is made up of two components:

 new trading, lending, and investment protocols,

 stablecoins, which are cryptoassets that allow financial transfers while aiming to retain a
fixed face value in relation to fiat currencies, namely the US dollar.

While DeFi proponents' major aim is for intermediation without the need of centralised
organisations, we believe that some degree of centralisation is unavoidable. As a result, a
"decentralisation illusion" exists. To begin with, centralised governance is required in order to make
strategic and operational choices. Furthermore, several aspects of DeFi, particularly the consensus
procedure, encourage power concentration.

DeFi has the ability to supplement traditional financial activity in theory. However, it currently has
limited real-world applications and is mostly used for speculation and arbitrage among several
cryptoassets. Given its self-contained character, DeFi-driven disruptions in the larger financial
system and actual economy appear to be restricted for the time being.

If DeFi is to become a commonly utilized type of financial intermediation, it must meet a number
key criterion. For starters, scalability of the blockchain and large-scale tokenization of existing
equities would have to be increased. DeFi, on the other hand, will need to be adequately controlled.
Public authorities would need to work with DeFi's built-in governance systems to provide adequate
financial stability measures and to build confidence by addressing investor protection concerns and
illicit activity.

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Overview of DeFi Space
Since mid-2020, when DeFi operations began to take off, the rise of stablecoins has been
exponential. The market capitalization of the biggest stablecoins in circulation reached $120 billion
in late 2021, compared to the $200 billion market capitalization of the largest money market fund.
USD Tether, in particular, has grown in popularity as a "vehicle currency" for investors looking to
trade in and out of cryptoassets. As the first stable coin, it has benefited from a large user base that
has drawn new users looking for convenience in trade (network internalities).

The technique for ensuring a constant value differs depending on the design. Because they are
controlled off-chain, the majority of stablecoins are Centralized Finance coins, such as USD Tether.
DAI, for example, is a DeFi stablecoin that is controlled on-chain. A designated intermediary
oversees issuance and redemption, as well as the reserve assets that back the stablecoins, in the case
of CeFi stablecoins. Some of these assets are bank deposits or near replacements for bank deposits.
Short-term securities, such as Treasury bills, certificates of deposit, and commercial paper, as well as
cryptoassets themselves, are examples of other assets. DeFi is still reliant on CeFi and traditional
financing to the extent that it uses stablecoins.

DeFi stablecoins keep track of all transactions on-chain, eliminating the need for centralised
middlemen. They rely on a pool of cryptoassets that is overcollateralized, meaning the underlying
assets are worth more than the stablecoins in circulation. DeFi stablecoins incentivize users to
actively monitor the collateralisation ratio because crypto security has a significant price fluctuation
when evaluated in the reference fiat currency.

Cryptoassets may be traded on both centralised (CEXs) and decentralised (DEXs) markets (DEXs).
The former are built on the same foundations as their traditional equivalents. Limit order books are
off-chain records of outstanding orders posted by traders that CEXs keep. DEXs, on the other hand,
function in a very different way, matching the counterparties in a transaction using automated
market-maker (AMM) algorithms.

Trading on DEXs appears to be more expensive than trading on CEXs at the moment, especially in
smaller transactions. For example, on a popular DEX, the comparable bid-ask spread for the Tether-
ETH pair was up to 30 basis points larger than on a CEX. Furthermore, when transactions are

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confirmed on the blockchain, trading on DEXs incurs execution fees. These are the result of so-
called "gas fees," which are meant to reimburse validators. As cryptoassets got more popular and
blockchains like Ethereum became more clogged, gas fees skyrocketed.

2. Motivation

The research topic came into my mind while I was reading an article on new launches of Dex
(Decentralized Exchanges). I was aware that due to cost and governance issues it is very hard for
DEx to sustain but there were many launches happening with their tokens skyrocketing which
made me thinking if there is any protocol changes in the system. Diving deep into it, I realized that
there are many facts unknown to the investors staking there money into the exchanges.

