When one thinks about financial systems, what comes to mind? Perhaps financial institutions like banks, central banks, insurance companies, asset managers, and hedge funds? Perhaps financial markets, issuers and investors, public market trading on centralized exchanges with central counterparties and bilateral ‘over-the-counter’ private market trading?
The global financial crisis of 2007/2008 revealed that such institutional, bank-based lending and market-based securities financial systems are easily destabilized, driven by large, centralized, opaque and overly-interconnected financial intermediaries. In fact, only expensive, coordinated action by central banks on both sides of the Atlantic and massive government bailouts saved the entire institutional system from collapse.
Aside from such institutions, consider instead the functions a financial system performs for an economy: facilitating payment for goods and services, managing investments via pooled funds, transforming short-term deposits into long-term loans, managing risk, coordinating decentralized decision-making through financial markets, and overcoming problems stemming from asymmetric access to information and incentives.
Why do financial intermediaries perform some of these functions but not others? One reason has to do with economies of scale and scope in information gathering and processing. Big banks are good at assessing creditworthiness, incentive structures and debt workouts. And really big banks with huge balance sheets have funding cost advantages and enjoy implicit too-big-to-fail government guarantees. Information and communication technology innovations have led institutions to favor automated data-driven decision-making over in-person interaction and consolidation in the globalized economy have led to the emergence of ever bigger financial intermediaries.
Another reason has to do with new competitors. The availability of big data, advances in artificial intelligence, and the rise of digital platforms have fueled the vertical and horizontal disintegration of traditional banks’ business model. Specialized service providers operating on new digital distribution channels now easily provide functions like payments and fund management, which do not require access to deep balance sheets. Digital platforms can simply embed financial services into their ecosystem to reduce search and connectivity costs. While new service providers chip away at banks’ most lucrative services and big-tech platforms take over the communication with customers, banks are relegated to providing up-stream maturity transformation services such as deposit-taking and lending.
What Role do Blockchain and Distributed Ledger Technology Play in Finance?
Blockchains are open-source collaborative software platforms employing distributed ledger technology that sprouted up in the nexus of cryptography, internet computing, and game theory. The fact that they are decentralized, independent of central authority, and built on consensus-based trust makes them globally accessible and censor-resistant. Bitcoin, launched in 2009, was the first public, permissionless blockchain. Ethereum, launched in 2015, offers a programming layer that can deploy and run smart contracts and decentralized applications.
Decentralized platforms operating outside the financial system and government control have driven an unprecedented boom in the native tokens of public permissionless blockchains, also referred to as cryptocurrencies. There are over 9,400 blockchains, tokens, and protocols and the composite value of cryptocurrencies recently surpassed USD 2 trillion.
The boom is mainstream. Facebook’s Libra, now Diem, a global stable coin, challenges not only commercial banks, but also central banks and their currency monopoly. Coinbase, the US-based crypto-exchange with over 50 million registered customers, is now listed on Nasdaq. So-called fintechs, funded by specialized venture capital funds, are developing transformative business models leveraging cryptocurrencies and the blockchain, and even traditional financial intermediaries such as Goldman Sachs and BNY Mellon are beginning to provide cryptocurrency services to their retail and institutional client base. Meanwhile, regulators are scrambling to regulate cryptocurrencies, and central banks are exploring issuing their own digital currencies.
How are financial intermediaries reacting? To stay competitive, financial intermediaries are attempting to reap the economic benefits of a technology that can lower coordination, transaction and reconciliation costs in trade finance, securities issuance and trading, payments and supply chain financing. But rather than simply using blockchain / distributed ledger technology (DLT) to provide better IT solutions for current products and services, financial intermediaries should take a close look at decentralized finance.
What is Decentralized Finance?
Decentralized Finance or ‘DeFi’ is an umbrella term for a growing number of financial applications running predominantly on Ethereum. DeFi is a fast-growing segment of the crypto-space. The total value locked up in DeFi has exploded, recently surpassing USD 100 billion.
DeFi breaks down financial services into its core functions in the form of applications. DeFi applications are often referred to as ‘money Legos’ that can be ‘clicked’ together to build new financial products by connecting contracts with basic payment, lending, exchange and insurance functionalities, thus automating financial services. DeFi applications can also be connected with other smart contracts and machines.
The most popular DeFi applications include (i) lending and borrowing platforms like the Maker decentralized autonomous organization protocol (Maker DAO), (ii) decentralized exchanges (DEXs) like dYdX and Balancer, and (iii) fiat-money, crypto-currency, commodity-backed or algorithmic stable-coins like USD Coin (USDC), DAI, DGX (gold-backed) and AMPL. DeFi also includes payment applications like OmiseGO and the Request network, and prediction markets such as Augur and Gnosis.
New DeFi concepts include yield farming, where cryptocurrencies are put temporarily at the disposal of start-ups, liquidity mining, where DeFi applications entice users by giving out free tokens, and composability, meaning that since the code is public anyone can use the code of one app to ‘compose’ new apps.
DeFi has many advantages. The applications are highly decentralized and inclusive. Their protocols are potentially highly cost-efficient, accessible 24/7 worldwide via the internet, and fully transparent. Basic financial functions like borrowing, lending, investments and payments require no intermediary and there are no access restrictions. All one needs is an electronic wallet with an ‘entry’ crypto-currency like bitcoin or ether, a public address and a private key.
DeFi also has risks, including fraud, protocol error, and service disruption:
Fraud. One day after the DeFi project Meerkat Finance was launched in March 2021, a USD 31 million ‘attack’ took place, behind which some believe its founders were. Unfortunately, ‘bubbles’ often attract large-scale fraud because investors are not always disciplined enough in their due diligence of protocols and sponsors.
Protocol error. DAO, an early autonomous venture capital fund, was compromised due to a loophole in the code. This case demonstrates a key weakness of decentralized applications in dealing with unforeseen situations and highlights the need for software audits and circuit breakers.
Service disruption. Since most DeFi applications are currently running on Ethereum, the ecosystem is exposed to service disruptions of this blockchain, as was the case on March 20, 2020, now called Black Thursday, when the backlog of transactions waiting to be confirmed and registered on the Ethereum blockchain grew too large for the platform to handle these transactions smoothly.
As DeFi enters the mainstream, many questions remain open.
- Are applications fully decentralized?
- Can the ecosystem accommodate more than the currently estimated one million users?
- How can bad actors and money laundering be detected without financial intermediaries performing know-your-customer and anti-money-laundering checks?
- How can consumers be protected from fraud, hacks and ecosystem illiquidity?
- How can application interoperability with other public and private blockchains be ensured?
- What could convince customers to trust DeFi protocols more than banks?
- How will DeFi interact with the current financial system serving billions of customers around the world?
One thing is clear: the future of finance can be as decentralized as blockchains technology allows it and as much as we want it to be.
Axel Wieandt is a Finance professor at WHU Otto-Beisheim School of Management.