How has crypto contributed to the transformation of the financial service industry? Will DEFI bring the next innovation boost?

For a long time after the launch of the Bitcoin Blockchain in 2008, crypto currencies were of no importance to the traditional financial industry. Within the last 1 to 2 years, however, they have established themselves as an asset class which is slowly being recognized by the financial service industry.

The crypto community’s focus on value transfer by means of tokens led to the ICO-hype in the years 2017 and 2018. These unregulated ICOs triggered regulators and legal bodies to introduce a token classification allowing the proper legal treatment of tokens issued. For the financial industry, security tokens are the most important class, since security tokens can not only be used to represent current financial instruments, but they are also enlarging the possible asset universe for the industry. The notion of a “token” has seemingly started a transformation of the finance industry towards digital /crypto asset markets.

Crypto currencies themselves, however, are not yet relevant for payments, the original vision of Bitcoin. Nevertheless, crypto currencies have triggered an innovation boost for payments. Based on blockchain technology together with the concept of tokenization and the emergence of stablecoins the financial industry has recognized the advantages of programmable digital money and is discussing the introduction of programmable Fiat money on a broad front — whether as central bank money or as commercial bank money. Experts seem to believe that the first countries will introduce programmable digital central bank money (CBDC) in the next few years.

So far largely unnoticed by the traditional financial industry, a potential new driver of innovation has emerged within the crypto community - DEFI (Decentralized Finance). DEFI is a movement that aims to enable everyone to access financial instruments and services, e.g. decentralized stock exchanges, secured loans and asset management, on public blockchains through permissionless protocols and dApps. Due to its low volume - although growing rapidly - and the lack of a regulatory and legal basis, the DEFI movement is hardly noticed by the traditional financial industry.

However, DEFI could become an innovation driver for the financial industry, just like the crypto currencies themselves did:

• DEFI could give greater significance to crypto as an asset class and also increase the acceptance of crypto currencies for payments.
• Due to the ongoing efforts to establish tokenized Fiat money, real assets and traditional financial instruments, the DEFI movement, currently limited to crypto tokens only, could expand and thus compete with or at least supplement the traditional financial industry.
• This competition could be achieved by following the path of projects working on regulatory compliant Fiat money (e.g. Libra) , i. e. further developing and adapting the concepts and technical infrastructures around Bitcoin & Co. Towards this goal DEFI could serve as a basis for developing “DEFI-for-Finance” infrastructures. These might then enable new products and business models competing with traditional financial industry.

Crypto has been an innovation driver for the traditional financial industry

The “crypto industry” has served as a driver of innovation for the traditional financial industry. The financial industry has adopted technologies and concepts and adapted them accordingly for the use within the industry. (Mis-)developments of the crypto industry were taken up and are further developed according to the rules of the financial industry. These innovation phases are shown schematically for some relevant topics in Figure 1 and are summarized below.

Figure 1: Schematic representation of the development of the crypto industry in cumulative phases (upper part). In the lower part of the figure, the corresponding development of the traditional financial industry are compared with each other with a time lag. The arrows indicate the innovation triggered in the finance industry. The figure shows only a selected set of developments in either industry.

Phase 1: Crypto currencies develop into an asset class of their own right and foster new or more efficient use cases

The emergence of the crypto currencies themselves as well as the technology behind, public blockchains, has had 2 main direct consequences for the financial industry:

1. The development of private/permissioned blockchains which in turn form the basis for a large number of specific use cases in the financial industry. These are currently being implemented or investigated, e.g. trade finance, cross-border payments, clearing and settlement, OTC trading.
2. The development of the crypto currencies towards a (small) asset class. The market capitalization is about a factor 4 smaller than that of the DAX and even a factor 40 smaller than the value of the physical gold market, but already a factor 10 larger than the silver market [own estimates]. The path of the crypto currencies from a “playground for technology nerds” to the beginning establishment in the financial sector took about 4 to 5 years. During this time, work has been done to secure the use of the asset class from a regulatory perspective. In many countries, clarity has been achieved regarding the legal and tax treatment of crypto currencies and an ecosystem of technical applications and services up to “enterprise grade” custody solutions and crypto brokerage services has developed, allowing financial institutions to integrate the asset class into their business processes in the usual way. Consequentially, it can be observed that the interest of institutional investors in the crypto asset class is currently increasing [4].

