In the near future, algorithms and decentralized computer programs will determine how value is created, exchanged, transferred, and turned into financial instruments and derivatives. The financial industry, which has traditionally taken this role, will transform as this technology—dubbed DeFi—replaces legacy financial infrastructure and leads to an age of ‘integrated value exchange.’
Intro to DeFi
Decentralized finance, or DeFi, is a general term used for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries (banks, brokers, wealth managers, etc.). According to Coindesk, “DeFi draws inspiration from blockchain, the technology behind the digital currency bitcoin, which allows several entities to hold a copy of a history of transactions, meaning it isn’t controlled by a single, central source.”
DeFi applications, built primarily on the public Ethereum blockchain, are surging, notes Gartner in a recent report: “DeFi applications are primarily the domain of cryptocurrency speculators hungry for triple-digit yields … but DeFi has the potential to transform financial services and move into the mainstream...”
That potential is happening right now. DeFi has gone from a $1 billion industry in 2019 to over $100 billion today. Beyond crypto traders, legacy financial institutions understand the need to get in front of this technology.
DeFi transforming the financial industry
In much the same way as artificial intelligence and machine learning in FinTech are disrupting the wealth management space, DeFi will transform banking and financial services. For instance, the “robo-advisor” in wealth management commoditized several core financial advisor services, like reviewing and constructing portfolios. Once adopted, the same “robo-advisors” that had disrupted them were then allowing these companies to operate more efficiently and work with clients that they would not have served previously, such as those with lower income. Advisors, meanwhile, began to focus on more valuable services, such as holistic financial planning. This is a common theme seen in disruptive technologies.
Along the same lines, DeFi will commoditize some of the core services that banks, financial services companies, and even FinTechs offer today, such as lending, and it will enable them to provide services more efficiently, benefitting the end-consumer. Forward-thinking businesses will need to understand where the risks for disruption are. For example, financial institutions may take a more significant focus on the customer/investor experience as they see DeFi’s potential to compete much more cost-effectively with some of their core products and services. (See Beyond the Bot, where Gartner predicts that soon “89 percent of businesses will compete mostly on customer experience.”)
“Many enterprises still haven't really grasped the implications of DeFi yet,” notes Gabe Higgins, Blockspaces co-founder, “but several pioneers are paving the way. Traditional companies like Shapeshift and Binance, which are both digital asset exchanges, have taken strides in embracing DeFi instead of waiting to be disintermediated. It won't be too long before financial services will need to confront the fact that their long-standing, entrenched services are being replaced by decentralized protocols that give users more transparency and control over their assets.”
There is hope for banks, FinTechs, and anyone else wanting to get ahead of the curve and build financial technology leveraging these emerging trends. As much of what is happening in this space is made using open-source technology, DeFi protocols can be used to deploy innovative, differentiated products and services rapidly. The great thing about this space is that much of the tech being created is at the infrastructure and middleware level, allowing people or organizations to build valuable applications that serve specific use-cases quickly. This is why the DeFi space was able to gain so much traction and innovate as fast as it did. Developers can sometimes spin up a new product in literally just a few days. However, we aren’t really seeing enterprises engaging at this level yet, a potential opportunity in the near future.
As previously stated, DeFi is built on a distributed ledger infrastructure. The advantage of building applications on top of distributed systems is that it allows open access and can disintermediate certain actors, making many financial use-cases more efficient and less costly. DeFi applications can run autonomously without the influence of a central operator; they are often governed in a democratic fashion whereby the users have control over the future of the application or protocol.
Almost any centralized financial service or product could be replaced by decentralized protocols and/or blockchain-based tokens. We're currently seeing this in lending and trading. For example, in the DeFi lending space, the protocol disintermediates the lender matching process, the risk management process, loan provisioning, and the ultimate transfer of value between parties.
In the investment management space, crypto tokens and blockchain-based algorithms are starting to replace the need for ETFs (Exchange Traded Funds), mutual funds—baskets of assets and equities—and even hedge funds, enabling lower fees and virtually no limitations in terms of access.
For example, suppose decentralized protocols/algorithms are applied. In that case, there doesn’t even need to be an intermediary manager, perhaps just a token derivative representing the individual stocks or assets, and a computer algorithm that rebalances and/or trades based on a set of rules or criteria. All of this happens automatically due to smart contracts (essentially self-executing programs that run on a blockchain).
Finally, DeFi protocols democratize access since anyone can use them. Banks only provide services to individuals who meet specific requirements around credit, account balances, etc. DeFi protocols’ open-source nature makes them, by default, open for use by anyone with the right means to access them (a device, internet, and a crypto wallet).
