Can traditional capital markets benefit from DEFIs?
DeFi Decentralized Finance
Incumbents in traditional capital markets, as well as new players looking to gain market share, should consider innovations in the crypto ecosystem known as Decentralized Finance (DeFi). These innovations are a model of the direction that traditional capital markets are likely to take in the coming years as regulations catch up with the capabilities of distributed ledger technology (DLT) and the technology itself is refined through widespread adoption.
Distributed ledger technology
Decentralized exchange protocols, also known as automated market makers (AMMs), are one of those innovations that have been widely adopted in the crypto space. AMMs are the underlying protocols that power all decentralized exchanges (DEXs) like for example Uniswap:
trades are settled in near real-time. Compare this to the two days needed to settle the most liquid securities in today’s advanced capital markets,
there is no involvement of counterparty risk,
and they have better balance sheet management.
Financial institutions involved in capital markets must reserve cash on their balance sheet to cover the risk of their trading partner failing to deliver a service or a product. The mandatory reserves are determined by the trading parties, and they must freeze cash on their balance sheet until the trade is settled to compensate for this risk. With the near real-time clearing and settlement enabled by the DLT infrastructure (demonstrated by the DeFi protocols), reserve requirements are a fraction of the amount required to be held in reserve by i.a. Wall Street. If AMM-like protocols could be adopted in traditional capital markets, the vast majority of capital currently tethered to the balance sheet could be deployed in the economy or capital markets, turning opportunity cost into economic gain.
Automated market makers (AMMs)
Real-time settlement, adopted on a large enough scale, also has the power to reduce systemic risk. Since the 2008 financial crisis, large global central counterparties (CCPs) have increasingly been adopted as intermediaries in response to regulations designed to reduce the risk of systemic failure. While CCPs implement complex risk mitigation strategies, they are now interconnected to the extent that they increase the risks they were supposed to mitigate. In fact, according to a 2018 report by the Financial Stability Board, the 11 largest CCPs are connected to 16–25 other CCPs, with the two largest accounting for “nearly 40% of the total pre-funded financial resources provided to all CCPs”. The insolvency of a single CCP will negatively impact most accounts and could result in cascading insolvencies even worse than those associated with the 2008 financial crisis.
In addition to near real-time settlement, decentralized exchange protocols (AMMs) reduce operational costs and limit profit-seeking by decentralizing intermediation. The infrastructure that comprises an exchange is reduced to code and dispersed among participants, with the participants themselves providing the necessary liquidity. This latter function has the power to initiate the capital formation and democratize access to capital — which is exactly what we are now seeing in the proliferating AMM cryptocurrency space. AMM protocols have gained popularity in the “Wild West” of cryptocurrency markets, where independence and anonymity are commonplace.
By April 2020, spot transaction volume via AMM protocols exceeded $164 billion in a single month, accounting for more than 10% of the total spot transaction volume in the broader cryptocurrency markets.
AMM protocols
What DEFI can offer? What cryptocurrency investors should know about DeFi?
Other DeFi products have also grown in popularity over the past year. One example is lending, where users lock digital assets into collateral pools from which they can be borrowed. Compared to traditional lending, the automated management of deposits, settlements and collateral reduce the fees charged for performing these activities. DeFi lending debt (a key indicator of adoption tracking) has grown from $500 million in mid-2020 to exceed $25 billion by May 2021, led by Compound, Aave and Maker protocols.
AAVE Protocol
In addition to loans, more complex derivatives are being implemented, including options, futures and synthetic assets. In short, DeFi protocols are rapidly mirroring traditional capital markets, but with far more positive aspects.
Of course, DeFi — as it currently exists in the cryptocurrency world — is non-compliant from a regulatory perspective due to its pseudo-anonymity, as well as its reliance on self-reliance. But this fact should not discourage traditional financial operators and startups. There is already a clear plan for how innovation in the DeFi space can be aligned with traditional capital markets infrastructure.
The big players in traditional capital markets have already noticed the change and are making moves towards the new technology. For example, they are aggressively throwing themselves into the battle for digital asset storage. Moreover, many forward-thinking jurisdictions have already established regulatory frameworks, encouraging experimentation and innovation with DLT-based solutions for capital markets.
DeFi space can be aligned with traditional capital markets infrastructure
From these regulated jurisdictions, a growing number of new entrants are leading the way. Singapore-based regulated digital securities’ platform iSTOX has completed the FinTech MAS regulatory framework. This made it one of the first DLT-based capital market platforms to be approved and licensed by Singapore’s main market regulator. ISTOX finalized its $50 million Series A capital raising in January, bringing in investment from several Japanese government entities, including the Japan Development Bank. Such investments are another strong indication that incumbent capital markets see DLT-based infrastructure as a game-changer.
Of course, for a complex and structurally critical system such as modern capital markets, change will happen gradually. Consider the example of trustees who are legally and practically entrenched in the structure of capital markets. It is likely to be a decade before fiduciary exclusivity can occur on a large scale, as regulations must change and DLT-based market infrastructure must be developed, tested and widely adopted. This means that there are many opportunities for both old and new players in today’s world of DLT-based capital markets. For forward-thinking traditional financial players, it’s time to get up out of your comfy chair and move to the insanely fast-growing DeFi sector. That’s where the future lies.
Looking at how the industry is evolving, there is no doubt that DEFi markets will complement what we already call Internet 3.0. This new Internet of the so-called metaverse will provide all-in-one solutions not only for financial gains but also for planning for the future, securing assets, using services or doing digital work. Etheros is the metaverse! Etheros today is the answer to what is to come in the next few years. It is a world where you can invest, play, build a store of value for generations to come, as well as create avatars, NFTs and much more.
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