Phase 2: ICOs as trigger for the token economy

Following the original vision (Bitcoin as a payment system), the main focus of the crypto community was the development of non-native (i.e. beyond Ether and Bitcoin) tokens using Ethereum’s Smart Contracts. ICOs (Initial Coin Offerings) were the first large-scale application where monetary value was transferred by means of tokens. The issuance of tokens under unregulated ICOs grew rapidly, culminating in 2017 and 2018, when ICOs were conducted for more than USD 6 and 12 billion, respectively [54]. Due to the fact that most ICOs appeared to have a securities character [55] and the lack of investor protection, regulators intervened. This intervention started the financial market’s journey towards the tokenization:

• From 2018 on, work was done on token classification. The most common classification was already published in 2018 by FINMA [56]. According to this classification, tokens are divided into payment, usage and security tokens. In particular, the definition of security tokens (“represent assets such as shares in real values, companies, income or entitlement to dividends or interest payments. The token is thus to be regarded in terms of its economic function as a share, bond or derivative financial instrument” [56]) has opened up tokenization to the traditional financial economy.
• Experts expect that tokenization could initiate an important transformation of the financial sector. According to a survey published by the WEF [60], 10% of global GDP could be “stored” on “the” blockchain by 2027. In one analysis, Finoa [59] has allocated these 10% of the GDP to different asset classes and concludes that more than 10% of a USD 24 trillion token market in 2027 might be attributed to new or currently illiquid asset classes such as insurance, infrastructure projects, alternative assets.
• An indication of the expected transformation towards a token economy and the importance of crypto assets is the regulatory and legislative activity in Europe since 2019: on January 1, 2020, the Liechtenstein Blockchain Act came into force, as well as the Crypto Custody Act in Germany; furthermore, planned laws regulating asset tokenization are pending in various countries; and on September 24, 2020, a draft (for consultation) of the planned EU regulation around digital finance “the digital finance package” which amongst others is designed to provide regulation for crypto assets (“MiCA Markets in Crypto Assets) as well as amend MiFID2 regarding instruments issued on DLT-systems. This is expected to allow the traditional financial industry to integrate crypto assets into their business activities in a consistent way across Europe.

Phase 3: Stablecoins as Blue Print for programmable Fiat money

The term stablecoin was introduced when designing crypto currencies with lower volatility (more stable) versus Fiat currencies than native crypto currencies like Bitcoin and Ether. Stablecoins are generally linked to a fiat currency. This coupling is achieved in most stablecoins by depositing a respective amount of collateral denominated in local currency in custody outside the blockchain. One of the first stablecoins of this kind is Tether (USDT), a controversially discussed [62] coin issued on Ethereum in 2015. The best known stablecoin at present is DAI, issued by the MakerDAO project [23] on Ethereum. DAI is collateralized by Ether and is linked to the USD through trading incentives.

In my opinion, the concept of tokenization together with the development of stablecoins has significantly influenced the very broad discussion about programmable Fiat money, especially CBDC (Central Bank Digital Currency) currently taking place:

• Banks are experimenting with issuing their own Fiat Coins. The best known examples of this type of token are the JPMorgan coin (JPM Coin) [21] and the Utility Settlement Coin (USC), a token project in which a number (14) of financial institutions are participating [19], [20]. Both tokens are still in project status. Both are stablecoins, which are secured with Fiat funds outside the blockchain. The aim of both tokens is to increase the efficiency of transactions between the participating financial institutions and their customers. According to a recent article [22], Goldman Sachs is also investigating the feasibility of its own Fiat token.
• CBDCs are digital, programmable Fiat currencies issued by central banks - a direct equivalent of today’s central bank money or cash. In a report published by the BIS in January 2020 [11] based on a survey of central banks, 80% of the central banks surveyed stated that CBDCs are on their radar. While about 40% are in an exploratory and experimental phase, about 10% are already in a phase where proof-of-concepts or pilot applications are being developed. Some examples: China probably has the most advanced activities around CBDC. According to reports, China has already started to issue the digital renmimbi [12] and has started to form partnerships with private companies to integrate the digital renmimbi into platforms [13]. Sweden’s Riksbank announced earlier this year that it has already started testing the digital crown (e-krona) [15]. In October 2020 the ECB has published a report on the digital EUR[65], which is expected to be the start of a public dialogue on the topic.
• Probably the most ambitious private project to tokenize Fiat currencies currently underway is Libra [25]. The project was launched by Facebook in 2019. Libra issues global stablecoins, with collateral outside the blockchain. For details see the following section.

