What Does DeFi Need To Go Mainstream?

Regulators across the globe are keen to regulate the new digital currencies, financial products and exchanges. The recent announcement by the US regulator CFTC (Commodities and Futures Trading Commission) is a recent example. All regulators say that they aim to provide market protection for consumers and reduce risks in the space. Interestingly the CEOs of many exchanges do not disagree. 

To understand this let’s take a step back to look at the big picture.

Web 3.0 is the next incarnation of the Internet. The first version of the web (Web 1.0) was a collection of websites where most static were web pages and the vast majority of users consumed content and few produced it. In the early 2000s, the advent of Web 2.0 coincided with the Dotcom crash. It enabled the creation of web hubs and platforms where users could offer content and services that could be charged for. 

Web 3.0 is based on the concept of a decentralised control, incorporating concepts such as decentralisation and token-based economics. This means integrity is monitored by a network of authorised validators called “miners” and not by “Big Tech” or an intermediary like a bank. This is very different from Web 2.0, where data and content are essentially centralised in a small group of companies.

An important aspect of Web 3.0 is that it enables the provision of financial services by a decentralisation network of organisations. This approach has significant implications for the banking sector as it effectively transforms the role that banks and institutions have on money, financial products and financial services. In many instances removing them entirely from the equation. 

I bought my first cryptocurrency in 2014, so I do not consider myself a luddite, but I feel there may be too much optimism in the space. Let’s take a look at the building blocks of this new world to better understand where the opportunities but also the real challenges lie. 

The Blockchain 

Is the blockchain overhyped? No. Is it ready to replace existing centralised control mechanisms such as banks, corporations and governments? Also no.

The most well known blockchain is of course the distributed ledger governing Bitcoin, the cryptocurrency with the largest Market Cap. The Bitcoin Blockchain certifies the ownership and tracks all the change of hands experienced by every bitcoin ever created. It provides a decentralised and secure ledger of all bitcoin transactions. As the first of its kind, it now looks slow and less fit for purpose than newer blockchain technologies subsequently launched (think AOL versus yahoo and subsequent players). However, Bitcoin remains a leader due to its superior security and its finite supply. 

Why is there such excitement surrounding blockchain technology? Simply because the blockchain allows the creation of smart contracts that autoexecute when certain conditions are met, eliminating the need for all intermediaries that would normally be necessary to validate and execute transactions. This potentially huge disruption to the financial services industry has of course not gone unnoticed by the incumbents. Practically every financial institution is exploring how they can benefit from the security and efficiency of blockchains. Meanwhile, none of these institutions have abandoned their traditional modus operandi yet as blockchain technology still faces some serious real world challenges. This means that the vast majority of transactions still take place on traditional banking architecture. 

On paper, the blockchain offers huge improvements on the current financial system. But the devil is in the details. Today many blockchains consume huge amounts of energy compared to centralised databases making a systematic use of the blockchain potentially expensive and very damaging to the environment (though there is a rapid trend towards the use of greener energy sources). They also have huge latency - so transactions can take longer than on traditional centralised databases. That makes them unsuitable for many payments transactions. It is estimated that the bitcoin blockchain can validate at 7 transactions a second - as compared to Visa which can process 24,000 transactions per second. 

Lastly blockchains are sometimes erroneously presented as risky even though hacks are practically impossible. In reality the weakest link is their users. The blocks are hard to hack but the wallets are just as vulnerable as traditional banking interfaces as they are vulnerable to human error. But in traditional banking sometimes fraudulent transactions can be reversed. This is mostly not the case in the blockchain.

The real issue is that the financial services industry and their regulators have not developed the rules and practises needed to make blockchain based finance a viable alternative to replacing traditional financial services. 

Is the blockchain the future of finance? Probably but not yet.

Cryptocurrencies

Cryptocurrencies are …? 

Few people understand them and we have even heard many high profile investing and banking world veterans denounce them as valueless and overhyped. However they have not only outperformed every other investable asset in the past decade but their adoption has also continued at pace. Slowly influential people like Jamie Dimon at JP Morgan are reversing their negative stance.

