Much like the rise of cryptocurrencies as trillion dollar digital asset class has sparked both excitement and anger in the world of traditional finance, the next wave of tech-enabled financial innovation is sparking a mix of anxiety and exuberance. It’s called decentralized finance (DeFi), referring to the use of blockchain technology to allow users to cut out middlemen and lend, invest, and access capital markets directly.
With US President Joe Biden new executive decree on cryptocurrencies suggesting a supporting approach to emerging fintech, it’s time to understand how DeFi could challenge the naysayers.
The fact that people can now tap into the fast-growing online loan and yield markets with little more than a digital wallet – allowing their money to work for them around the clock – opens up widespread access to financial solutions which were once the domain of the well-to-do. Now even Wall Street stalwarts could face code disruption, since investors no longer need to have the minimum capital levels required by consumer protection guidelines (which often lock out the very people they they were supposed to protect).
To be clear, the advent of DeFi in itself does not represent a disruption of traditional financial services or products. Rather, it is a new approach to pooling financial access for those who previously found the scale of economic mobility just out of reach. If they have a smartphone, blockchain-based financial services represent a protest vote. DeFi has similar risk-reward economic characteristics to a mutual insurance structure, which has been around for centuries. While this shared economic relationship may not be for everyone, everyone’s right to participate in these new markets (with ancient roots) must be protected.
DeFi’s promise is based on the recognition that many aspects of our traditional brick-and-mortar business model have reached a point of diminishing returns. In total, DeFi markets peaked at two hundred billion dollars and should increase to eight hundred billion dollars. They typically leverage the other game-changing innovation of the blockchain financial services era – stablecoins – as a digital economy that makes programmable transactions possible.
Risks and Rewards
Yet no emerging innovation is without risk, especially when it comes to the movement of money. This is why DeFi presents both a challenge and an opportunity: can it lower the barriers to wealth creation by building a virtual Wall Street for all, or is this nascent sector too risky due to the potential for opacity and the lack of harmonized investor protections and disclosures? ? Should the responsibility for reducing DeFi risk lie with digital wallet providers, who, after all, are the interface for all digital asset markets, banking and payment services?
Either way, this represents a game-changing moment for financial inclusion and wealth creation, notwithstanding that the emerging internet of value is still in its connection phase. The software does not take any holidays nor does it need expensive layers of management and overhead to perform its functions. Of course, it may be subject to bugs, cyber risks, exploits, and other potential failures. But DeFi protocols are also constantly evolving and becoming more and more sophisticated.
Perhaps more than any other area of crypto finance, DeFi offers the best example of how harmonized market conduct, clear risk disclosure, code audits and privacy-preserving digital identity can replace adverse regulatory measures as a means of preserving the integrity of a financial system. These complementary innovations are being developed alongside the continued growth of the digital asset market. Indeed, the rapid emergence of these markets also comes with a public audit trail that speaks to the continuous improvement of the world of open finance.
Yes, age-old warnings such as “buyer beware” and “never invest more than you are willing to lose” apply to DeFi as well as traditional capital markets. But the potential offered by well-regulated DeFi outweighs the risks. These include transparency and verifiability, thanks to the superpower of public blockchains. There are also powerful advantages with price discovery, settlement speeds and finality, and the fact that software, like the internet, is always on. Armed with trusted forms of digital currency and software-powered capital markets, finance can now keep pace with the modern economy.
One of the main risks of concern to policymakers, regulators and financial compliance bodies is the inherent opacity of counterparties to a financial transaction or arrangement, who may be unknown or pseudonymous. But that’s not a flaw with DeFi so much as an issue for self-hosted digital wallets, which enable a “at your own risk” version of crypto finance while allowing an open developer community to thrive. Due to their novelty, DeFi protocols can also be powered by often untested software that may be riddled with bugs or fall prey to technological vulnerabilities.
Yet despite these challenges, the presumption of privacy and access to even basic financial services represents a healthy point of tension between emerging blockchain-based financial services and prevailing financial compliance requirements designed to protect against money laundering. money and other crimes. What if privacy and financial integrity were not trade-offs? The emergence of digital identity and authentication standards alongside blockchain-based financial services can help ensure that the continued growth of DeFi does not come at the expense of important financial security or disclosure requirements. Indeed, there is now a cottage industry in the realm of crypto financial integrity. Great businesses are building themselves in blockchain forensics and analytics, as well as tracking, tracing, and even recovering illicit money flows denominated in various cryptocurrencies. These companies, including newer ones like Solidus Laboratories– which focuses on DeFi risk reduction and harmonize market integrity standards– form a veritable “digital firefighter” if a crypto transaction or market goes wrong.
In a world where so many people are on the margins of the financial system, we should be encouraged by the art of the possible through the emergence of ever-available digital financial services. If DeFi and similar new approaches to finance really go mainstream, a person’s wealth or opportunity may no longer be determined by the zip code or country where they were born. This, in large measure, because the scale of economic mobility is no longer supported by bricks and mortar, but by bits and bytes.
Dante Disparte is chief strategy officer and head of global policy at financial services firm Circle. He is a life member of the Council on Foreign Relations and sits on the World Economic Forum’s Digital Currency Governance Consortium. Note: Circle is a partner of the GeoEconomics Center.