Against the background of the innovations mentioned above, a recently published paper by Sandner, Gross, Schulden und Grale [27], based on a survey of payment experts, concludes that Libra and CBDC could have a significant impact on the European banking system.

Example for a Phase 3 innovation: Libra project — regulatory compliant stablecoins

Probably the most ambitious — certainly the best documented — private Fiat money project currently underway is Libra [25]. It is an example for a “Phase 3 innovation”, i. e. the goal is to implement a stablecoin (phase3) based on the concept of tokenization (phase 2) and a permissioned blockchain (phase 1).

Note: Libra serves as a reference for the attempt to formulate a “Phase 4 innovation” based on DEFI later on in the article.

The Libra project was launched by Facebook in 2019. For the purpose of coordinating the development of the blockchain and also for the issuance and operation of the Libra-inherent crypto currencies, the Libra Association headquartered in Switzerland was founded (the following is a high level description with lots of detail missing):

The current plan of the Libra Foundation is to issue Libra token versions of the USD, EUR, GBP and SGD. The tokens issued on Libra will be secured with money, money-like securities, and short-dated government bonds in the respective currency named Libra Reserve is held in custody by a network of global custodian banks under the management of the Libra Association. It is also planned to form a Libra-token defined via a based of those single currency Libra tokens.

The Libra Blockchain seems to be a permissioned blockchain. Only members of the Libra Association participate as so-called validators in the consensus algorithm of the blockchain. Validators ensure that the blockchain is consistent and contains only valid transactions. Over time, the network and the associated governance is planned to be put on a broader basis based on clear and transparent rules within the Libra governance framework.

The service, i.e. access to Libra tokens themselves, is made available to end users via a cascade of regulated players or players (Designated Dealers and Virtual Asset Service Providers (VSAPs), s. Figure 2)under the governance of the Libras Association, see Figure 2. VSAPs, e.g. wallet providers, stock exchanges, have direct contact to the user and are responsible for conducting KYC processes.

Libra also foresees “unhosted” users at a later point in time, i. e. blockchain addresses that are not overseen by a designated dealer or VSAP, but these will carry transaction limits and will be subject to special control procedures (not shown in figure 2).

Figure 2: Schematic representation of the interaction of the respective actors in the Libra payment system.

The planned Libra Payment System is a vivid example for combing all of the above mentioned innovations from the crypto sector and trying to make them available to the financial industry in a regulatory compliant way. Libra plans to develop a global, performant and above all a scalable blockchain. By means of tokenization (cash and cash-like securities) several stablecoins secured in the real world are generated. Through appropriate governance and admission rules, the concepts from the crypto industry seem to be planned to be adapted to the financial industry (the payment system has an operator; validators must meet appropriate requirements; Designated Dealers are expected to be financial institutions with experience in FX trading and VASPs must operate according to the Financial Action Task Force guidelines)

Phase 4: The influence of DEFI is still unclear

Since the end of 2019, the DEFI/Open Finance movement has been one of the most prominent topics in the crypto community. Details are explained later in this article. So far, DEFI has not received much attention in the financial industry apart from some players being active in crypto currencies. Some initial hypotheses on the possible impact of DEFI on the traditional finance industry will be developed in this article. The judgement on the validity of these hypotheses is left to the reader.

In the meantime … the crypto community invented DEFI

Figure 3: Dollar equivalent of the crypto currencies locked in DEFI applications as a function of time for the period October 2019 to September 2020. Source: defipulse.com [28].

