Financial infrastructure touches every part of our lives, from paying for a coffee to buying a house, whereby playing a critical role in economic development and stability. In recent years, FinTechs have emerged to improve the user experience of institutions and offer additional services through an API. They have sought to democratise access to global markets by making them more transparent and give some level of control to the user. We’ve seen this happen in other industries where new technology improves user experience. For example, in the travel industry Booking.com effectively removed a whole layer of intermediaries and gave people direct access to booking hotels, flights and even day trips. The advent of decentralised finance (DeFi), made possible by blockchain technology, takes user experience of financial markets one step further. By digitising financial markets, the people using and engaging in them are able to re-imagine how they are built. Putting users at the heart of financial market design, instead of venues, will incite the creation of novel products based on individuals and institutions unique trading needs.
Aren’t markets already digital?
Whilst markets are electronic, they are still based on a paper system developed centuries ago. They depend heavily on the role of financial intermediaries matching trades with counterparties, ensuring funds are in the right place and validating sources of income – all of which involves a high degree of cost and complexity. Still, users of financial services have to put their assets with the intermediary venues. These venues then allow the user to put the assets to work in their venue, preferably in their products. Switching costs are very high to go from one venue to another. In contrast, DeFi puts the user and their assets at the center. Everything revolves around the assets in the user’s wallet(s). Users decide which mechanisms to deploy these assets into or, even better, which methods to permit access, while assets never leave the control of the user. Financial services, as a concept, becomes very different when self-custody is at the center. It allows the servicing architecture to be built around people’s wallets and assets, making it truly customer-centric. As a result, switching costs are near zero and services are hyper competitive for users’ attention.
Furthermore, digitisation puts a programmable layer on assets so its value can be embedded into other derivative and programmable products on the blockchain. Due to the transparent nature of this technology, all data about that asset, including information like previous ownership and, if it’s a security, pointing to prospectus information, is stored in the token’s code. A token can be transferred as a self contained entity, taking with it all of the aforementioned information. Once an asset is digitised, it can move freely across the DeFi ecosystem between platforms, combined with others to form unique trading pairs and used for lending and borrowing. This dematerialisation 2.0 signifies true liberation from traditional markets.
Autonomy for investors
Whilst the interest in DeFi has grown considerably, this is likely to substantially increase even further and faster as institutions begin to understand more about the sector and can trade products using regulated decentralised market infrastructure.
Source: DeFi Pulse
In current financial infrastructure, users are constrained by the products and services offered to them by financial institutions to whom they must entrust their assets. Trading decisions are represented by a database entry update opposed to physically moving assets from one place to another. In decentralised market structures, investors and traders have full control over their assets because of features like self-custody. This is arguably more beneficial for the end users who have transparency over where their assets are stored. DeFi provides the tooling and infrastructure for people to build the financial products and services unique to their wealth creation and trading needs. Digitising assets creates opportunities to collateralise anything creating greater breadth in global financial markets and allowing for greater fluidity and optionality. In a decentralised market structure, digitised Tesla stock or Swiss Franc gives you as much opportunity to generate yield as the US dollar, creating parity among collateral. However, it is only in a regulated environment where these types of traditional assets can be onboarded and traded.
Defi is more than just crypto
The explosion of crypto assets, such as Bitcoin and Ethereum, demonstrates how smartcode can transfer value without the need for intermediaries. But digitising assets can go far beyond crypto-native assets and into the world of regulated securities. The need to tokenise depends on finding liquidity. In traditional markets, policies of economic stimulus have made the search for yield increasingly difficult for market participants both on the retail and institutional side.
In a decentralised structure, people can do more with their idle assets. Deriving income from assets in traditional market infrastructures is limited to certain assets, such as shares, currencies and property. Tokenizing assets and putting them into decentralised market structures enables income creation from a wider range of assets. But traditional financial products, like securities, can only operate within regulated environments. Many attempts have been made to onboard securities into DeFi, but they need a regulated ecosystem to move around in before these attempts can become successful.
Regulation can drive creativity
The long held belief is that regulation will stifle innovation. However, enabling more assets and counterparties into the DeFi ecosystem through regulated platforms, will foster more creative products and trading solutions that crypto hasn’t even thought of yet. There is a direction of travel towards regulatory lines that DeFi is moving closer to. 1inch recently announced it will use part of its $175 million funding round to build a regulated offering in Europe so that institutions can engage. We’ve already seen the German regulator, BaFin, bring crypto in line with existing securities laws so that DeFi projects can be built under their supervision. The contagion of assets could lead to sanctions that involve stopping assets to be transferred back into fiat. These regulatory fears are spreading into assets too. Uniswap delisted 100 assets in July 2021 citing increased regulatory pressure.
There is a significant amount of capital sitting on the side-lines, waiting to enter DeFi. Existing securities laws can be translated into code, which will foster environments that certain asset types and outfits with a fiduciary responsibility can finally transact on. Solving this will inevitably expand the DeFi system 10-100X and we will see interesting new products and services, driven by customer design.
Written by Timo Lehes, co-founder Swarm Markets, a regulated DeFi exchange