Decentralized Finance Is a Continuum
A fintech VC’s case for the end of Industrial-era finance
Decentralized finance, otherwise known as DeFi, sits at the intersection of financial products and services with decentralized networks and open protocols. The implications of DeFi will be pronounced across both developed and emerging markets.
- In developed markets, DeFi will provide greater choice to consumers, strip out costs from the legacy financial system, and bring greater liquidity and product innovation to capital markets.
- In emerging and frontier markets, DeFi will provide a more secure store of value and bring banking-style services to the 1.7 billion adults who lack access to any formal financial system.
At FinTech Collective, we believe that DeFi will be an infinitely more durable phase of development and adoption for blockchain technology than anything we have seen to date. The financial services sector is at the dawn of a new era of network-based finance — an era characterized by transparent, trustless, secure, and programmable financial products.
Part I. DeFi — How Did We Arrive Here?
Since the inception of Industrial-era finance, the banking system in developed markets such as the U.S. has relied on a number of highly capitalized financial institutions, law firms, and regulatory bodies to serve as the foundational “trust layer.” Without a better alternative — and given that the financial services serves as the lifeblood for our economy, comprising nearly $4.1 trillion of our nation’s $20.5 trillion annual GDP — such a construct was needed to ensure against systemic risk. In support of this system, a multitude of intermediaries who extract rents exist today within each vector of financial services — PSPs (payment service providers) in payments, TPAs (third party administrators) in the asset management space, trade clearinghouses in capital markets, and claims adjustors and brokers within insurance.
Intermediated finance in the U.S. has served its purpose, providing for the abundant capital needs of both the Industrial Revolution and the Information Age. The existing banking system has proven its resilience by surviving the calamities of both the Great Depression and the Great Recession, all while keeping inflation averaging 3.2 percent over the past century. The system has provided market participants with execution certitude and relative stability.
But Industrial-era finance has also resulted in large fee pools and inequality in the distribution of access. American consumers pay $35 billion every year in overdraft and NSF fees to incumbent financial institutions. Yet, 70 percent of Americans still do not have $2,000 in liquid savings. Within parts of the U.S. capital markets that are still heavily intermediated, such as the municipal bond market, $20 billion in fees gets paid out every year to bankers and broker-dealers on $400 billion in yearly issuances (5 percent of the muni market goes to fees). Similarly, only 65 percent of the $1 trillion in annual global insurance premiums goes to pay out actual claims — the remaining 35 percent, or $350 billion, goes to administration costs, insurance brokers, and corporate profits. Over the past two decades, we’ve seen fintech startups build on new-age technology stacks to solve some of these inefficiencies, eating away at the cushy margins within these massive markets.
The core innovation of decentralized finance is that the “trust layer” is now the software and code itself. Without the time and cost associated with a high level of intermediation, the promise of DeFi is wide — broader access to financial products, programmable money, real-time risk transfer, and auditability of financial contracts. Moreover, anyone with a computer or mobile phone with an Internet connection can gain access to more open and transparent financial services.
The first realized use case for DeFi (and the original vision of Satoshi’s Bitcoin) was programmable money — the ability to send money instantly across the globe the way information is sent over the Internet. With a global remittance market that stands at $500 billion annually and incumbents that can take up to a 10 percent fee per transaction, programmable money has already had an immediate impact. With a true peer-to-peer format and even lower transactional costs than fintech startups such as TransferWise, cryptocurrency remittances have exploded. A recent report by Clovr shows that 15 percent of global remittances by U.S. citizens are currently executed using cryptocurrency.
Potential future use cases also abound. Within developed capital markets, the global banking sector spends $55 billion per annum on the post-trade settlement and clearing of securities. Final settlement of most securities still occurs two days after the trade date, introducing additional credit and market risk. Most of these reconciliation and administrative costs can be eliminated through having a real-time, shared source of truth between counter-parties.
Finance built upon blockchain infrastructure will also open up new possibilities for financial innovation within developed markets. “STOs,” or security token offerings, will help bring wider access, transparency, and liquidity to some of the more opaque areas remaining in the U.S. capital markets. The next decade will see tokenization of a wide range of assets, including the $54 trillion CRE (commercial real estate) market, the $1 trillion private debt market (including MCAs and term loans), and the $6 trillion fine art and collectibles market. In the long run, encoded compliance functionality and immutable ledgers serving as perfect audit trails make tokenized securities extremely attractive as a backend for all securities.
Moreover, in a DeFi world, consumers can recapture sovereignty over their identity and financial data. Data sovereignty and security can not only prevent damaging mishaps like the $439 million Equifax hack that affected 2.4 million Americans, but also pave a path towards monetization of one’s own financial data assets.