Almost unnoticed by the mainstream, the DEFI movement (DEFI — DEcentralized FInance) has developed during the past 2 years. The goal of the DEFI or Open Finance movement is to extend Bitcoin’s promise to provide financial services and products such as loans, savings, exchange or trading available to everyone - without any access restrictions. The interest in DEFI protocols and applications has recently increased explosively, especially during the past half year, as can be seen in the value of crypto currencies locked in DEFI smart contracts (s. Figure 3).

The DEFI ecosystem is largely located on the Ethereum Blockchain. The respective functionality is implemented by means of (at least with the goal to have) autonomous, decentralized Smart Contracts and is therefore accessible to anyone with technical access to Ethereum. [28] and [29] provide a very good overview. For illustrative purposes some of the products are listed in the following paragraphs.

Savings deposits and (secured) loans
In this type of DApps/protocols, users deposit crypto currencies in Smart Contracts and receive interest. The deposited crypto currencies can also serve as collateral and users can receive correspondingly secured loans in other types of crypto currencies. Both the credit and loan interest are calculated and credited or deducted by Smart Contracts on the basis of fixed formulas from supply and demand with regard to the respective crypto currency. Some examples: Compound [41], Aave [42].

Decentralized exchanges (DEX)
Decentralized exchanges correspond to trading functionality implemented on-chain on the basis of Smart Contracts. They enable peer-to-peer trading without the presence of trusted third parties (operators of the trading functionality). Therefore, the DEXs are also considered “non-custodial”, i.e. the user does not have to hand over his coins to a third party for safekeeping, but the safekeeping is realized via Smart Contracts. The order book of classical exchange setups is replaced by so called Automated Market Makers (AMM). AMMs are (sets of) Smart Contracts which provide liquidity in respective tokens and allow an automatic trading - AMMs are certainly at the beginning of their evolution but might carry potential.

Given this automatic setup, the user has no counterparty risk, but - as with all DEFI applications - bears all technical and operational risks. Examples of DEXs are: Uniswap [43] , Kyber [44], dYdX [45]. It is reported [37] that the trading volume of DEXs is constantly increasing and currently corresponds to approx. 4 to 7% of the volume of the central exchanges.

Other “financial services” offered in connection with DEFI are

• Asset Management - usually wallets that allow the user to manage crypto assets within one or even across multiple blockchains. In order to support DEFI protocols, the wallets sometimes also allow direct interaction with DEFI protocols, e.g. Instadapp [46], argent [47], DeFi Saver [48].
• Prediction Markets - Marketplaces allowing users to bet on the outcome of certain events, e.g. election results, scores, project completion dates, etc., e.g. Augur [49], Gnosis [50].
• Generation of derivatives through tokens. These derivatives replicate prices of “off-chain assets”, i.e. real-world valuables such as gold or shares, but also price movements of crypto currencies, e.g. Synthetix [51].
• Staking - there is no equivalent in the traditional financial world. In decentralized proof-of-stake blockchain systems, validators - equivalent to “miners” on Bitcoin - check the correctness of the transactions and generate/propose blocks. They receive transaction fees for this service. In systems with “proof-of-stake” consensus algorithms, the validators lock a deposit on-chain - the stake. If a validator provides the service in accordance to the rules, the stake is returned to validator; if not, it loses part or all of its deposit and may no longer be able to act as a validator. In DEFI-staking, the investor provides validators with capital and receives a share of the revenues.

DEFI - Radical user orientation, high innovation speed and a new type of products

From the point of view of the traditional financial industry, you would say: “Granting secured loans is part of our core business and we have been doing it for centuries, derivatives are traded all over the world and asset management is also an established business, so what should be new here? „

Well…
… at first glance, every single DEFI application seems to replicate seemingly well known concepts and products from the traditional financial industry, and that at present still in a rather rudimentary form and with, compared to the financial industry, negligible volumes.

However,

• all users have direct access to the services and products without the use of intermediaries. They can compare the available services transparently and simply use the ones that seem most suitable,
• it is precisely the openness of DEFI that can also lead to products “going viral” and good products rapidly establishing themselves in the market. This generally promotes competition and can especially increase the market opportunities for new providers,
• as the products are implemented by means of Smart Contracts the products execute automatically,
• new, innovative products services can be offered easily and quickly. If analyzed carefully one finds that DEFI-products do not just replicate classical financial products, but carry interesting new features given that DEFI opens a new way of building financial products,
• users can combine the services and thus put together products according to their specific needs.