3. Literature Survey

 Usman W Chohan (2021), firstly mentioned in his paper that Decentralized Finance (DeFi)
holds the potential of a new alternative financial architecture that stresses disintermediation and
decentralisation in order to empower individuals in accordance with cryptoanarchist ideas. However,
it is beset by a slew of issues, including market manipulation, distorted incentives, excessive short-
termism, Pyramid schemes, and money-laundering issues, all of which serve to discourage DeFi's
widespread adoption.

 X. Meegan and T. Koens (2017), in their paper mentioned on the risks pertaining to defi.
Blockchain and Distributed Ledger Technology are being used to alter traditional centralised
financial systems on a worldwide scale. The seeming distinction between centralised and dispersed
financial services might result in prejudice against either. They mentioned about risks which if not
mitigated can lead to wealth destruction of many investors. Term staking was highlighted but as
these paper is 4 year old, it does not have detail about other staking platform launched.

 M. Nathan (2019), mentioned openly about one protocol which was AAVE. Aave is a non-
custodial liquidity protocol for generating interest on deposits and borrowing assets that is open
source. Aave is a decentralised software based on the Ethereum network. In essence, Aave is a
liquidity system that runs entirely on Ethereum smart contracts. Aave does not match loans

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individually; instead, it relies on pooled money, as well as the quantities borrowed and collateral
deposited. This enables Aave to provide rapid loans.

4. Research Gap / Limitations

 There are many researches that have been done regarding the rise of decentralized exchanges
but hardly few spit out the truth on the risks and mitigations occurring through it.
 Recently many DAOs are receiving staking as investors are pouring money considering it is
backed by the stable coin which may not lose its floor price but the same is not true.
 Investors can lose a lot of money, so it is important to make them aware about these types of
schemes.

5. Research Objectives

 The main objective behind conducting the research is to find out if the investors are aware
about these schemes or not.
 People investing into these projects may be astonished by the APY they offer but do they
know the tech behind the products and the schemes
 To make people aware about the tech, so that they can choose the best projects based on
their risk appetitite.

6. Research Methodology

Approach
Here, the methodology of research which we have proposed is Secondary Research. Rather than
using primary research which would have mostly been conducted by conducting sampling survey
into the forums and community members, we have chosen secondary research as the source would be
much more viable and research oriented.

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Sample
Qualitative Data has been collected as a part of the research. Simple random sampling has been done,
so to avoid any clutters in the research which can be conducted without any discrimination.

7. Findings

Overcollateralization is common in DeFi lending. The cause is identical to the reason behind DeFi
stablecoins' overcollateralization: the inherent lack of confidence in anonymous transactions, along
with the extreme volatility of the cryptoassets utilised as collateral. When the collateralisation ratio
falls below a certain threshold, loans might be immediately liquidated to safeguard the lender.
Currently, the requirement for crypto collateral prevents financing to individuals and organisations
for purposes such as home purchases or productive investment.

DeFi lending systems also provide a one-of-a-kind financial product known as flash loans. These
allow arbitrageurs to operate without having to put up their own money by taking out a loan for the
full arbitrage deal and then repaying it. These loans have no maturity date and are practically risk-
free (no collateral is required), as they are only provided if the arbitrage deal guarantees the payback
of both principal and interest.

DeFi advocates for a decentralised system. This is true for both blockchains and the apps they serve,
which are built to function autonomously – to the point that the outcomes, even if incorrect, cannot
be changed. However, with DeFi, complete decentralisation is a mirage. The inability of businesses
to develop contracts that cover all potential scenarios, such as relationships with employees or
suppliers, is a major premise of economic research. There are many arguments that centralization
helps enterprises to deal with "contract incompleteness." The corresponding idea in DeFi is
"algorithm incompleteness," which states that it is impossible to construct code that specifies what
actions to do in all feasible scenarios.