In emerging economies such as the Philippines, DeFi has already become a reality. In a country where 77 percent of individuals are unbanked, 5 million Filipinos (10 percent of the country’s adult citizens) are using a cryptocurrency exchange and application to pay their utility bills, refill their SIM cards, or send payments to friends and relatives. Similarly, Colombia has 60 percent of its population unbanked and only a 9 percent penetration of digital payments due to an obsolete, closed-off banking infrastructure. The Colombian government has mandated the modernization of its ACH (automated clearing house) used by all 27 banking institutions in Colombia via distributed ledger to allow for modern and lower cost financial applications to be built on top of this new infrastructure.
In economies with either runaway inflation or oppressive government regimes, decentralized finance has been a beacon of hope. Cryptocurrencies have become the only feasible store of value for citizens of Venezuela, where hyperinflation of 3.5 percent daily has destroyed the value of the country’s currency and military personnel seize physical notes from fleeing citizens.
These cases illustrate that DeFi is making life easier on those who have it hardest in emerging economies — the unbanked and the small or medium size enterprise. In the coming decades, DeFi will be an important catalyst for improved socioeconomic mobility.
The structure of global finance has remained largely the same for the last 250 years following the start of the Industrial era. Today, however, the potential for advancement is multiplied infinitely by the arrival of distributed ledger technology.
Part II. Mapping the DeFi Ecosystem.
In the first wave of blockchain (2010–2016) — which was focused on digital currency development and speculation — most of the capital was allocated to, and most of the value was appropriated by, mining (BitMain, Bitfury) and exchanges (Coinbase, BitMex, Kraken, and Gemini). The currency frenzy of 2017–2018 created an exchangeable asset of nearly overnight value which, combined with a decentralized protocol, led quickly to innovation in company formation and funding. This, in turn, led to the token and ICO phenomenon.
With that phase of unprecedented expansion and contraction behind us, the early signs of a deeper and broader re-platforming of financial services are visible. We are already seeing use cases proliferating across consumer, enterprise, and institutional markets.
To organize the landscape, we use a sector-based approach to developing investable themes. In doing so, we have looked deeply at the problems and opportunities within decentralized finance and worked to understand what is poised for disruption, compatible with the principles of decentralized access and execution, and actionable within our time horizon of 5–7 years (See chart below, “Investable Themes in Decentralized Finance” and “Decentralized Finance Market Map.”)
Decentralized finance is a continuum, and the above mapping includes projects with varying degrees of decentralization. In a utopian world (i.e., one without tradeoffs), it could make sense to decentralize everything. But it certainly does not yet today. In some cases, building on highly decentralized infrastructure has serious trade-offs in speed and scalability. Decentralization for decentralization’s sake alone is a meme.
Where user design is critical or customer service is needed, we expect to see a proliferation of centralized applications building on top of core protocols that have proven some level of product-market fit. We’ve already seen this with Abra and BitPesa (built on top of Bitcoin rails), as well as with Veil (built on top of Augur and Ethereum).
Within our DeFi market map, there are some investable themes that are of particular interest to us:
Micropayments: Metered payments and machine-to-machine (M2M) payments enabled by digitally native currencies. There are a large number of use cases for instant, high-volume, and low-fee payments. One can imagine a future where an autonomous electric vehicle navigating the streets of London makes real-time payments for tolls, battery recharging, and parking. The Lightning Network leads as the overlay micropayment network on Bitcoin, with strong potential to move into other core consensus protocol (Layer 1) chains. We are also seeing the development of extremely creative implementations — such as Tippin.Me on top of Lightning Network, which allows Twitter users to “tip” each other small amounts of Bitcoin for being helpful or sharing content on the social media platform.
Crypto-backed lending: The borrowing and lending of crypto assets on blockchains. In order to thrive, the digitally native world will require the same robust repo and credit markets that exist in traditional markets. Smart contract functionality offers a new level of programmability to credit obligations and allows for a non-custodial format. Dharma Protocol, a FinTech Collective portfolio company, is preparing to release Lever — an extremely sleek interface layer that allows both retail and institutional investors to instantaneously borrow and lend crypto assets at scale, without needing to hassle with complicated legal contracts or wonky interfaces. Holders of crypto assets can now earn coveted yield. The TAM of this debt market will expand rapidly with the proliferation of NFTs (non-fungible tokens) and STOs.
Asset creation (derivatives / tokenized ETFs): Financial service protocols that allow for real-time risk transfer and margining. Universal Market Access (UMA), a FinTech Collective portfolio company, is a decentralized platform for bilateral financial contracts. On top of its protocol, UMA has created an “ETF chase” that allows any sponsor to create trustless real-world asset exposure, such as a tokenized S&P 500 or gold ETF. The implications are enormous for potential investors in emerging markets who are being shut out of certain asset exposure due to either censorship or high investment minimums.