Due to its characteristics of openness, flexibility through programmability and composability, DEFI is also referred to in the literature as the “LEGO of a decentralized financial system”. These characteristics could very well lead to radical user orientation and much higher innovation speed if applied within financial services.

DEFI - Not yet an industrial-strength foundation for a new finance paradigm

For direct use in the financial sector, DEFI is not applicable in its current state, because

• users are not sufficiently protected. The most popular example of losses in the DEFI ecosystem is the so-called “Flash Loan Attack” in February 2020, in which ethers with a value of approx. 1,000,000 USD were stolen from a margin trading application in the course of two attacks [30]. Similar to the ICOs in 2017, DEFI is currently in a hype phase and due to a lack of investor protection, some irregularities are suspected to happen, e. g. [38],
• DEFI services are “permissionless”, no KYC checks are carried out,
• the DEFI movement is still limited to a small community [31],
• the DEFI services are based purely on public blockchains and the respective crypto tokens. They are also subject to the high volatility (except stablecoins) of the crypto currencies and their - from the point of view of traditional financial services - low liquidity,
• the technical environment of public blockchains including DEFI Smart Contracts and protocols is not yet sufficiently mature for an “industrial strength” use. It is difficult if not almost impossible for “John Doe” to assess the products. An example is the YAM project, where a smart contract error led to losses of several 100,000 USD [32],
• of the lack of maturity of the DEFI ecosystem, for example there are sizeable differences in interest rates for basically identical services in different protocols/dApps [33],
• of lack of privacy, confidentiality and anonymity. As DEFI is built on permissionless blockchains transaction data and account balances are pseudonymous, e. g. in case of Ethereum public addresses of a users as well as transaction amounts and account balances are visible. There are already efforts underway tackling these topics, e. g. project Aztec [64].

The question therefore arises whether the financial industry can safely ignore DEFI or whether it should prepare itself for a possible innovation surge triggered by DEFI.

DEFI as innovation driver for the financial industry?!

To answer the last question based on my gut feeling: Yes, please watch what is going on with DEFI: Crypto currencies & the concept of stablecoins have fed the discussion around programmable Fiat money, ICOs have triggered the transformation towards digital/crypt asset markets. Now, with money as well as assets (securities) available on blockchain, why would DEFI not trigger the creation of new digital products and services on the blockchain and drive innovation further.

But let us now try to answer the question a little more analytically. To this end, Figure 4 summarizes possible development scenarios of DEFI and their possible influence on innovation in the financial sector.

Figure 4: Schematic illustration of possible DEFI development scenarios and possible innovation potential based on the current DEFI hype.

Based on these 4 possible scenarios - analogous to the developments described above - 2 innovation thrusts can occur:

• Further development of the asset class of crypto currencies through DEFI
• Transformation through regulatory compliant adaptations of DEFI into “DEFI-for-Finance”

Further development of the asset class of crypto currencies through DEFI

At present, “seasoned bankers” think just as critical of the DEFI movement as they did of the crypto currencies per se just a few years ago.
"Extrapolating" the proven innovative power of “crypto”,

• Increasing size of the crypto ecosystem
• Improvement or refinement of the algorithms and models deployed
• Development of new products and services
• Improvement of the technical implementation and apps that allow access for non-specialists

it can be assumed that due to the activity already taking place and the steadily increasing popularity, a technically and methodologically more mature generation of DEFI-protocols and -dApps will possibly be available within a short time.

Furthermore, through the acceptance of the crypto currencies as an alternative asset class per se, the financial industry will possibly try to generate additional returns for the crypto portfolios of institutional investors, especially against the background of low interest rates. In addition to traditional financial instruments based on the crypto currencies, such as futures trading, DEFI may be the way to generate return. This would not only bring the DEFI-use to the financial players, but would in turn strengthen the asset class "crypto " as a whole.

DEFI-for-Finance - Transformation through regulatory compliant adaptations of DEFI

In this section, a hypothesis is formulated how DEFI adapted to the financial sector - “DEFI for Finance” - could look like and what consequences this would have for traditional finance players.

