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Decentralized Finance Will Change Your Understanding Of Financial Systems
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Decentralized Finance Will Change
Your Understanding Of Financial
Systems
PHILIPP SANDNER FEBRUARY 22, 2021
Authors: Benedikt Eikmanns, Prof. Dr. Isabell Welpe, Prof. Dr. Philipp Sandner
Decentralized Finance (DeFi) is likely to have a significant impact on how
banks operate in the future – and even has the potential to shift the
structure of the whole financial system at a macroeconomic level. Before we
discuss and substantiate this hypothesis, we would first like to introduce the
core concept of DeFi.
Decentralized Finance or “DeFi” in short, is an umbrella term encompassing
the vision of a financial system that functions without any intermediaries,
such as banks, insurances or clearinghouses, and is operated just by the
power of smart contracts. DeFi applications strive to fulfill the services of
traditional finance (also coined as Centralized Finance, or just CeFi) – but
in a completely permissionless, global and transparent manner.
DeFi applications could be at the verge of
challenging traditional finance actors on
various fronts
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The vision of a new financial system accompanies the blockchain space since
its inception. However, while it has been an aspirational dream for the
blockchain community in the past, the vision of a new financial system has
come some steps closer.
Bitcoin on hundred dollars bills
Photo by Bermix Studio on Unsplash
Since 2020, DeFi is growing at an astonishing pace and billions of USD
have been put in the ecosystem. The growth is mainly led by applications
(also denominated as protocols) that are built on the Ethereum blockchain.
In the following, we give an overview of the actors in the DeFi ecosystem
from an economic point of view, introduce the maturity stages of DeFi and
explain the potential of DeFi to outperform the traditional finance system in
the years to come.
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The primary business model of commercial banks is to accept deposits and
to give loans to its clients. Borrowing and lending are an elementary
cornerstone of an efficient financial system as holders of funds get an
incentive to provide liquidity to the markets and in exchange earn a return
on their otherwise unproductive assets.
DeFi protocols enable for the first time to borrow or lend money on a large
scale between unknown participants and without any intermediaries. Those
applications bring lenders and borrowers together and set interest rates
automatically in accordance with supply and demand. Moreover, those
protocols are truly inclusive, as anybody can interact with them at any time,
from any location, and with any amount.
In fact, the recent hype around DeFi applications is largely driven by the
advancement of borrowing and lending protocols, such as Compound. In
contrast to traditional finance, loans in DeFi are commonly secured by overcollateralization. However, companies such as Aave are currently working on
enabling uncollateralized loans similarly to traditional finance.
Investment banks and issuers of financial instruments
The business model of investment banks usually involves the advisory on
financial transactions. Also, the creation or trading of complex financial
products and the management of assets fall in the realm of investment
banks. DeFi protocols are already offering similar products.
For instance, Synthetix is a derivatives issuance protocol, which enables the
decentral creation and trading of derivatives on assets such as stocks,
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currencies, and commodities. Also, decentral asset management for
cryptocurrencies is evolving. Yearn Finance, for example, is an autonomous
protocol, which searches for the best yields in the DeFi space and invests
automatically for its users.
The function of an exchange is to organize the trading of different assets,
such as stocks or foreign currencies, between two or more market
participants. Even the exchange of cryptocurrencies against fiat money (e.g.
US Dollar) can be attributed to CeFi, as the regular holder of
cryptocurrencies needs to use exchanges like Coinbase or Binance (which are
centralized organizations) to swap a unit of a cryptocurrency against
another.
Now, with the emergence of decentralized exchanges (DEX), holders of
cryptocurrencies no longer need to leave the crypto space for swapping their
tokens. A prominent example of a DEX is Uniswap. DEX are composed of
smart contracts that hold liquidity reserves and function according to
defined pricing mechanisms. Such automated liquidity protocols play a key
role in the development of an independent decentralized ecosystem without
any CeFi intermediaries.
An important function of insurance is to smooth out risks and bring
security for market participants. An example of decentralized insurance is
Nexus Mutual, which offers insurances that cover bugs in smart contracts.
Since everything is based on smart contracts in DeFi, vulnerabilities in the
code of smart contracts is a fundamental risk for DeFi users. Decentralized
insurances are still in their infancy, but it can be expected that a larger
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amount and more sophisticated insurance models have the potential to
emerge in the DeFi space in the future.
