How institutions and organizations respond to DeFi will impact their role in the emerging financial system as it evolves.
What is DeFi?
DeFi is the term given to a new form of financial intermediation that reduces the reliance on central intermediaries. Applications or protocols that are built to facilitate this new form of intermediation are referred to as decentralized applications (DApps) and are built on public blockchain infrastructure. DeFi projects are typically open source, interoperable, internet-based protocol stacks that leverage smart contracts built on public blockchains, such as Ethereum, to facilitate financial services.
Smart contracts that operate on public blockchains, are a critical component of DeFi. Smart contracts are code stored on a blockchain platform that autonomously perform a set of predetermined actions, generally pursuant to terms of an agreement, without the need for an intermediary. Once deployed these smart contracts are immutable and the source code and transactions facilitated by the smart contract are recorded on the blockchain for anyone to view.
For example, a smart contract could be programmed to exchange a certain amount of currency for another, between two counterparties. If the smart contract code verifies that the required currency from each counterparty has been provided, it will execute the transaction, thus eliminating the need for third parties to facilitate the transaction. A group of smart contracts can interact to facilitate a number of different functions and often times an application will rely on multiple smart contracts that are linked together.
Most DeFi services mimic existing services found in today’s tiered financial system but this was not always possible. Historically cryptocurrencies were too volatile to facilitate financial transactions, other than for speculative trading. The answer to this problem came in the form of “stablecoins” – assets that utilize either complex algorithms (as with DAI) or legal relationships with a trusted centralized entity (as with USDC) to peg their market value to an external reference (such as a fiat currency). Stablecoins, given their ability to replicate the features of traditional money and compatibility with DeFi applications, are able to act as a foundational component for facilitating more sophisticated products, similar to the way in which the existing financial system operates.
Why is it important?
If you apply this decentralized peer-to-peer model on a global basis to the various forms of financial transactions that require an intermediary today (for example, collateralized lending, interest-bearing deposits or investment portfolio management), the potential impacts to the existing global financial system and its intermediaries become significant.
DeFi empowers individuals to retain more control over their assets compared to the traditional financial system, and allows individuals the financial freedom to choose how to invest their assets without the need to rely on an intermediary. This does not mean that individuals will no longer need financial guidance or that traditional financial institutions will become obsolete, but the way individuals and institutions interact within the financial system and make financial decisions could look very different in the future.
DeFi will also impact business-to-business interactions. As institutions begin to plug into the blockchain ecosystem, and tokenization of financial assets such as derivatives and securities continues to mature, there is potential for smart contract-based decentralized applications to begin acting as intermediaries between institutions. An example of this would be if, instead of clearing trades through the Depository Trust & Clearing Corporation (DTCC), institutions were able to instantaneously trade tokenized securities in an open marketplace facilitated by smart contracts on the internet.
Another area of disruption will be the tokenization of real-world assets on public blockchains. This will unlock liquidity for firms by allowing historically illiquid assets, such as commercial real estate, to be represented as tradable fractionalized tokens on a public blockchain. These tokens can then be posted as collateral or included in investment pools on DeFi protocols. This will also apply to existing supply chains, as it will allow for a more open smart contract-driven marketplace, where entities transact using privacy-preserving technology on a public blockchain and prices are dictated by market conditions.
What are the opportunities?
DeFi is still in the early stages of innovation and institutions will have a prominent role to play in developing the ecosystem. There are financial opportunities, including new services and products, as well as operational efficiencies that can be gained by leveraging the existing DeFi ecosystem and infrastructure. As this new financial ecosystem continues to evolve it will create significant growth opportunities for institutions that are able to adapt and embrace these changes.
Institutions should investigate the potential opportunities to automate and enhance their processes by leveraging decentralized finance applications.
Examples of ways in which a decentralized finance application could change the traditional process and parties involved include:
- Exchanging digital assets, for example converting Bitcoin for another digital asset in an open internet marketplace, taking all the typical processes of banks and payment service providers, translating them into contract language and automating them
- Lending, borrowing and saving: instead of banks using savings to invest and lend, smart contracts manage deposits, pay interest and lend based on predefined terms outlined by the market
- Derivatives that typically involve a contract with an organization or individual and a clearing house or intermediary to settle, can be managed by smart contracts in an open market
- Tokenizing physical assets or financial assets in the supply chain or financial transactions and allowing for more accurate, efficient and transparent marketplaces
Institutional interest in DeFi will continue to increase as the number of participants and amount of capital locked in these protocols continues to rise. Institutions will take different approaches to how and to what extent they interact with DeFi applications based on their risk appetite and existing capabilities, but no financial institutions can choose to fully ignore the emerging digital economy.
What are the risks?
With any nascent technology or innovation there are several obstacles to overcome – DeFi is no different. There are concerns surrounding regulatory uncertainty, scalability, security and technology risks (software bugs and hacks), governance of decentralized applications and several others.
The largest unknown in DeFi relates to the current lack of anti-money laundering/know your customer (AML/KYC) guidance or frameworks. Proposed guidance by the financial action task force (FATF) seeks to provide clarity around how institutions interacting with DeFi applications should consider AML/KYC requirements but there are still significant factors that need to be clarified. Given DeFi’s unique and complex services, regulatory clarity will take time to evolve.
Cybersecurity is another major risk. Most of the hacks related to cryptocurrencies result from either a weakness in the smart contract source code that is exploited by a malicious actor, an inherent design feature that allows an individual the ability to syphon or withdraw user assets at their discretion, or the mismanagement or theft of private keys. In smart contract-related cases, a thorough review of the smart contracts and protocol would mitigate a substantial amount of the risks. General education around wallets and key management, coupled with established processes for recovery and security, could help resolve risk of key loss or theft.
There are also wider questions around governance. DApps are set up for decentralized community governance, so the process of making changes, updates and strategy decisions is being refined and tested across multiple protocols. A common governance model includes the use of a decentralized autonomous organization (DAO) and a governance token to facilitate voting on changes amongst token holders. Decentralized or community governance is still very new and the communities and processes used will continue to evolve as the industry matures.
Private companies, regulators, developers and public officials are all working to address these concerns and risks but given the depth and breadth of DeFi it will take time for regulatory clarity to emerge. Institutions have a wealth of knowledge and expertise that they can provide to these participants and they will have to work with these groups to bridge the gap between traditional and decentralized finance.
Conclusion
DeFi is one of the latest and possibly the most significant milestones in the evolution of internet-based digital assets and finance. Over time, this decentralized ecosystem and its participants will converge with experienced institutions, who act as the trusted gatekeepers of the traditional financial system. Whether or not institutions prepare to fight or embrace this new technology and form of intermediation will have significant impacts on how they operate and their prolonged success in the emerging digital economy.
Summary
Decentralized finance has the potential to transform financial intermediation, supply chains, and existing business models. Organizations can’t afford to ignore the opportunities it presents. Financial services firms in particular should act quickly to establish themselves as trusted players as regulators catch up with a boom in activity.