From the point of view of the crypto industry [62], the greatest advantages of DEFI result from the fact that the DEFI applications run on permissionless blockchains and the implementation is based on Smart Contracts. Thus

1. anyone with Internet access has access to all DEFI services
2. anyone is free to implement DEFI applications
3. the applications operate decentralized (this is often not (yet) the case) and are therefore not subject to the control of a Trusted Third Party
4. the applications are interoperable (apart from a possible lack of technical interoperability of the underlying block chains. However, this does not currently play a major role, as the vast majority of DEFI services are implemented on Ethereum.)

These supposed advantages are counterbalanced by the usual rules that apply in the financial industry:

1. Users have to go through KYC and any regulatory approval processes (in the following, the processes are summarized by KYC) in order to use the services
2. Only appropriately regulated entities may offer financial services
3. Contracts can only be concluded between legal entities, not computer programs

DEFI-for-Finance goals

The goal will now be to create a framework for a DEFI infrastructure that reflects the advantages of DEFI as much as possible, but at the same time observes the rules that apply in the financial industry, i.e.

1. Provide access to infrastructure and services to as many KYC approved users as possible.
2. DEFI-for-Finance should be open to as many entities as possible within the scope of their regulatory capacity to offer services.
3. The services should run as autonomously as possible, but the Smart Contracts can be clearly assigned to and are controlled by one provider.
4. Inter-operability between services should be ensured.

How could a DEFI-for-Finance platform look like?

Figure 5: Permisionless DEFI Apps (black arrows) are located on a permissionless blockchain (black square)

Figure 5 presents a schematic overview of what DEFI looks like: unpermissioned DEFI-dApps/-protocols built on unpermissioned blockchains. Given this open architecture any user can access any service and any service provider is free to build and offer any service.

Figure 6: Traditional finance consists of KYCed provider infrastructures (green squares). Within each service provider silo the services (black arrows) are open to customers without further access restrictions.

Compared to this open architecture traditional finance is made up of ‘service provider silos’ , where KYC processes are part of new customer onboarding processes of each service providers, e. g. banks. After the onboarding process (KYC, risk classification, etc. ) of a provider services offered by this service provider — and only those — are accessible to the customer within the bank’s own infrastructure without restrictions, however, in line with the customers classificaton e.g. restrictions due to the user’s stored risk appetite (see Figure 6).

Figure 7: Services: rounded arrows, black: no KYC-check, green: with KYC-check, rectangles: platforms, black: without KYC-check, green: with KYC-check. Top: Consortium platforms, Middle: Consortium platform with efficiency between the service providers as the main goal. Bottom: Permissionless platform with KYCed services.

The adoption of blockchain from a technical point of view together with tokenization (see Figure 1 phases 1 and 2) has led to the development of blockchain ecosystems of different natures within the financial industry. Figure 7 provides a high level overview. Top: A provider or a consortium of providers offer their customers services by means of a platform. The customers can access all or a subset of the platform services services after a one-time KYC check. For some parts of the services offered, there may be separate access restrictions (mixed forms are possible). Middle: Consortium platforms whose primary goal it is to ensure efficient cooperation between service providers. (End-) customers are given access to the respective services of one provider via the KYC processes of this provider. In this model, the traditional model (see Figure 5) is essentially retained and only efficiencies of the technology are leveraged. Bottom: The services are offered on a permissionless blockchain. Each individual provider performs KYC checks for its service(s). This corresponds, for example, to the current practice of token issuance on Ethereum.

Figure 8: In order to be able to use the services deployed on the platform (green rectangle) the user needs to go through a platform wide KYC-process. After this the user can access any service (black arrow) that is in a regulatory compliant way available to him/her without further access control.

The platform variants mentioned have the same underlying pattern. They are, just like the traditional finance industry, provider centric while the core of DEFI is user centricity.

In DEFI-for-Finance the whole product universe - irrespective of the provider - has to be available to the user and the user needs to be able to select and combine the products solely based on his/her requirement. The minimal requirement to achieve this in a compliant way is the introduction of platform wide KYC-processes as shown in Figure 8.