So-called stablecoins are based on blockchain protocols that have the
principle of price stability inherently encoded and, thus, fulfill the function
of a reserve currency. The introduction of stablecoins set the foundation of
the functioning decentralized financial system, as they enable participants to
engage with each other without the underlying risk of price volatility. There
are three options how a cryptocurrency can reach price stability.
First, stablecoins can reach high degrees of price stability by pegging a
currency to other assets. For example, for each issued unit of USD Coin a
real US Dollar is held in reserve.
From a decentralized finance perspective, another interesting approach is the
issuance of stablecoins by using other cryptocurrencies as collateral. A
central protocol for the Defi ecosystem is Maker DAO, which issues the
cryptocurrency DAI that is backed by other cryptocurrencies and ensures
with its algorithm that the value of 1 DAI is hovering around the value of 1
US Dollar.
Thirdly, there are more experimental approaches that aim to reach price
stability without the use of collaterals. For instance, the protocol Ampleforth
automatically adjusts the supply of token in accordance with demand.
Crypto-based finance has reached the
next maturity stage, as it covers all basic
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Decentralized Finance Will Change Your Understanding Of Financial Systems
functions of a financial system
We argue that DeFi has reached an important intermediate step to become a
substitute for traditional finance solutions. While crypto-based finance
solutions were merely capable of realizing efficient value transfers in the past,
now the time value of money is reflected in crypto-finance.
Three maturity stages of a decentralized finance
system
Stage 1: Efficient value transfers
Until now, centralized exchanges and wallet providers have been the only
successful blockchain business models at scale. The reason for the success of
centralized exchanges is that they are the main entry point to the crypto
space (see Figure 1). The common user needs to swap fiat money (e.g. US
Dollar) against a cryptocurrency before being able to interact with services
in decentralized finance. Furthermore, wallet applications are established
that enable users to safely store and transfer their cryptocurrencies.
Based on those two applications, exchanges and wallets, efficient value
transfers between unknown parties could be conducted for the first time
without the need of traditional finance actors. This enabled the crypto space
to fulfill limited functions of a financial system, namely speculation on
(crypto) assets and the facilitation of payments. Thus, disintermediation of
financial firms occurred – but only, if savers of traditional finance wanted to
diversify their portfolio towards crypto assets or needed a frictionless
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payment system. We propose this to be the first maturity stage of a
decentralized finance system.
Figure 1: First maturity stage - The crypto space as alternative for value storage and payments
Own illustration
Stage 2: Connecting savers and borrowers
Still missing was the ability to deal with flows of funds from savers to
borrowers and vice versa. In the following years, additional elements of a
more advanced financial system were developed. The function of a payment
system could be advanced with the development of stablecoins,
decentralized exchanges, and borrowing/lending protocols. Thereby, DeFi
developed the necessary platforms for facilitating the flows between savers
and borrowers.
It might be no coincidence that the start of the explosive growth for the
whole DeFi ecosystem could be observed with the advancement of the
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lending/borrowing protocol Compound. Since Compound started the
distribution of its governance token, COMP, on June 15, 2020, the whole
DeFi ecosystem showed a steep growth trajectory. Functioning
lending/borrowing protocols, such as Compound, might have been the
missing cornerstone for the foundation of a properly working decentralized
financial system. This can be marked as the second maturity stage of the
decentralized finance system.
Figure 2: Second maturity stage – Schematic illustration of the interplay between traditional ... [+] finance
and decentralized finance
Own illustration
Stage 3: Competing for traditional finance funds
DeFi can be described as a platform that is competing with traditional
financial firms for the same resources. However, DeFi is an encapsulated
system, which is not obeying the same rules as traditional finance. In
particular, national law does not apply and regulatory policies can hardly be
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enforced in the DeFi space. This might be a major competitive advantage
over the highly regulated traditional finance firms.
For example, financial innovations can be freely developed and implemented
in DeFi without regarding regulatory boundaries. On the other hand, the
absence of common legislative and political principles has certainly major
disadvantages. It can be doubted that mainstream savers would consider the
current DeFi environment a trustworthy destination to invest their pension.
Hence, the crucial question for the advancement of DeFi to the next
evolutionary stage will be:
To which degree are savers of traditional finance willing to relocate their
funds towards DeFi applications?
To which degree are borrowers of traditional finance willing to access
funds from DeFi applications?
To answer both questions at the current point in time: Only to a very
limited degree. The reason is that most traditional finance savers or lenders
do not trust the crypto space or simply do not know about DeFi. The influx
of capital into DeFi applications since June 2020 most likely stems from idle
assets on crypto wallets, i.e. from a redistribution of assets within the crypto
space. Nevertheless, the rising use of DeFi protocols proves that the system
is scalable and working. Today, the users of DeFi belong to the group of
"innovators" or "early adopters" (i.e. a very small proportion of households).
