The recent 108-page “Kalifa Review of UK Fintech” report mentions Decentralised Finance exactly once, in the context of how crypto-assets should be regulated.
This cursory mention stands in contrast with legendary venture capitalist Ben Horowitz’s recent characterisation of DeFi as one of the key inflexion points towards a decentralised internet. This gap between the innovators’ excitement and the policymaker’s coverage of DeFi will be bridged in 2021 as policymakers become much more aware of why DeFi presents opportunities that London must capitalise on to retain its title as one of the major fintech capitals of the world.
Decentralised finance, commonly abbreviated as DeFi, represents an entirely new way of building the infrastructure for financial services.
Unlike mainstream financial services that are deployed on brittle, legacy technology hosted inside a bank’s firewalls, DeFi applications are networked algorithms or ‘protocols’ that are deployed as smart contracts on public blockchain technology.
This novel architecture enables decentralisation in two ways – first, the technology is controlled not by a rent-seeking monopoly or oligopoly but by a community that operates in an environment of near-perfect competition.
Second, any changes to the technology or economics of the protocol require democratic decision making in a transparent setting rather than by a small group of individuals with their biases and idiosyncratic motivations vying for personal rather than collective benefit of stakeholders.
Indeed, this “stakeholder problem” lies at the heart of the challenge that global regulators face in regulating the modern financial system.
Due to lack of transparency, financial institutions lack incentives to act in the best interest of all stakeholders and not just the majority shareholders or executives while externalising risks to the taxpayer.
Regulators have tried to address such perverse incentives by making more and more rules, which require endless inspection and verification by an oligopoly of audit firms, the cost of which is again borne by customers and minority shareholders.
Fixing broken rules
Unfortunately, creating more rules to fix previously broken rules has not worked for anyone. Financial institutions are incentivised to follow the letter rather than the spirit of conduct and prudential regulation, concentrating returns in a small section of the society and costs to the main street.
Economic inequality continues to increase, profitability of banks continues to decline and egregious conduct issues such as the Wirecard debacle continue to occur with unfailing regularity. Arguably, all that the volume of new rules since 2010 may have achieved is to transfer systemic risk into the shadow banking system and make the entire financial industry less profitable and less able to serve the marginal customer.
Further, while the current generation of mobile-centric fintech applications has delivered a superior, lower friction user experience by eliminating brick, mortar and mainframe in favour of scalable software as a service platforms and APIs, such services haven’t made much progress in reducing systemic risks in the financial system.
In fact, by applying behavioural analytics techniques from Facebook, trading applications such as Robinhood and ‘Buy Now Pay Later’ applications such as Klarna may have increased the risk to the financial health of customers.
This stakeholder problem in fintech was highlighted recently when Robinhood, which monetise customer order data by selling them to a large hedge fund, also stopped Reddit subscribers from selling GameStop stock ($GME) leading to substantial losses to individual customers.
In contrast, the DeFi movement takes the view that “Sunlight is the best disinfectant”. Instead of relying on a vast stack of paper that requires an oligopoly of auditors to implement containing myriad, mutually conflicting rules, DeFi emphasises transparency and automation, opening the doors to low-cost financial services to everyone.
Instead of endless paperwork, DeFi relies on open-source software that can be inspected, reviewed or tested by anyone. For instance, it is not possible for a DeFi protocol to discriminate between users based on gender or ethnicity without such discrimination being immediately detected by anyone looking at the code.
Such transparency of logic enables a fundamentally fairer and more inclusive architecture for financial services – something that no number of paper-based rules, controls and audits can deliver.
Similarly, if the decision-making power in a DeFi protocol is heavily concentrated in a few hands, this fact would come to light immediately thanks to the array of blockchain analytics tools like Nansen.ai and Dune Analytics. Further, if a DeFi protocol is exposed to solvency or liquidity risks, protocol token holders have an in-built economic incentive in the form of tokens to create and champion proposals to mitigate such risks.
This promise of innovation, efficiency, transparency and inclusion at scale has attracted the attention of innovators across the technology and financial services industries.
Starting from an aggregate $600 million in assets in 2019, DeFi protocols have grown to nearly a million users, $40 billion in assets and nearly $60 billion in market capitalisation in 14 short months.
DeFi applications today include collateralised lending, automated market makers and collateralised derivatives trading among others.
More recently, DeFi protocols are finding compelling applications with adjacent spaces such as the $180 billion gaming industry, the $67 billion art industry and the $53 billion music industry, thus truly starting to deliver the internet of value that Bitcoin promised.
Competition for talent and investment in this sector is fierce and the UK can lead in this exponentially growing sector of fintech by working closely with innovators and creating a favourable policy environment for DeFi start-ups, investors and professionals.
DeFi is indeed too big an opportunity for the world’s fintech capital to miss and we must capitalise on it in the way we have done in the previous generation of fintech applications and services.
Head of Institutional Business at Aave
Aave is the world’s leading DeFi liquidity protocol. Decentralised finance creates significant opportunities for financial institutions to enhance market transparency, market efficiency, financial inclusion and systemic risk reduction for consumers worldwide.
Ajit drives institutional growth, strategy and partnerships to enable institutions to participate in decentralised finance.
The previous five years of his career were devoted to building bridges between financial institutions and the crypto/internet of value ecosystem. This included building banking and payments rails for Binance and Paxful, advising crypto startups, driving the buildout of the fintech practice for ConsenSys and building the UK Blockchain Business for PwC.