Given that users might face regulatory restrictions or might not be granted access due to their risk appetite, pure KYC services will not suffice but need to be ‘upgraded’ to platform wide “Access-Services” (s. Figure 9). The role of these services is to perform the KYC-processes for users and also

Figure 9: In addition to Figure 8: Access Services (green boxes), Users (roundish rectangles), access and risk classes (blue and purple circles), the green arrow indicates the off-chain interaction (KYC and classification) between a user and an Access Service. For simplicity only one Access Service is shown.

classify the access to services for each user based on user data and the user’s risk appetite. This is done ‘off chain’, i. e. a user would select an Access Service and provide his/her data necessary for the platform KYC-process as well as other classifications to the service. In addition it would provide his/her public blockchain address to the access service. The service in turn grants access, and classifies the user - mapped onto the user’s public address. Given that the KYC and classification are performed off-chain, only the user’s public address is visible on-chain. All other user data are kept private between the user and the Access Service. In case the user wants to use a service or product, the respective Smart Contract contacts the Access Service and in return gets to know if the user behind the pubic address is allowed to use this product or service. In case a service requires additional data, these are sent by the user off-chain to the service provider or are provided by the Access Service upon user consent - further discussion on privacy are omitted here as this article focuses on the concept.

It seems that with the setup as described above (Figure 9) the DEFI-goals 1, 3 and 4 can be reached: any user that gets “admitted” to the platform has access to the services he/she qualifies for, smart contracts are related to service providers and users can (as far as allowed by their classification) use the services in an inter-operational way, i. e. chain them together.

However, goal 2 is not necessarily fulfilled within the above setup. This goal “ …. open to as many entities as possible within the scope of their regulatory ability …. “ imposes some requirements on the access of service providers

• Someone needs to ensure that a service provider has the correct regulatory status in order to be able to provide the service
• Someone needs to ensure that no qualified service provider is going to be blocked from entering the platform, e. g. due to other provider’s commercial

Note: Topics around platform operation is not touched as the goal of the article is to look at the effects of DEFI on the financial service industry. The topic of platform operations is complex and needs to be answered under the prevailing legal and regulatory requirements. The discussion of possible blockchain setups, their advantages and disadvantages is omitted as well.

Both topics seem to ask for a platform governance body. The governance needs to be sufficiently strict in order to ensure that providers fulfill the regulatory requirements but at the same time ensuring that no qualified provider is hindered from entering the platform due to commercial interests of others.

This problem has been recognized by the Libra project, as well [25]: “ … An open, transparent, and competitive process for the provision of network services and governance of the network is key for 1) expanding the membership base of the Association and 2) ensuring its renewal over time. At both stages, the Association will set open-call criteria to ensure that the selection process is objective and transparent, and also that it incorporates critical dimensions for the growth, diversity, safety, and integrity of the network…”. Therefore, the future evolution of the Libra project might provide some valuable insight on how to setup such a governance framework.

To summarize, in this section it sketched out how to develop a DEFI-for-Finance infrastructure in analogy to e. g. CBDC projects. As for DEFI it is key that the infrastructure is open to as many as possible users/customers as well as (regulated) providers. For this openness to be guaranteed, an open and inclusive governance framework is essential.

DEFI-for-Finance could lead to a radical shift towards customer and product centricity

By design DEFI-for-Finance will induce a shift from provider centricity to customer centricity. Customers’ choices are not confined any more to products within a service provider’s infrastructure, but can easily put together his/her own product and service portfolio across different providers within a single infrastructure. Even more so, the fact that a customer is bound to hold his/her assets either in self custody or with an independent crypto custodian will lead to a further weakening of the the traditional relationship between customer and service provider. As a consequence product quality is likely the main driver of value for the customer and thus of revenue driver for the provider. Margins gained on cross selling activities will have less relevance in DEFI-for-Finance than in the traditional finance industry.

The infrastructure itself is designed to create a level playing field for providers. However, off-chain and timing elements might introduce differentiating factors between the providers.