Despite their massive volatility, it is clear that cryptocurrencies as an investable asset are already part of the financial ecosystem and they will remain so. We are in the land grab phase of the industry and as such inevitably, some (most?) projects will inevitably not succeed - but there will still be massive success stories. In the recent past several regulators, governments and financial institutions have portrayed them as dangerous and illegal, but today most are seeing them as an effective addition to the financial tools available to us. We are seeing financial and governmental institutions getting involved across the globe - most realise that they need to balance the need to get involved with the risk of damaging a powerful innovation. Two high profile recent interventions are the role regulators played in causing Meta to abandon its global cryptocurrency Diem and the Chinese government’s ban on their citizens of trading or mining cryptocurrencies has not had a discerning impact on the global crypto market it has just cut Chinese citizens from taking part. At the same time, governments are looking to use this technology themselves. Several economies - including China - have issued CBDCs (digital currencies issued by sovereign states) and the Central Banks of many big markets such as the US, Canada, The EU, Japan, India and the UK are all exploring CBDCs.

Cryptos and CBDCs use very similar technology (even if not all CBDCs will be using distributed ledger technology) but they are very different beasts. The first are independent currencies whose value is largely defined by supply and demand. The second is a macroeconomic tool that can be manipulated and directed to address the issuer’s political and economic objectives. They are (or will) both be traded on specialised exchanges that are most certainly going to be regulated due to many reasons: to make the trading parties feel protected, to fight illegal traders and for the governments to be able to tax transactions. Cynically many feel that the latter is the most important reason for governments' drive to regulate. 

Regulation remains perhaps the most uncertain and complex issue facing anyone involved in this space. Greater regulation may be welcomed by some including traditional asset managers who will feel they can deploy far larger amounts of capital into cryptocurrencies when the playing field is clear. As we said, surprisingly many of the exchanges are happy for the validation regulation would bring, as it may cause short term constraints but designed well it could lead to a real extension of their addressable market.

NFTs

 2021 was the year NFTs - Non-Fungible Tokens - really took off. They are attracting lots of attention as all kinds of assets like the first tweet or an actor’s “artwork” are being transformed into NFTs and sold. To oversimplify a complex product, a cryptocurrency is a fungible token as it can be replaced with another token that is of identical value. An NFT is unique and each one has a value inherent to itself. They can be sold but they are not mutually exchangeable for an identical item. In theory the NFTs can accelerate the adoption of blockchain based financial services: assets or deeds to assets can be stored as NFTs and can be traded using cryptocurrencies or linked to smart contracts. These NFTs can also be fragmented so you could own a percentage of a Jack Dorsey tweet or a flat in Kyiv if you wanted to. This makes their potential great, but to date few real financial products have been created using NFTs. According to Investment Bank Jeffries the size of the NFT market should reach $80B by 2025. 

This is a great growth but still a fraction of global financial transactions. The NFTs could be useful in making markets more efficient but in their current incarnations they are simply a proof of concept. The reason for this is uncertainty about how they operate and are regulated. The rules, requirements and expectation of buyer and seller are still ambiguous and not transparent. Until the rules of how NFTs operate are clear they will probably remain a marginal product.

DeFi

DeFI or Decentralised Finance is the natural outcome of the invention of NFTs, Crypto and the Blockchain. If assets can exist without the validation of a central entity, then financial products can be created and offered using these tools that do not rely on one central provider. For example I could receive interest for my crypto holdings if I pass ownership to another entity that needs the liquidity and that is willing to pay me to “park” my money on their account. The same could be done by me receiving the rights to a property through an NFT from a person in need for a loan guaranteed by some fraction of the value of the property. These products are not new. The way they are delivered is. So in theory I could get a much better deal through them than through a bank and all its associated intermediaries. This is the core objective of DeFi to decentralise and maybe even democratise finance. This is not a hypothetical opportunity; these types of transactions are already happening across the globe.

But these financial transactions are more efficient but also potentially riskier than engaging with a traditional financial approach (aka knows an TradFi). With DeFi I could get a higher rate for my crypto savings than with my TradFi bank, but the provider of this savings product could also potentially disappear with my funds. Without a regulatory and legal blanket, my recourse options to be able to recover the DeFi loan I have extended if the borrower stops paying me, is not clear. Many legal protections we are used to when engaging in financial transactions may not apply to DeFi. Some see DeFi users are courageous individuals that are currently being rewarded for their courage with higher returns. 

Until regulation covers DeFi, it risks remaining a marginal product suitable for a select few.

I’m sure that by now you see a trend. 

The mass adoption of the Blockchain, Cryptocurrencies, NFTs and DeFi is dependent on one one need. The need to be regulated. Until they are, some will use them but the mass of the market will stick to traditional banking services. So the only thing that will make Web 3.0 finance mainstream is to come under the umbrella of what most of the finance entrepreneurs say they hate the most: Regulation.