Throughout 2021, DeFi investors have enjoyed yields of 10 per cent, 15 per cent, sometimes 20 per cent on certain digital assets. Very few traditional financial instruments can compete with those returns – and the finance sector knows it.
This is what happens when an industry gets disrupted. Hotels and taxi companies learned this with the emergence of Airbnb and Uber, respectively, and incumbent companies pulled every financial and regulatory lever they could to maintain their positions.
The same is happening now in traditional finance, but with even higher stakes. Throughout 2021, as well, lawmakers, regulators, and heads of central banks have stepped in to nudge the regulation of decentralised finance in their countries. And yet DeFi keeps growing. At the time of writing, more than $100 billion is locked into the DeFi markets. In just a few years, the disintermediation of traditional finance has moved from theory to reality. That reality concerns those who have a vested interest in maintaining the status quo.
Suppose the innovations that Uber and Airbnb — or Netflix and Napster before them — brought to market are at all analogous to what is happening in finance today. In that case, we already know how this story ends and who the winners will be. The only mystery that remains is how this will happen.
Below, we explore how the relationship between decentralised and traditional finance could play out and how institutions can leverage the innovations of the former to ensure they end up on the right side of history.
Central banks and regulators recognise DeFi’s disruptive potential
In the United States, there is a narrative emerging around decentralised finance in Washington that it represents a ‘shadow bank’ and must be brought to heel.
Two comments illustrate this point:
- ‘In my view it is untenable to allow an unregulated, unlicensed derivatives market to compete, side-by-side, with a fully regulated and licensed derivatives market’, Commissioner Dan Berkovitz of the Commodity Futures Trading Commission said in a June speech. ‘… Experience with the development of the “shadow banking” system shows that competition between regulated and unregulated entities in the same market can result in the regulated entities assuming either more risks to generate the higher yields necessary to compete with the unregulated competition or seeking less regulation for themselves to level the playing field’.
- Massachusetts Senator Elizabeth Warren made headlines in September when she called crypto ‘the new shadow bank. It provides many of the same services, but without the consumer protections or financial stability that back up the traditional system’.
While both framed their criticisms of decentralised finance in terms of fair competition and consumer protection, both were clear in their comments that they felt it was the regulator’s role to put the brakes on DeFi, and soon if possible.
Flourish in a sustainable way
Contrast those sentiments with those of Jon Cunliffe, Deputy Governor for Financial Stability at the Bank of England, who in an October speech touted regulation as a way to ‘ensure that the potentially very large benefits of the application of this technology to finance can flourish in a sustainable way’.
Commissioner Berkovitz and Senator Warren’s comments are fair in that decentralised finance certainly carries some risks, as with any sector investment. It can expose participants to higher price volatility than they may be accustomed to, for example, and it puts the heavy responsibility of custodianship on individual investors. Nevertheless, the technologies clearly solve existing problems in the world’s financial systems. This is why Cunliffe’s remarks are particularly noteworthy. They concede that traditional finance would benefit from an injection of innovation. The question now is how much disruption is tolerable.
We will likely see that answer emerge in the next few years, as DeFi and traditional finance work out their differences.
Are financial intermediaries still useful to clients?
As decentralised finance has ascended, conversations have sometimes centred around whether DeFi will eat traditional finance, in the same way, that Marc Andreessen described software eating the world. That’s the wrong way to frame the conversation, argues Kevin Werbach, chair of the Department of Legal Studies and Business Ethics at the University of Pennsylvania’s Wharton Business School. DeFi could simultaneously disrupt, operate alongside of, and integrate with traditional finance, Werbach told MarshMcLennan in a July interview.
‘The question that DeFi poses to traditional finance is whether intermediation is valuable’, he said. ‘If the things that a bank or an asset manager does turn out to be things that can be provided more cheaply and efficiently in an automated way through software, then that will ultimately lead to capital flowing away from those traditional intermediaries’.
This puts the future of finance squarely in the hands of clients. It is the clients who will determine the levels of disruption and disintermediation that the financial sector will undergo.
What the future holds
‘Ultimately, where the average individual puts their money will decide what the future holds’, Will Hamilton, Head of Trading and Research at TCM Capital, wrote in October. ‘ … If incumbent institutions don’t help facilitate access for consumers, they’ll seek it out themselves’.
Building a more accessible financial system with DeFi
At present, both DeFi and traditional finance create steep barriers to entry for clients.
- The traditional finance instruments are hidden behind the many intermediaries that DeFi exists to make obsolete.
- Most DeFi platforms are complex and require a level of tech-savvy that the majority of people simply lack.
There is a world in which each system helps solve the other’s problems. For example, DeFi can learn from the simplicity of choice that traditional finance offers clients, Tranchess co-founder Danny Chong wrote in November:
‘In traditional finance (TradFi), we don’t see a smorgasbord of too many options, confusing the uninitiated without clear directions on where investors should put their investments and what are the risk levels. For more traditional investors to take a leap in faith, we need to simplify it to give investors clear and simple options: hold, earn yield, or go long or short with risk levels indicated’.
Likewise, traditional financial institutions can begin to embrace and integrate the innovations that decentralised finance has introduced. That puts institutions on the ground floor of decision-making when clients begin to decide which intermediaries should stay, and which should go. Furthermore, an infusion of institutional capital could strengthen the DeFi sector to give it greater stability and liquidity.
Guan Zhen, a partner at Singapore-based investment firm Point Hope Group, wrote in September that the next generation of DeFi projects will not be designed by blockchain engineers but ‘by emerging hedge fund talent opting to develop strategies and products on DeFi. It will catalyze a future where investment access is democratised’.
In other words, institutions have the opportunity right now to shape the development of DeFi and its relationship with traditional finance.
The path toward institutional DeFi
Look for a period of consolidation in DeFi as institutional investors commit to the technology. As that consolidation unfolds, the features of a given platform will get moulded in accordance with regulatory requirements and client demand. This is how the technology will get fortified.
From that point of new stability, we imagine partnerships will emerge, and interoperability between traditional and decentralised financial companies will become the norm.
‘It’s easy to think of traditional ‘centralised’ banking infrastructure and DeFi as competitive or oppositional forces — but the reality is that the two are likely to converge over time’, Leon Gauhman, Chief Strategy Officer at digital product consultancy Elsewhen, wrote in June. ‘There’s even a chance DeFi could help financial markets become more resilient by avoiding the friction points and siloes of centralised finance’.
As long-time members and participants of the blockchain community, Appold DeFi’s founders quoted ‘we are uniquely positioned to benefit from this sector growth. As a corporate investor, Appold DeFi’s participation in this industry is to expand the company’s net assets by asset acquisition and strategic positioning within the global Decentralised Finance industry’.
For further questions and advice, please feel free to contact us directly.
Founder and Partner – Appold DeFi