Tomorrow, the users might be mainstream households.
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DeFi has the potential to outperform the
traditional finance system in the years to
come
We argue that there are three reasons why DeFi has the potential to
outperform the traditional finance system and to gain increasing attention in
scientific, economic, and public debates:
1. Speed of growth: DeFi is a highly scalable and global ecosystem. Once
DeFi as a whole (or a specific DeFi application) proves its utility,
exponential growth is possible. The website DeFi Pulse monitors the total
value locked (TVL) on smart contracts on all relevant DeFi applications
(i.e. how much money has been poured into the ecosystem by its users).
The increase of TVL between June and August 2020 illustrates powerfully
the exponential growth potential of DeFi. While 1st of January 2020 the
TVL was at $0.7 billion, it started skyrocketing in June 2020, reaching
1.9 billion 1st of July, 4 billion 1st of August, and surpassed the $8 billion
mark 1st of September 2020.
2. Room for growth: According to Messari, a crypto market analytics firm,
the capitalization of all DeFi applications was just at 1.5% of the total
crypto market as of July 2020. Therewith, it could be argued that there is
a lot of room for growth only by further asset redistributions within the
crypto space. Looking beyond the crypto space, lets us derive the real
potential of DeFi. According to the Institute of International Finance,
global household debt alone amounts to 48 trillion US Dollar in 2019. If
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DeFi covers just 0.1% of that debt, DeFi's TVL would grow by 500%
compared to the beginning of September 2020.
3. New market segments: According to The World Bank, 1.7 billion adults
do not have access to banking services. DeFi is permissionless, meaning
that anyone can access those financial services from anywhere in the
world. In principle, just electricity, an internet connection, and
smartphones are needed. DeFi could provide a viable option in regions,
where banking services are too expensive compared to income, little trust
in financial institutions persists, or if financial institutions are simply too
far away. A prerequisite, however, for reaching unbanked adults is that
DeFi applications develop more intuitive user interfaces and simplify the
on- and off-ramp with fiat currencies.
Conclusion: Crypto-based finance is here
to stay
For the first time in history, a financial system is developing without
intermediaries at a large scale. So far, DeFi applications cannot compete in
terms of security, speed, and ease of use with traditional finance solutions
yet. But DeFi has produced real, working applications that have already
managed to attract billions of capital. Those resources will be used to
develop more competitive and user-friendly applications in the future.
Yes, there are parallels to the ICO hype of 2017, which resulted in a sharp
increase and price crash across virtually all cryptocurrencies in 2018. Since
then, the interest of mainstream media has diminished. However, it has been
largely unnoticed that the influx of capital through ICOs has enabled the
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blockchain community to bring the technology to the next evolutionary
stage. Now again, large sums are invested into blockchain technology. But in
contrast to 2018, applications already have been developed and are running.
While we might be standing at the verge of a new bubble, we might also be
at the beginning of a new big development cycle for blockchain technology.
For sure, many more development cycles need to follow. However, it is not
unrealistic to state that decentralized finance will be more efficient,
convenient to use, and secure than traditional finance. It will be highly
interesting to observe how the different actors in traditional finance will
respond when profits start to deteriorate because of DeFi.
Authors
Benedikt Christian Eikmanns is Senior Consultant at the strategy consultancy
Roland Berger and doctoral candidate (PhD) at the Technical University of
Munich. His research area is the economic evaluation of blockchain technology.
Prof. Dr. Isabell Welpe is a full professor (W3) at the Technical University of
Munich and head of the Chair for Strategy and Organization and co-founder of
the TUM blockchain center. Her research focuses on digital transformation and
business model innovation, and the role of emerging technologies for
organizations and society. Prof. Welpe is a board member of the Center for
Digital Technology & Management (CDTM), and an active member in several
(inter)national advisory and supervisory boards. She is a recurring speaker at
international technology and innovation conferences such as Digital Life Design
(DLD) and has been listed among the Top 40 under 40 of the „digital elite“.
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Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center
(FSBC). In 2018 and in 2019, he was ranked as one of the “top 30” economists
by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany.
Further, he belonged to the “Top 40 under 40” — a ranking by the German
business magazine Capital. Since 2017, he is a member of the FinTech Council
of the Federal Ministry of Finance in Germany.
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