A vision of finance: the rise of DeFi

October 2020 | FEATURE | BANKING & FINANCE

Financier Worldwide Magazine

October 2020 Issue

Open, permissionless and interlocking, decentralised finance (DeFi) – a monetary system built on public blockchains such as Bitcoin and Ethereum – has grown rapidly in recent years, piquing the interest of investors and technologists across the world.

According to Binance Academy, DeFi can be defined as the “movement that promotes the use of decentralised networks and open source software to create multiple types of financial services and products”. The idea, it says, is to “develop and operate financial decentralised applications (dApps) on top of a transparent and trustless framework”, including permissionless blockchains and other peer-to-peer (P2P) protocols.

“Empowered by blockchain technology, decentralised financial services have the potential to broaden financial inclusion, facilitate open access, encourage permissionless innovation, and create new opportunities for entrepreneurs and innovators,” states the 2019 report ‘Blockchain Disruption and Decentralized Finance: The Rise of Decentralized Business Models’. “As a new area of financial technology, DeFi may reshape the structure of modern finance and create a new landscape for entrepreneurship and innovation, showcasing the promises and challenges of decentralised business models.”

Currently, the three largest functions of DeFi are: (i) creating monetary banking services (e.g., the issuance of stablecoins); (ii) providing peer-to-peer or pooled lending and borrowing platforms; and (iii) enabling advanced financial instruments such as DEX, tokenisation platforms, derivatives and predictions markets.

“Overall, the blockchain-powered DeFi space is still nascent but offers a compelling value proposition, whereby individuals and institutions make use of broader access to financial applications without the need for a trusted intermediary,” says Philipp Sandner, founder of the Frankfurt School Blockchain Center. “People previously without access to such financial services could especially benefit from this development.

“Even more so, DeFi promises a full-fledged capital market,” he continues. “In contrast to the decentralisation of money through Bitcoin, DeFi aims for a broader approach of generally decentralising the traditional financial industry. The core of the initiative is to open traditional financial services to everyone, in providing a permissionless financial service ecosystem based on blockchain infrastructure.”

“While DeFi is perceived by many as the utopia of the future of financial markets, the system still operates within an unregulated environment.”

That said, while DeFi is perceived by many as the utopia of the future of financial markets, the system still operates within an unregulated environment. “The first step toward institutional and government buy-in is the custody infrastructure integrated by banks and financial intermediaries,” says Max Heinzle, chief executive of area2invest. “We are consequently moving toward a peer-to-peer financial market infrastructure with 24/7 markets, where we might even see a change of roles of so-called financial intermediaries.”

Problematic integration

While DeFi platforms have gained significant traction in recent years, integrating new blockchain-based structures with traditional financial systems is proving to be a significant challenge.

“Broadly speaking, DeFi is an ambitious attempt to decentralise core traditional financial use cases like trading, lending, investment, wealth management, payment and insurance on the blockchain,” explains Mr Sandner. “DeFi is based on dApps or protocols. By running these dApps on a blockchain, it provides a peer-to-peer financial network. Like Lego building blocks, every dApp can be combined with each other. Smart contracts work as connectors – comparable with perfectly specified application programme interfaces (APIs) in traditional systems.”

One potential key to integration is for blockchain-based financial systems to complement rather than replace the existing financial infrastructure. “We are seeing an increasing demand for regulated custody infrastructure being adopted by banks and financial intermediaries as a first step,” observes Mr Heinzle. “The second move is to connect this base infrastructure with modules such as access to liquidity on primary and secondary markets, tokenisation engines of digital assets or lifecycle management of such assets.

“While big banks continue trying to integrate DeFi infrastructure into core banking systems, small and agile banks are attempting to build a parallel IT infrastructure to avoid touching legacy systems,” he continues. “Though multinational banks are still on the innovation cycle of adopting cloud infrastructure, they also face the task of integrating DeFi. The next five years will be a challenging time for banks as they cope with new technologies.”

Innovative experimentation

Nascent though it may be, DeFI nevertheless appears set to disrupt the financial services sector in the years ahead. So, as digital finance methodologies continue to burgeon, to what extent is existing financial infrastructure on ‘borrowed time’?

In the opinion of Mr Sandner, it will take up to seven years before DeFi products potentially pose a threat to the existing financial infrastructure. “Given existing roadblocks, particularly accessibility and thin liquidity, DeFi is currently a space of innovative experimentation instead of professional financial operations,” he says. “However, this can be said for the majority of the crypto ecosystem. Owing to its nascency, these issues might be mitigated as the industry matures.”

Although nascent, in the view of Mr Heinzle, the first wave of DeFi has already hit traditional financial markets in terms of the adoption of infrastructure for managing and storing cryptocurrencies. “However, we are still in the very early stages, in which it is still undecided as to which blockchain protocol will be the dominant one for the financial services sector,” he opines. “Ultimately, I believe the unregulated DeFi world will merge with the regulated financial world – a transformational route of five years until we clearly know the path.”

Fraser Tennant