Decentralized Finance (DeFi), a new field applying blockchain technology to the financial industry, is reshaping the existing structure of the financial system.
This article provides a deep understanding of how DeFi makes traditional financial markets more resilient, improves financial inclusion, boosts innovations to traditional financial services, and whether regulators could set new legal frameworks for it.
DeFi refers to a decentralized financial system supported by various financial applications built by blockchain technology on networks without any involvement of financial intermediaries.
If you want to further explore what DeFi is, please reference our past paper ‘Decentralized Finance – An Overview’.
“Decentralized financial applications can make our financial systems more transparent, more resilient and less fragile,” Salil Deshpande, a partner at Bain Capital Ventures, said.
Incidents such as the 2008 Global Financial Crisis (GFC) and the COVID-19 pandemic illustrate legacy financial systems’ issues and their vulnerability to unforeseen macro-economic events. Blockchain innovators believe that DeFi could identify potential systemic financial risk that legacy capital systems found challenging to identify by providing a distributed framework.
The 2008 GFC is a good example, where the Federal Reserve and American Treasury Department committed an estimated total of US$150 billion to save American International Group inc. (AIG). Thousands of pension funds, hedge funds and mutual funds, were invested or insured by this giant. Systemic risk arose when complex mortgage-backed securities were embedded in ‘safe’ investment products. The interplay of structured products across various asset classes, exchanges, systems, and leverage created contagion potential. A distributed DeFi ecosystem would better allow systemic risk to be mapped across a singular, or many interconnected blockchains.
“If you want to send, lend or borrow money, you don’t need to join a private network like PayPal or Fedwire or a bank,” Peter Johnson, ex-Morgan Stanley banker and now a partner at fintech venture capital firm Jump Capital, said on DeFi’s advantages.
DeFi includes greater participants, with less friction. According to the World Bank’s data, around 1.7 billion adults are unbanked worldwide. Even in the United States, 1 in 5 adults do not hold a bank account, as surveyed by the American Federal Deposit and Insurance Corporation in 2018. If this is the case in one of the most developed nations globally, one can imagine the sheer volume of unbanked individuals in developing countries. However, most unbanked people do have access to smartphones, allowing them access to digital financial services. Micro-loans, yield, savings and transaction accounts are becoming popular at a micro level, with infinite global access.
DeFi is also innovating mega industries at scale – asset management, payment, derivatives, gaming, insurance, mortgages and real estate. The primary use-cases for these industries are efficiencies and pricing – why have many disparate systems with independent pricing mechanisms, when DeFi can house on interconnected blockchains.
“The cost of transacting in cryptocurrencies is significantly lower for local and international transactions to what regular financial institutions propose,” said Charles Awanda, Chief Knowledge Broker at Songhai Labs, a knowledge broker platform and accelerator of innovations.
As reported by the DeFi database DeFi Pulse, the most popular projects in 2020 are lending and borrowing space. Applications built in DeFi replace the role of financial intermediaries, which eliminates the labour and operational costs charged by banks, allowing for lower borrowing and higher lending rates. The higher interest rate premiums, lower remittance costs and speed in DeFi has introduced competition to traditional payment systems and banks, and are forcing them to innovate.
Thanks to the rapid growth of financial technology in the past decade, applying fintech has become one of the primary approaches to lowering transactional friction and maintaining competitiveness among rivals. By 2017, fintech merger and acquisition (M&A) was still an industry outlier, with only 1 in 10 top American banks acquiring fintech startups. However, during 2019, M&A between fintech and banking companies reached a total of US$44.6 billion in funding, and a record of US$233.8 billion in volume through 989 transactions. M&A is often a precursor to maturation of industries. We see this all occur alongside M&A activity within the digital asset industry, providing vertical consolidation and lateral M&A from traditional firms.
The Bank Merger Act and other related laws that ultimately prevent banks from becoming too big to fail have positioned small banks as the main instigators of substantial acquisitions in the past three years. One example was the merger between BB&T Corp. and SunTrust Banks in 2019 to form Truist Financial Corporation, resulting in the sixth biggest commercial bank in the U.S. by assets. Banks were trying to reach economies of scale through M&A for efficiency and competitiveness against emerging financial services. UBS is considering a merger with Credit Suisse to maintain competitiveness and reduce costs as consumers’ desire to save decreases.
However, the remittance costs in banking services still rank the highest amongst all remittance service providers. And together with other remittance service providers, banks seek more innovations to minimize friction and maintain competitiveness.
“There are some basic red flags that apply across any purchase or investment no matter whether it is a digital asset or a traditional security,” Peirce Weighs, commissioner of U.S. Securities and Exchange Commission, said.
Relevant regulatory laws on DeFi are not yet fully developed, but the topic of DeFi regulation has grown alongside DeFi’s expansion. 7 of 10 key members in the SEC admitted that lack of clear regulation could challenge DeFi growth. To cope with the red flags that DeFi presented, financial regulators in countries and regions like America, Britain and Europe started drafting new regulation protocols. For example, Europe is considering including DeFi in Markets in Crypto Assets (MiCA) while Britain and America are experimenting with ‘embedded regulation’ wherein regulatory approaches are built into each DeFi project’s design.
It is frequently argued that DeFi cannot be regulated because no central party holds management responsibility. We feel a well-developed legal framework can boost DeFi growth but will not impose additional risks to DeFi users. DeFi project developers are more likely to be the ones who burden the legal risk when regulations are fully developed. The good news is that “DeFi could eventually fall under the scope of global regulators as it grows in scale”, reported by Ciphertrace which is a forensic team funded by the U.S. Department of Homeland Security to fight crypto crime.
Undoubtedly, whichever your views on resilience, financial inclusion, innovation, or regulation, DeFi is reshaping the traditional financial system and diversifying markets.