Level playing field for service providers

A level playing field for the service providers in DEFI might possibly lead to the following consequences:

• Typical hurdles for customers switching between providers are non-existent or do exist only to a minimal extent
• Speed of innovation is bound to increase as the products compete directly with each other
• Easier market entry for small players as compared to what would be possible within the traditional finance infrastructure
• Due to the (assumed) wide reach of the platform, niche products should have a higher chance for adoption
• Given the transparency within DEFI-for-Finance some algorithms, models, implementation designs or even product might become standard and turn into commodity - as they can be replicated easily - and thus will be low margin from the provider point of view
• …

Differentiating factors between providers

Despite the level playing field on the platform, there seem to be some differentiating factors between the providers based on skills, organizational processes, connectedness in the market as well as innovation speed.

• Superior proprietary knowledge, e. g. valuations, risk assessments is likely to increase the product quality, thus increasing the chance for ‘winning products’
• Given that products within DEFI-for-Finance (besides the asset class ‘crypto’) are going have a relationship to the ‘real world’, e. g. security token based on real estate, well connected providers with access to better assets might be able to deploy ‘winning’ products
• DEFI-for-Finance providers with better processes connecting the ‘real’ world and the ‘digital’ world based on sound operational processes might also be able to offer better and/or more competitive DEFI-for-Finance products, e. g. superior NPL processes might lead to better DEFI-for-Finance loan products
• Possibly banks might also use DEFI-for-Finance - as additional channel - to extend their conventional business. For example they could ‘outsource’ some of the exiting loan portfolio to DEFI-for-Finance, transferring some of the credit risk to the users willing to buy into the respective products and thus reduce the bank’s credit exposure at the expense of some margin. Obviously, activities like this require highly advanced risk management and control on top of the respective tech knowledge.
• In the same spirit, banks possibly could convert conventional products requiring repetitive manual work, if feasible, into DEFI-for-Finance products and save some cost by using the ‘programmability’ of DEFI for automation and decrease cost. In [63] it is described how some traders move from OTC-Trading to using DEFI, for example. Given the apparent success of the Decentralized Exchanges using Automatic Market Makers, one could possibly think of similar trading functionality for ‘small trades’ implemented on DEFI-for Finance, for example. In case there might not be a 1:1 correspondence, the DEFI-representation might be ‘good enough’ or even superior. Obviously these conversions need to be conducted with extreme care (from risk, operational, business, marketing as well as customer relationship point of view).
• Winning products on a DEFI-for-Finance infrastructure will draw liquidity fairly quickly. Once a product with high liquidity has emerged in a certain product category, it will be hard to draw customers to challenger products although they might have (marginally) better features. This pattern, already observed for ‘classical finance products’ , might even be more pronounced for DEFI-for-Finance products due to transparency. Therefore, speed of innovation will also be a critical success factor.
• …

Summary

Finally, let’s summarize and try to answer the question, if traditional finance should ignore DEFI or if it should at least look into it and draw insights for possible new innovations and business models that might come up in the finance industry.

• By analogy to the earlier evolutions in the crypto industry, DEFI has a chance to introduce some innovations relevant for the industry
• DEFI is likely to make the asset class of crypto currencies more ‘interesting’
• DEFI can (possibly) be translated into a ‘regulated setting’ forming a DEFI-for-Finance infrastructure
• Given its strict customer centricity and product focus the DEFI-for-Finance infrastructure itself will create a level playing field for the service providers, i. e. existing brand names will be of lesser importance
• DEFI-for-Finance is - other than DEFI - likely to connect the real world (via tokenization of real assets, etc.) and the digital world.
• Service providers with sufficient technical skills and proprietary knowledge, good connections to the ‘real world markets’ and high innovation speed seem to be in the pole position to develop winning product and new business models

Therefore, although it is still in its infancy, it would be worthwhile for the financial industry players to look into DEFI. Certainly for those who are in the process of / thinking of including the asset class of crypto currencies into their portfolios. For the others as well as they might get some valuable insight on how they can create innovative products and business models based on digital money and tokenized securities early on.

Disclaimer

Disclaimer: The views expressed by the author of this article do not necessarily represent the views of his employer or any organization he is associated with. The author has made every effort to ensure accuracy of information provided; however, the author cannot guarantee such accuracy. This article is strictly for information purposes only. It is not financial advice. The author of this article does not accept liability for losses and/ or damages arising from the use of this publication.

References

Sorry for the fact that not all references are in English.

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[46] https://instadapp.io/

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