Regulation and Intermediaries as a Critical Differentiator Between Traditional and Decentralised Finance
The world of finance is undergoing rapid transformation, with new technologies and products being developed at a breakneck pace. One area that is seeing particular growth is decentralised finance (DeFi), which offers new challenges to traditional centralised finance products.
Centralised finance, also known as traditional finance, refers to financial products and services provided by centralised institutions like banks and credit card companies. These products are typically regulated by Government bodies acting as intermediaries and are subject to strict compliance rules. Examples of centralised finance products include loans, mortgages, and credit cards.
In contrast, decentralised finance products are provided by decentralised networks of individuals and organisations. Even decentralised products are not (yet) regulated by any Government body, access, and usage underly regulatory requirements like anti-money-laundering or know-your-customer obligations. Decentralised finance applications replaced the intermediary using Smart Contracts – a code or a transaction protocol intended to automatically execute, control or document events and actions according to the terms of a contract or an agreement.
Many of the financial primitives available within the traditional financial economy have already been recreated in an on-chain format, benefiting from the decentralised character and services. Such examples include:
- P2P payments (Lightning Network, Flexa)
- Spot trading (Uniswap, Curve)
- Lending markets (Aave, Compound)
- Derivatives (GMX, dYdX)
- Synthetic assets (Synthetix, Alchemix)
- Asset management (Yearn, Beefy)
- Insurance (Nexus Mutual, Unslashed Finance)
The DeFi Ecosystem has maintained its resilience even during periods of extreme market volatility, partly caused by the collapse of large Crypto institutions such as FTX or core financial institutions such as Silicon Valley Bank. However, besides the technological potential and the development of user-friendly applications, mass adoption, especially for corporations, has not yet occurred.
The rise of decentralised finance products has not yet led to mass market adoption.
In the future, customers will be able to access a wide range of financial services without worrying about whether they are using a centralised or decentralised product. They will simply be able to choose the products and services that best meet their needs.
We will likely see more companies and organisations using distributed ledger technology (DLT) to create new products and services. This will create more competition and innovation in the financial sector, which will benefit both consumers and businesses. Furthermore, the increased use of Blockchain technology will also lead to more transparency and security in the financial industry.
The consequence of tokenizing real-world assets (RWA) is asset liquidity.
One approach for companies to incorporate DeFi mechanisms as part of their liquidity management is to tokenize physical or digital assets. Existing yet illiquid physical assets like machinery, real estate, or vehicle fleets or digital assets like patents or software products build the basis for corporates to increase their liquidity. Real World Assets (“RWAs”) are assets that exist off-chain but are tokenized and brought on-chain to be used as a source of yield within DeFi. Asset Tokenization is the process of representing ownership of a physical or digital asset as a digital token on a Blockchain. This allows assets to be traded on a digital marketplace, making them more liquid and accessible to a broader range of investors. RWAs can render DeFi more compatible with external markets, resulting in greater liquidity, capital efficiency, and investment opportunities. In addition, RWAs allow DeFi to bridge the gap between decentralised and traditional financial systems.
For corporates, real-world asset tokenization can support the generation of new business models based on decentralised-ledger technology in several ways:
Increased Liquidity by making real-world assets more easily tradable on digital marketplaces, they are accessible to a broader range of investors. This can help to generate new revenue streams by using existing assets.
Access to Funding by issuing digital tokens that represent company assets. This can be done through initial coin offerings (ICOs) or security token offerings (STOs).
Improved Transparency by recording ownership of the company’s value and trading history on a distributed ledger. This can help to build trust with investors and customers and provide a new level of accountability for these companies.
New Business Models by using digital assets as collateral, for example, for decentralised staking, lending, and borrowing applications applying the concept of peer-to-peer transactions of digital assets on lending or trading platforms and other decentralised applications (dApps).
Cost Savings associated with traditional asset management and transfer processes. For example, Tokenization can automate the process of recording and tracking ownership of assets, reducing the need for intermediaries and paper-based documentation.
