Written by Jonny Fry
Writers linkdin: https://www.linkedin.com/in/jonnyfry/

The first Decentralised Finance DeFi project back in 2015 was MakerDAO, which enabled smart contracts to be used to lock up Ethereum tokens and generate Dai, a stablecoin pegged to the U.S. dollar. Fast forward to now - DeFi has $38billion of assets in this sector and in the last 180 days generated over $4billion of revenue.

So, not tiny, but compared to other financial markets, not that significant. Therefore, after seven years the question remains, is DeFi to remain merely a niche sector or can it, indeed, realise its potential and really challenge traditional financial markets? Smart contracts are very much a key driver in the DeFi sector, with IBM defining them as: “Digital contracts stored on a blockchain that are automatically executed when predetermined terms and conditions are met”. Linking with this, decentralised apps (dApps) are applications which use smart contracts and offer the ability to offer many of the services that historically banks have offered - making payments, lending, saving and buying and selling of assets. 

Meanwhile, tokenisation is steadily becoming more prevalent as a natural extension of TradFi for existing asset classes such as equities, debt instruments, commodities, real estate and even national currencies in the form of stablecoins and CBDCs. However, as our lives (including the provision of financial services) become ever more digital, physical national jurisdictions potentially become less relevant - yet local laws and regulations will still need to be adhered to. Digital markets will increasingly need to be globally coordinated if safeguards and investor protection are to remain in place. Therefore, surely there will be the need for consensus as to what actually needs to be regulated, and why:

• the protection of consumers? 

• for market stability?

• to maintain confidence in the markets?

• to encourage innovation?  

DeFi opportunities

• DeFi is inclusive: provided you have a digital wallet and have access to the internet, you are able to use DeFi and not have to rely on banks and other money transfer firms.

• Transactions are transparent: DeFi offers the ability to monitor actions in real-time including the repayment of loans, alterations in interest rates and releasing collateral. As there is greater transparency, users ought to have more confidence and trust.

• Smart contracts: it is possible to automate many traditional risk management and compliance monitoring functions.

• Data is held cryptographically and decentralised: blockchain-powered platforms hold data securely, and permission as to how and when access to data can be pre-programmed before a DeFi transaction is entered into. Since data is decentralised, it has built-in disaster recovery credentials and offers enhanced levels of security from cyber-attacks.

• Disintermediation: DeFi use of blockchain means there is only one ledger/database that the various parties can have access to and, being digital, it is possible to send and receive payments faster and cheaper (especially when dealing on a multi-jurisdictional basis) without having to engage with several intermediaries. This generates cost savings and efficiencies in terms of transactions and reporting.

 DeFi challenges

• Change: DeFi technology is new and regulators and institutions are cautious of change since this could impact on investors, potentially resulting in fines and compensation as well as damaged reputations. Furthermore, many of the systems and procedures are yet to be fully tested although the recent collapse in crypto prices has, for some DeFi platforms, been a baptism of fire.

• Regulation, or lack of: Swarm Markets in Germany was the first licensed DeFi platform globally. There is minimal, if any, protection when things go wrong and not being regulated means that the usual investors compensation schemes are not applicable. The platforms do not need to have insurance or hold capital adequacy reserves for most DeFi, and there are no laws enforcing capital reserves for DeFi service providers.

• Liquidity: many DeFi platforms rely broadly on private clients for transactions potentially creating challenges in times of stress, as we have seen recently. Celsius is an example of a DeFi App which has struggled as investors look to encash. Lack of liquidity has forced prices down.

• Decentralisation: this can present a challenge for regulated investors because they may end up trading with parties which would usually struggle to complete standard AML checks. Given the fines faced by financial institutions in the past around AML, there will be a reluctance to be caught again. Because some DeFi platforms are truly decentralised, there is also the added difficult issue of getting redress (as you do not know who is responsible) in the event of unlawful actions.

• Hacking: this is, and always will be, a risk where money is involved. In 2021, over $10billion was hacked. However, in a rather bizarre incident a so-called ‘ethical hacker’ stole over $610million from the Polygon DeFi platform only then to return it.

• User experience: as with many matters to do with crypto, DeFi is not that easy for a novice as the user has to deal with digital wallets, create, and more importantly, store and remember private keys (aka passwords).

Money and banking.com summarises the challenge DeFi faces since currently much of DeFi is centred around cryptocurrencies: “While the solutions employed in TradFi are often inadequate and incomplete, features such as counterparty identification and centralized verification make them both more complete and more effective than those currently in place in the world of crypto/DeFi.  Ironically, addressing the severe deficiencies in the current crypto/DeFi infrastructure may prove difficult without making highly unpopular changes that make it look more like TradFi - like requiring participants to verify their identity.” 

However, irrespective of the above, DeFi certainly offers new opportunities for traditional, regulated institutions since they understand the added transparency and traceability that using blockchain offers. Equally, as we see DeFi being embraced there will inevitably be some losers such as the brokers and clearing houses who could no longer be needed as much. An example of the growing importance of the DeFi market can be seen in the $100trillion asset management industry. 

JPMorgan Chase’s announcement that it is to tokenise its mutual funds and “introduce $trillions to the DeFi sector” could well prove an inflection point as other fund managers follow suit. This type of activity could well take DeFi from being niche to mainstream and, in turn, encourage other firms to make their borrowing, lending, and services available on DeFi platforms. After all, there is no shortage of customers looking for higher yields, quicker settlement, different investment opportunities, greater transparency, lower costs and generally more flexibility with their money. DeFi offers the potential it can deliver on these wishes.

Source: Teamblockchain

A combination of technologies such AI, Bigdata, IoT blockchain etc., offers the promise that much of the current regulatory reporting and compliance functions could be automated and coordinated on a worldwide basis. This would enable regulated companies to design and market financial services products and services on a global basis, at a fraction of the regulatory and compliance costs they currently incur.