Furthermore, some characteristics of DeFi blockchains encourage the concentration of decision-

making authority in the hands of big coin holders. Validators of transactions must be compensated
sufficiently to encourage them to participate without committing fraud. Proof-of-stake blockchains,
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which are intended to increase scalability, enable validators to stake more of their currencies in the
hopes of "winning" the next block and gaining reward.

In order to trade cryptoassets in DeFi, new and unique matching processes are used. The centralised
limit order book, which involves retaining computerised records of all pending orders, is a frequently
used method in conventional finance. Similarly, off-chain limit order books are used by crypto
controlled exchanges. However, with DeFi, the enormous amount of orders would make managing
an on-chain limit order book prohibitively expensive. Another mechanism in conventional finance is
the dealership model, in which dealers employ asset inventories in over-the-counter trading. This
mechanism is based on building trusting relationships with counterparties. Owing to the secrecy of
transactions, such intermediation is not possible with DeFi, and it also goes against the declared goal
of creating an intermediary-free economy. Decentralised exchanges use so-called autonomous
market-maker protocols to avoid limit order books and the dealer model.

There are many channels through which spillovers can occur such as –

 Leverage
 Liquidity Mismatch
 Run risk in prevalence of stable coin
 Traditional finance system

Concentration can enable collusion and hinder the viability of blockchains. It raises the possibility
that a few major validators may gather enough authority to manipulate the blockchain for financial
advantage. Furthermore, powerful validators might clog the blockchain by conducting fraudulent
transactions between their own wallets, causing other traders' costs to skyrocket. Another fear is that
validators may be able to foreclose huge orders in order to increase trading profits. Although front-
running is also seen in conventional finance, it is frowned upon by authorities. Investors will be
harmed by these rent-seeking behaviors, which may undermine DeFi's appeal in the future.

The vulnerability of stablecoins is determined by their design. Liquidity mismatches exist in coins
backed by short-term assets with illiquid secondary markets, such as commercial paper. Market risk
exists for those backed by volatile collateral, such as cryptoassets, because the value of these assets
might swiftly fall below the face value of stablecoins. Despite the fact that overcollateralization
normally mitigates such risks, it might be depleted when volatility rises.

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 8. Conclusion

The DeFi ecosystem is continuously evolving, despite its tremendous growth. It is now focused
mostly for crypto asset speculation, investment, and arbitrage, rather than real-economy use cases.
DeFi is vulnerable to criminal activity and market manipulation because to the insufficient
implementation of anti-money laundering and know-your-customer (AML/KYC) rules, as well as
transaction anonymity. Overall, DeFi's core assumption - lowering the rents paid to centralised
middlemen – does not appear to have been realised.

History has shown that the early development of innovative technologies is typically accompanied
by bubbles and a loss of market integrity, despite the fact that it produces inventions that might be
useful to a wider audience in the future. DeFi might still play a key role in the financial system with
advancements to blockchain scalability, large-scale tokenization of traditional assets, and, most
critically, appropriate regulation to maintain protections and boost confidence.

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References

i. Borio, C (2019): "On money, debt, trust, and central banking", Cato Journal, no 39, pp 267–
302.
ii. Todorov, K (2021): "Launch of the first US bitcoin ETF: mechanics, impact, and risks" BIS
Quarterly Review, December.
iii. Gorton, G and J Zhang (2021): "Taming wildcat stablecoins", working paper, September.
iv. Kevin Werbach, DeFi Is the Next Frontier for Fintech Regulation, The Regulatory Review
(Dec. 10, 2021), available at https://www.theregreview.org/2021/04/28/werbach-defi-
next-frontier-fintech-regulation/.
v. Gareth Jenkinson, As DeFi booms, Ethereum’s blockchain competitors are catching up,
CoinTelegraph (Jan. 21, 2021), available at https://cointelegraph.com/news/as-defi-
booms-ethereum-s-blockchain-competitors-are-catching-up.
vi. Ian Allison, Insurance Giant Aon Is Testing the Waters of DeFi, CoinDesk (Mar. 3,
2021)

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