Decentralized finance is a highly technical topic.
The way it functions isn’t exactly simple, and it involves more than a single entity. While understanding how it works might be a topic for more technical ears, the effect it has had on the financial industry is a topic that should be understood by all.
In this article, we’ll briefly go over what DeFi is, and how it works, but the focus of this content lies on where DeFi is headed— and how understanding the possible outcomes for its future can help you make more informed decisions.
Let’s begin with the basics.
What Does Decentralized Finance Stand For?
Decentralized Finance, commonly known as DeFi, represents a revolutionary approach to financial operations by leveraging peer-to-peer transactions facilitated through a network architecture. In this system, validation is achieved through the consensus of all devices connected to the network simultaneously—a fundamental characteristic derived from the principles of blockchain technology.
The marriage of digital technologies, particularly blockchain, to the financial sector, has marked the onset of a transformative era. The financial domain, being at the forefront of embracing technological advancements, witnessed the profound implications of an ongoing revolution.
Ethereum, as a pioneering force in the blockchain realm, has consistently been intertwined with the narrative of this technological evolution. Notably, it has played a pivotal role in shaping the landscape of decentralized finance, emerging as the second most influential project globally within the blockchain ecosystem.
Despite initial skepticism, DeFi proved too compelling to disregard. Initially met with attempts to undermine its credibility, over time, even entities within the established financial order recognized the need to comprehend and integrate the evolving dynamics of decentralized finance.
DeFi’s Role in Open Finance Developments
In response to the burgeoning influence of decentralized finance, the financial industry witnessed the emergence of Open Banking as a countermeasure against the encroachment of alternative players in the financial landscape. Essentially, it represented a strategic move to either impede or construct a parallel financial ecosystem.
As DeFi gained momentum, conversations about market openness evolved into regulatory measures aimed at enhancing the flexibility of financial service offerings. This involved a series of steps to streamline bureaucracy within the financial system, coupled with regulatory flexibility to foster competitiveness. Consequently, companies outside the traditional financial circuit were empowered to provide their own services.
The initial manifestation of this opening up of the financial system was observed with the rise of fintechs, marking an unprecedented level of decentralization. Despite offering a limited range of specialized services, fintechs managed to outperform traditional institutions, solidifying their position and securing a portion of the consumer market—a trend we foresaw almost a decade ago.
This opening up of the financial system is what led to Open Banking, which eventually gave way to Open Finance, and the rest, as they say, is history.
If you’re interested in where finance is headed, MJV has got you covered. Click here and download our Financial Trends Report for 2024.
How Does DeFi Really Work?
DeFi hinges on the utilization of blockchain technology, often relying on Ethereum as the foundational framework for numerous DeFi operations.
Blockchain, a type of immutable distributed ledger, secures entries cryptographically, forming the basis for transactions. It is also the underlying structure for cryptocurrencies, which are tokens created within a blockchain and possess inherent value.
The DeFi model is constructed around smart contracts—applications running on a blockchain utilizing the distributed ledger and cryptographic encryption capabilities. These contracts outline the terms and conditions for executing specific operations.
In contrast to traditional transactions facilitated by a central authority, a smart contract is programmatically designed to execute the financial transaction stipulated within the contract. These contracts can manage cryptocurrency assets, facilitating their transfer from one entity to another.
DeFi smart contracts not only execute transactions but also offer transparency in terms and conditions, as they are available in code format for scrutiny by others. The absence of a central authority in DeFi adopts a peer-to-peer model, enabling two parties to execute a transaction without the need for an intermediary.
Within the DeFi model, emphasis is placed on empowering individual users. The custody of cryptocurrency assets involves control over both private and public encryption keys. Adopting a decentralized approach, individuals hold custody in the form of private cryptographic encryption keys.
The Next Big Thing For DeFi: The Tokenization of Real-World Assets
A significant hurdle to the widespread adoption of DeFi and blockchain solutions lies in the intangibility of crypto assets. When confronted with cryptocurrencies, the initial query often revolves around their concrete existence: Where is the money, and how can one possess it?
This inquiry isn’t exclusive to retail investors; even figures like Warren Buffett raise the same question. Buffett’s stance on crypto, articulated during a Berkshire Hathaway shareholder meeting in 2022, echoes the sentiment that crypto lacks productivity and intrinsic value. He questions its utility, emphasizing the eventual need to sell it back without tangible benefits. On Squawk Box, he further labeled crypto as a gambling token devoid of intrinsic value.
The challenge skeptics grapple with is discerning the value inherent in crypto—what precisely is acquired when purchasing crypto, and what real-world backing supports it? Buffett’s argument against the intrinsic value of crypto extends to mainstream currencies like the dollar, contending that their value hinges on mutual agreement among agents. In contrast, digital “illiquid” assets, including crypto, can find support through real-world assets (RWAs) facilitated by blockchain technology. Tokenized RWAs, in particular, open up investment avenues across various financial strata.
A noteworthy example is Freeport, which divided Andy Warhol paintings into a thousand fractions, essentially transforming artworks into tradable shares. For a mere $200, one could claim ownership of 1/1,000th of Warhol’s Rebel without a Cause (1985). This concept bears resemblance to NFTs, although the latter are entirely digitized assets. Given that the art market is valued at $67.8 billion and artworks can command prices as high as $7.5 million at auctions, tokenized artworks, even in fractional form, present an enticing investment avenue for individuals with more limited financial means.
