Despite the ongoing boom in decentralized solutions, the realm of finance is still pretty much centrally governed by banks and other financial institutions that are in full control of people’s assets while making decisions about investment on industrial scale. #DeFi has recently emerged as a viable alternative that leverages a set of more progressive agile tools to the status-quo claiming to hand over the control over to the hands of users. What are these bespoke tools and mechanisms, and how are they more competitive compared to their fintech counterparts?
Essentially, DeFi is advantageous compared to its fintech predecessor mostly because it provides some extra functionality and fewer operational risks thanks to its decentralized nature of minimizing trust at the software level. Besides being built with trust-minimized software, which brings down the bureaucracy level typical of fintech (banks are still disposing of the apps users funds and data), there is a number of other reasons for DeFi gaining ultimate traction as a new tech layer set to re-invent conventional financial instruments bearing either some ultimate novelties or hybrids thereof. Here we’d like to focus on these five:
DLT is able to ensure that the individual is the sole custodian of their assets at all times.
With open source code and developer tools, DeFi presents an infinite scope for experimentation with new financial instruments.
While most of existing fintech solutions are merely digital versions of registered financial instruments, programmed finance allows to create novel bearer instruments and operate a whole new class of cryptographic assets.
DeFi doesn’t merely put existing financial mechanisms like loans, collateral or debt obligations on the blockchain, but also operates a whole new class of tokenized assets in the sense that pretty much anything can be tokenized.
Blockchain assets are inherently accessible and transparent, so issuances, repayments, and loan terms are both human and machine readable.
In this piece we are first to examine the essence of decentralized settlements, and then will look into how decentralized capital formation boosts the overall efficiency of the newly built system. Let’s dive in.
Hybrid financial instruments: Wall St. meets blockchain
Hybrid instruments are those that mix cryptocurrencies with legacy finance, each being the product of very different settlement systems. Before figuring out the types of hybrid instruments, let’s outline the core distinction between the two settlement systems, and see why crypto is eventually set to outplay its legacy counterpart. First off, crypto assets are essentially digital bearer instruments by nature that function as peer-to-peer settlements in real time on a gross basis. What is means is that the buyer and seller simultaneously exchange value for value with no counterparty risk that simultaneously delivering the asset and the payment to buyer and seller in a peer-2-peer manner. Conversely, the legacy financial system uses a delayed-net-settlement system involving layers of intermediaries, i.e. buyer and seller do not simultaneously exchange value for value in every trade. All of the above eventually leads to counterparty risk and inaccurate ownership ledgers.
Two type of hybrids
A critical distinction between a hybrid asset and a non-hybrid one would be the way they are issued and settled:
“Crypto wrapped around legacy”, like stablecoins and tokenized gold bars.
Issued, traded and settled on a blockchain, but the underlying assets (e.g., cash, gold) that back this category of hybrid operate in the legacy financial system.
With legacy assets ( dollars, securities, commodities or real estate) collateralizing the crypto instrument
“Legacy wrapped around crypto”, like bitcoin-settled ETFs, futures, and other derivatives:
Issued, traded and settled in the legacy system, but the underlying crypto assets (e.g., bitcoin, ether) that back this category of hybrid operate on a blockchain.
With crypto assets collateralizing the traditional financial instrument.
Why does the hybrid category involve fewer operational risks?
By nature, crypto systems objectively have lower settlement risk than legacy systems. Here’s the ranking of settlement risks by category from lowest to highest.
More so, by virtue of underlying blockchain tech stack, DeFi is currently laying out the operational ground for new decentralized forms of capital formation to emerge, ultimately making fundraising mechanisms more advantageous compared to a conventional VC:
Current trends & further challenges
Turning to some major challenges of financial infrastructure of decentralized Web, these bullets are worth mentioning:
In the wake of emerging secondary derivatives and decentralized exchanges, decentralized exchanges would generally make more sense for non-institutional crypto only investors.
The absence of complex derivatives on the market puts institutional investors at risk, especially pensions funds as they won’t have investment mandates, because there is yet no way of managing risks.
Probably the last thing worth pointing out is that comparing fintech and Defi from the performance perspective is inherently wrong, since the key point worth comparing is the elevated level of trust, not the performance. When the technology is finally ready to scale to provide multiple access points, the adoption will come.