“We've seen the first iteration of this with the internet,” says Tyler Tarsi, CTO Recursive Research. “Instead of being located in a major city, people can contribute value from anywhere in the world with just a connection. But what we've lacked so far is an effective way to transfer value in an internet-native way, and that's where DeFi infrastructure comes in. I'm excited for that because it's much more equitable and transparent than the gated world we live in today. It's going to take a while to get there, building new financial infrastructure from scratch is no small feat. But it is inevitable.”
What does the future look like?
“All sources of value will be tokenized so that value can flow freely across geographies and industries,” explains Tarsi. “People from traditional finance are often skeptical about DeFi because it's just about tokens. But this misses the point. Tokens can be used to represent anything—real estate, social clout, employment, community membership.”
It isn’t crazy to think that our future will allow almost anything to be valued and transacted. Hence the term we’re dubbing ‘integrated value exchange’—a system in which many forms of value can be exchanged digitally with relatively low cost and friction over decentralized networks. We have the capability today to represent almost anything as a token and monetize and/or transact it. The main problem that prevents us from achieving this lies in liquidity. Will there be a market for tokens that can actually be bought or sold? With the innovation of liquidity pools to create markets—the foundation of DeFi—the exchange of value across assets becomes much more accessible.
In DeFi, liquidity is provisioned and aggregated across many different cryptocurrencies to enable decentralized trading. Creating pools of liquidity can be drawn from instantly, rather than having to match a buyer and seller at the time of transaction. DeFi incentivizes people who provide up-front liquidity in order to create markets between assets. When you want to access some of this liquidity, an algorithm will determine how the transaction will work (i.e., how much of one asset you should get and at what price for another). These algorithms are referred to as Automated Market Makers (AMMs).
What’s interesting about this phenomenon is that these pools of liquidity can be tied together. Pools of liquidity may exist across different assets but not necessarily between each specific asset. For example, a pool (or market) may exist between Asset A and Asset B and also between Asset B and Asset C. But what if we want to convert Asset A to Asset C? Traditionally, you might have to find a buyer or seller for Asset B, make that transaction, and then go and find a buyer/seller for Asset C. This could be expensive and time-consuming and creates friction when trying to make this process happen digitally.
Think about it: a whole payment processing industry exists for this purpose, and the number of assets they exchange between is still very slim. However, if all of the liquidity was readily available and could ‘hop’ between assets frictionlessly, you can make the leap from Asset A to Asset C much more efficiently. DeFi enables this, and it can do so across a much broader selection of assets at a level of an efficiency greater than what is possible currently. In a future where there will likely be trillions locked in DeFi liquidity and where the spider web of ‘liquidity connected assets’ grows wider and wider, we can imagine how the exchange of a myriad of assets will be possible with very little friction. This would mean there could be much more liquidity for previously illiquid assets, like real estate, art, and other physical assets.
This concept gives rise to an entirely new paradigm of how value can be transacted. Within the next decade, you may go into your favorite store and choose to pay with a digital wallet composed of a combination of different assets that you own. Perhaps some fiat currency (i.e., USD), some Bitcoin, some digital collectibles (i.e., NFTs), and maybe even some instantaneous debt you need to issue to cover the rest of the purchase (i.e., a DeFi loan). There may even be a day sometime soon where you will be able to pay for everyday items in tokenized representations of your home’s equity. As Tyler Tarsi stated, tokens can be used to represent anything, and therefore the possibilities are endless for what you will be able to transact with given ample liquidity.
While at the checkout counter in the future, you would simply scan your smartphone over the cashier’s point-of-sale system which would trigger a transaction from your universal wallet that would store all of your assets. Based on the assets you decided you wanted to pay with, they would all be automatically exchanged and transferred to the merchant in whatever form of value they wish to accept.
While there may be some other hurdles to realize this vision for all asset types, such as assessing the value and accessing liquidity for unique assets like real estate, these are not challenges outside the scope of what we can achieve. The future will be seamless cross-asset value transfer, or ‘integrated value exchange.’
David Steen has spent the last 10+ years as a technical trader in cryptocurrency, derivatives, and foreign exchange markets. Cryptocurrency sparked his curiosity in 2012, and by 2017 he was working with multiple blockchain/crypto companies in the areas of self-sovereign identity, anti-fraud, and gamification. As a data-driven growth strategist/analyst, he often works with companies that have revenue between $0-100 million, however, it’s the startup mentality that he’s drawn to most.
David can be reached at firstname.lastname@example.org.