Echoing this sentiment, Roland Berger, in their exploration of RWA tokenization, asserted that it not only broadens investment opportunities by overcoming geographical and financial constraints but also enhances the precision and immediacy of asset pricing. Consequently, RWA tokenization extends access to investment opportunities to a more extensive demographic that was previously excluded.
Is DeFi Shadow Banking With Steroids?
In the aftermath of the 2008 financial crisis, extensive academic and policy endeavors focused on understanding “shadow banking.” Broadly defined, shadow banking refers to financial activities mirroring those in the regulated banking system but escaping regulatory oversight.
At the time of the crisis, shadow banking encompassed familiar entities like investment banks, money-market mutual funds (MMMFs), mortgage brokers, and various contractual forms such as sale-and-repurchase agreements (repos).
Esoteric instruments like asset-backed securities (ABSs), collateralized debt obligations (CDOs), and asset-backed commercial paper (ABCP) were also part of this landscape. Credit default swaps, facilitating new forms of leverage outside the banking system, were deemed integral to the shadow banking system.
While these forms of shadow banking differ, complexity emerges as a common thread, acting as a destabilizing force. Complexity renders financial products and their interactions within the broader financial system harder to grasp, increasing the likelihood of unforeseen risks.
Even if risks are anticipated, complexity-induced opacity amplifies the chances of underestimating risks in favorable times (leading to bubbles) and overestimating them in adversity (exacerbating panics).
The financial crisis of 2008, triggered in part by the expansion of shadow banking, has left enduring social costs. Regulatory systems have struggled to fully address the risks associated with derivatives, securitizations, and money market mutual funds constituting Shadow Banking 1.0.
Yet, on the horizon looms the prospect of Shadow Banking 2.0 in the form of decentralized finance, or “DeFi.” Despite DeFi proponents envisioning a future where money transfers are as seamless as sharing photographs, the stakes involved with money are significantly higher.
Without regulatory intervention, the development of DeFi poses the risk of amplifying the complexities, leverage issues, rigidity, and runs reminiscent of Shadow Banking 1.0.
The silver lining is that there’s still an opportunity to prevent DeFi from evolving into Shadow Banking 2.0. This potential hinges on proactive regulation designed to curtail DeFi’s growth and separate whatever persists from the established financial system and the real-world economy.
Rather than introducing new financial products and services, DeFi merely aims to provide existing ones in a decentralized manner, eliminating intermediaries. However, the DeFi ecosystem is replete with intermediaries, and achieving complete disintermediation in financial services is an impractical aspiration.
If DeFi falls short of delivering true decentralization, regulators are justified in taking measures to rein it in, safeguarding the stability of our financial system and the broader economy.
Is It Going To Overtake The Prevailing System?
In this exploration, we venture into speculative terrain, contemplating various scenarios for the future of the financial services ecosystem. While the exercise involves some uncertainty, it holds validity when pondering the long-term trajectory.
Scenario 1 – The Merge
A plausible future unfolds where we witness the convergence of the current financial services ecosystem—transformed significantly over the past decade and no longer adhering to traditional norms, particularly post-pandemic—with the realm of decentralized finance (DeFi).
Envisioning this scenario, the existing financial system assimilates decentralized finance technologies and practices. Concurrently, DeFi undergoes a shift towards stability and predictability, values entrenched in the current system.
Scenario 2 – Dethroning the Status Quo
An alternate prospect involves a decisive shift between financial systems. This scenario contemplates the potential dominance of one ecosystem over the other, driven by a killer competitive advantage, the evolution and adoption curve of emerging trends, or a specific macro-financial phenomenon.
The outcome could manifest as the unequivocal supremacy of DeFi over the traditional system in place now. This in itself could lead down two branching paths. The first being the emergence of shadow banking 2.0, where unregulated DeFi runs rampant through the financial system, leading to more prevalent and harder-to-counter financial crime.
The second scenario is what proponents of DeFi believe is the “ideal scenario,” one where decentralization leads to money-transferring being as simple as sending someone a photograph. Intermediaries are no more, and the power that financial institutions previously held lies instead in the hands of the people.
Scenario 3 – Full Disruption
In a third hypothesis, the interplay of disruptive technologies and a lack of regulation, a common occurrence with novel arrivals, may confer such a substantial advantage to financial players that it results in the obsolescence of any other financial system.
While this scenario suggests a comprehensive disruption, it’s essential to note that these changes are contingent on various factors, including the development of a new form of technology or model that supersedes the blockchain and renders both DeFi and the traditional system obsolete.
Any evolution in these scenarios will likely manifest through discernible signs of change, whether in the form of emerging technologies or shifts in consumer market behaviors.
Where Do We Go From Here?
The growing adoption and development of DeFi, cryptocurrencies, and blockchain technologies is but a tiny part of the financial puzzle. No one trend or movement acts alone in an ecosystem as complex as the financial industry.
Multiple factors have been, are, and will be responsible for what the future of finance will look like. Hindsight is 20/20, but foresight requires a magnifying lens (or maybe a microscope is a more appropriate metaphor). In order to get even a tiny glimpse at what the future holds, you need to understand the big picture.
If you’re interested in where finance is headed, even just within the next few years, MJV has got you covered. Click here to download our Financial Trends Report for 2024. In it, we go in-depth into the world of DeFi, Open Finance, instant payments, and much, much more. Don’t miss out on this opportunity to get a head start on the competition!