Incorporating the mechanisms of Decentralised Finance can help companies improve their liquidity management by providing new opportunities for funding and investment, as well as new ways to manage and trade assets. As these trends continue to develop, we will likely see a future product suite for customers that don’t realise the difference between the underlying technology. This means that customers will be able to access a wide range of financial services without worrying about whether they are using a centralised or decentralised product. Instead, they will simply be able to choose the products and services that best meet their needs.
Corporate Adoption – How to Win Corporate Hearts
While the technology already offers all the necessary tools and mechanisms to participate in new business models, corporates are still hesitant to broadly implement and engage with DeFi applications. Comparing the total value locked of Decentralised Finance applications of $48.73bn (per February 2023) to the entire Crypto Market of $1.06tn (per February 2023) and a traditional tech index, the Nasdaq100 of Euro 14.02tn (per February 2023), you can tell that corporates neither invested nor implemented Decentralised Finance applications in a broader context for their own purposes.
The key topics that need to be addressed to become accepted in the eye of corporates are:
Regulation – Regulatory balance for decentralised finance applications has not yet been found, resulting in limited options for regulators to regulate the usage of DeFi applications. Limiting access to it is one potential solution, as initially discussed in one of the first Market in Crypto Assets (MiCA) drafts. MiCA is intended to close gaps in existing EU financial services legislation by establishing a harmonized set of rules for Crypto-assets and related activities and services. MiCA was proposed by the European Commission in 2020 as part of a broader digital finance package paving the way and pursuing its ambition to turn the EU into an attractive place for Crypto-Asset Service Providers (CASPs) to do business globally.
Insurance – Traditional financial institutions offer their investors investment protection that varies in amount depending on the institution. As insurance is a crucial element in the risk management perspective not only for private investors but especially for corporates, Decentralised finance insurance is essential for bringing DeFi applications to mass adoption. Solution providers like NexusMutual, RiskHarbor, or Unslashed Finance offer their clients a wide(r) range of products to limit the risk when entering the Crypto sector. Risks covered range from
Security Risks against events like cyber attacks or rug-pulls;
Technology Risks limiting the risk of code failures leading to unintended actions executed through the smart contract
Collateral Risks providing protection of collateral for loans backed by Cryptocurrency
Custody Risks providing solutions for risks related to wallet theft. Decentralised insurance is a fast-growing sector of Decentralised finance by applying not only the need for transparency and security for the investors but by leveraging proven mechanisms from the traditional finance industry
Conflict Resolution mechanisms in the decentralised finance industry are not easy to understand by design. Whereas it’s hard to imagine who the counterparty of a Decentralised protocol could be, regulators understand how to approach this potential conflict. Smart contracts need to be deployed by a registered company. The company must be registered in a jurisdiction in which underlying law will be applied in case a dispute needs to be settled
Counterparty Risk has recently received a lot of attention from retail and institutional investors due to the fall of FTX and its negative headlines. As a result, knowing your client does not only apply to the provider but knowing your counterparty and the associated risks such as failure, reputation, or security risks have become a strong focus for the customer himself. Whereas in traditional finance, providers of financial products have clear guidance on which level of detail they have to
Inform and consult their clients before investment advice can be given, investor protection is yet an openspace within the decentralised finance industry.
TradFi institutions, such as Goldman Sachs, Hamilton Lane, Siemens, and KKR, all have announced that they are working towards bringing their real-world assets on-chain. Furthermore, protocols like MakerDAO and Aave are tailoring their Crypto-native platforms to become compatible with RWAs.
In summary, the world of finance is rapidly evolving with new technologies and products emerging. Still, many private investors and corporations are hesitant to explore these emerging opportunities due to associated risks such as monetary loss and reputational harm. However, in light of recent macroeconomic developments such as Covid, supply chain issues, resource scarcity, and resulting inflation, liquidity management has become more relevant than ever. Additionally, increasing interest rates over the past 14 months are accelerating the motivation to validate the opportunities that centralised finance in combination with Decentralised finance applications offer. Therefore, if you are seeking to optimise your liquidity management and explore the potential benefits of decentralised finance, now is the time to act and evaluate your options.