Open-custodial asset exchange: Otherwise known as decentralized exchanges (DEXs) — the trading of crypto assets using smart contract order matching. We ardently believe that we must stay true to the core crypto adage of “not your keys, not your coins,” and move away from the custodial nature of the largest exchanges — such as Coinbase and Bitfinex — which introduce systemic risk back into the system. The recent QuadrigaCX incident is the latest in a series of exchange fiascos over the years reminding us that a centralized custodial system is unsustainable. The 0x protocol has gained a high amount of visibility for creating a standard ruleset that allows anyone to become a “relayer” and stand up a decentralized order book. IDEX is also moving the open-custodial exchange framework forward with the Aurora staking system to lower fees while increasing usability and transactional throughput.
Caveat: the keys to mass adoption…
The ingredients are in place for early adoption of DeFi applications. But by any measure, we are only in the first innings of the movement. True mass adoption will require more robust developer tools and APIs, improved UI/UX at the application layer, working scalability protocols, and better blockchain data solutions. (For an illustration of this, see chart below, “Investable Themes - Keys to Mass Adoption.”)
The UI/UX of the industry has taken a tremendous leap over the past year, with the help of projects such as MetaMask. As a result, many dApps (decentralized applications) have gone from “unusable” for the average user to “kinda usable,” a zero to one advancement. But we are still a long way away from your grandmother being able to open up a “CDP” on MakerDAO.
The holy grail will be to alleviate the decision fatigue of needing to sign certain on-chain transactions and to obviate the need for users to provision usage tokens through dApp-to-dApp liquidity protocols such as UniSwap. Over time, the technology will recede into the background, with users not even aware that the financial products and services they are using are running on blockchain rails.
Part III. The Pieces Are in Place for Institutional Venture Investors.
With a renewed industry-wide focus on build rather than price, higher quality entrepreneurs entering the space daily, and a bit of regulatory clarity, the proper ingredients are in place, from an institutional VC’s perspective, to ramp up investment.
The “crypto winter” of the past 15 months has seen an inflection point in the industry from a human capital perspective. With the gold rush behind us, many of the crypto industry’s bad actors have been forced into unceremonious exits. Most of the founders and teams remaining are here for the right reasons. The quality of entrepreneurs and overall talent level of the teams currently drawn to building on decentralized architecture continue to impress.
The #hodl mentality has slowly given way to #buidl. Even for a successful crypto network launch such as Augur, the path to very early commercialization alone was over three years from its ICO date. Given the formal verification process, building robust, smart contract-enabled protocols and apps is more akin to specifying hardware than software. Most teams look at this daunting task and seek a long-term capital partner that understands the trials and tribulations of getting a decentralized network off the ground. They welcome traditional institutional VCs into the conversation and want to know how the fund can assist them and whether it can potentially follow-on.
Projects that one day aspire to launch a token within their decentralized network, whether it be in the form of a security token or utility token, want the time to both build out the technology and refine the token design model before — or while — releasing it into the wild. At the end of the day, these are all still early-stage projects being built on nascent technology.
Lastly, financial services, whether decentralized or centralized, will always command the attention of global regulators. For a while, it appeared that regulators in the U.S. were reticent to pass judgement for fear that it could stymie innovation. Expectedly, decentralized projects pressed too hard and fast and didn’t properly self-regulate. Based on the comments from SEC Chief Clayton, we are now operating from a legal framework where most ICOs are deemed to be securities, providing constructive clarity for all market participants.
Part IV. The End of an Era and the Dawn of a New One
Decentralized finance is the beginning of a secular shift away from Industrial-era finance and into the new world of network-based finance. A more open and programmable financial services sector is the natural, secular arc that we have been following within fintech for the past two decades.
Network-based finance will preserve the access, execution, and trust that we covet from Industrial-era finance — it will just look drastically different over the next century than it has over the past two. We will eventually arrive at 10x better product experience for DeFi users and de novo financial services use cases that we can’t even fully contemplate today.
With this north star in mind, we look forward to being thought partners, product evangelists, and proud investors in the building blocks of the future of decentralized finance.
FinTech Collective backs creators with a hunger to reimagine how money flows through the world. We are a sector-focused venture capital firm, based in New York City and investing globally. The firm was founded in 2012 by serial entrepreneurs with four prior exits and one IPO in capital markets tech, payments tech and enterprise AI. Since inception, FinTech Collective has seeded 28 portfolio companies and has been active in crypto and blockchain since 2013. DeFi positions include Axoni (re-platforming capital markets), Dharma (decentralized protocol and application for asset lending), Oxio (emerging markets exchange for mobile connectivity), TradeBlock (OTC data and messaging platform), and UMA (decentralized financial contracts platform). Recent exits include Quovo acquired by Plaid, Reorg Research acquired by Warburg Pincus, and Openfolio acquired by Stone Ridge Asset Management. The firm is currently investing out of FTC II, a $100m+ early-stage fund with a focus on software, data, financial services, and digital assets. A weekly client newsletter is available at fintech.io/newsletter.