Decentralized finance, once a fringe idea, is gaining relevance thanks to a growing number of projects and proponents.
“Software is eating the world. DeFi is the software that is starting to eat Wall Street,” Tyler Winklevoss, founder of Winklevoss Capital Management and the Gemini cryptocurrency exchange, said in a recent tweet.
In its purest form, DeFi is finance that does not rely on central financial intermediaries such as banks, brokerages or exchanges. Instead it relies on smart contracts — legal contracts written in and enforced by software — on blockchains like Ethereum.
This is where DeFi is going: Instead of proving creditworthiness to a bank to obtain a loan, customers can use cryptocurrency as collateral to borrow money through the set terms of a smart contract. Instead of all payments running on traditional rails such as the automated clearinghouse, some will happen through the buying and selling of cryptocurrencies. Instead of trading stocks on a stock market, people can buy and sell cryptocurrency on a blockchain. Smart contracts could automate supply chain finance, cutting middlemen such as auditors out of the process.
The decentralized digital asset exchange Uniswap; MakerDAO, an open-source project on the Ethereum blockchain as well as a decentralized autonomous organization; and Compound, a DeFi lending protocol, are all examples of pure decentralized finance.
To be sure, these efforts are early in their evolution, experts cautioned.
“The space is very experimental,” noted Hong Fang, chief executive of OKCoin, a digital asset exchange that operates in 184 countries, and a former Goldman Sachs banker. “I don’t think we will wake up tomorrow and see banks, Nasdaq or Fidelity being taken out. This is still a pioneer sector. People who are crypto literate will be attracted to it.”
Joe Duncan, a visiting lecturer at Columbia University’s Department of Industrial Engineering and Operations Research who teaches a course on cryptocurrency and blockchain, agreed that the field is compelling but unproven.
“I’m a huge fan of projects like MakerDAO and Uniswap,” Duncan said. “I think they’re all interesting, but we’ll have to see how they develop over time.”
Still, decentralized finance could take on many of the roles that traditional banks fill today, like credit, payments, custody, stored value and onboarding to the financial system, he said.
Meanwhile, hybrid versions of decentralized finance have emerged that blend traditional banking with DeFi. This is sometimes called centralized finance or CeFi. One example is stablecoins, digital currencies that are always equal in value to a central bank currency such as the U.S. dollar and that have centralized issuers. Another example is Coinbase, which lets people buy cryptocurrency, stores it for them and lends against it in a centralized manner. And ConsenSys hosts several Ethereum blockchain-based finance projects, including JPMorgan’s Quorum.
All of this is important to traditional bankers because it represents a new level of competition yet also presents opportunities for banks.
“There are a number of banks that quietly behind the scenes are spending a lot of time on this because they see where the puck is going to be, as opposed to where the puck is today,” said Caitlin Long, founder and CEO of the de novo Avanti Bank in Cheyenne, Wyo. “They understand there’s something important happening here.”
This is a glimpse at where this movement is headed, what it will look like, and where traditional and forward-thinking banks might play a role.
Movement toward DeFi
Alan Lane, CEO of the $2.6 billion-asset Silvergate Bank in San Diego, is a proponent of decentralized finance.
“We believe DeFi could enable a more resilient, efficient and democratic financial system,” he said. “When traditional financial services are made available over a public, permissionless blockchain such as the bitcoin blockchain, anyone with access to the internet and a smartphone can send, receive and store money through a digital wallet.”
This could help people who are underbanked access financial services and better contribute to the world economy, he argued.
Stablecoins could help speed up and lower the cost of payments, Lane said. If the U.S. government issued its own digital currency, then private enterprises like traditional banks and money-services businesses would create the apps and digital wallets that would facilitate payments to the end user.
“There is an art to creating that experience,” Lane said. “Payments that take place on open, decentralized blockchains should look and feel the same way we make payments today with debit cards and smartphones.” Users wouldn’t even know their transactions are taking place on a blockchain.
The typical cross-border payment, Long said, goes through six different institutions: two central banks, two correspondents and an originator and a receiver bank.
“It’s very difficult to figure out where something got caught up in that process, because there are six different institutions involved,” she said. “You can’t have a straight-through process because you have so many intermediaries.”
Like Lane, Long said stablecoins could be used to smooth out this process. Stablecoin transaction volumes crossed the $1 trillion mark in 2020, according to The Block Research.
“There are real signs that something special is happening in the stablecoin world,” Long said. “This is driven by mainstream businesses that are looking at stablecoins as a better, faster, cheaper way to settle a U.S. dollar obligation. Instead of having to go through those six [banks] to get their payments settled, they can actually get it within minutes in stablecoin form.”
In the future, Long sees the potential for pure decentralized, humanless finance.
“Whether we go with smart contracts and distributed ledger architecture, or whether it’s automation using centralized architecture is really the question,” Long said. “But the automation of operational functions is 100% going to happen and it is happening. It’s just happening slowly.”
Middlemen vs. communities
Eliminating middlemen and conducting financial transactions through a smart contract on a distributed ledger is an ideal, but in real life things break. Hackers have broken into smart contracts, and thieves gradually stole $450 million of bitcoin from the Mt. Gox exchange from 2011 to 2014. In traditional financial services, people in contact centers and branches make things right when fraud, errors or breakages occur.
Aaron Wright, a professor of law at Yeshiva University, said the blockchain community is trying to address such issues through community governance.
“Imagine if these financial protocols were run more like Wikipedia and less like hierarchical companies, there may be some benefits to that,” he said. For instance, Wikipedia, which is community governed, has coped with fake news more successfully than traditional companies like Facebook, Twitter and Instagram.
“The question is becoming who’s better able to manage, a centralized company working closely with regulators, or could community-based approaches actually be better?” Wright said. “I think it’s too early to tell, but I personally think when you have all the stakeholders that have the ability to weigh in, you may actually get better decisions.”
One way traditional banks could play a part in DeFi is by using it to make lending more efficient, Lane said.
“Borrowers can securely apply for a loan and receive funding in a matter of minutes and even use digital currencies as collateral,” he said.
Silvergate Bank offers bitcoin-collateralized loans on a homegrown distributed ledger it calls SEN (which stands for Silvergate Exchange Network) Leverage. Customers can obtain and repay loans 24 hours a day, 365 days a year, Lane said.
Other banks could do the same, Duncan pointed out.
“It has surprised me that they’re not being more aggressive in it,” Duncan said. “They’re almost doing nothing.”
Banks will feel the effects of the decentralized movement first in payments, Long says.
“I think it’s really important that a bank stay on top of this, because there are new payment systems coming that offer better, faster, cheaper solutions, and that is an opportunity for them,” she said. “But to the extent that they fight it or ignore it, instead of understanding the opportunity for them to plug into these new networks, they may be on the losing end of this.”
These trends will lead to the rise of the modern core software providers that can helps banks offer services tied to application programming interfaces, Long said.
“If you look at the banks that have succeeded in making that transition, they’ve built middleware for themselves to be able to interface with these new systems,” she said. “I think there’s going to be a big shakeout in the next few years between the banks that have systems that can connect to these new payment rails that settle in minutes and those that can’t.”
Credit: Source link