Is DeFi the next phase of Financial Engineering?
Cryptocurrencies💰 : An emerging Asset class! 🏦
Cryptocurrencies have been mostly categorized as a speculative instrument, versus an asset class or a currency. However, the total Market Capitalization of the cryptocurrencies space has grown markedly over the last decade, and the recent DeFi craze has got many of the Institutional Investment Firms thinking of its future prospects, with many now accepting this market to be one of the emerging asset classes.
If cryptocurrencies do become an asset class, the impact this will have on financial services firms will largely depend on the coordinated approach of global regulators and policymakers to regulate and enhance market participants’ confidence in these instruments.
Cryptocurrencies and the Regulatory Context 📝
However, things seem to be getting difficult for the global regulators & policymakers, especially after the recent DeFi craze. It is often argued that the underlying infrastructure coupled with different economic incentives over which cryptocurrencies are being created are so different from what traditionally have been possible that it will be wrong to try to evaluate crypto assets using the same traditional legal definitions.
The invention of cryptocurrencies not only implies an evolution of our monetary systems but also of our legal and judicial definitions pertaining to monetary policies and economics.
And based on recent developments, nothing could be more true. The inherent financial models being created through tokenization are so markedly different from what has been traditionally possible that there really is no present legal framework which can be used to classify them and we currently lack the quantitative and econometric models to accurately price them or to study their market behaviour.
DeFi : The Next phase of Financial Engineering?👨🔬
The question then arises, what really do these crypto assets represent?
Most of the individuals less familiar with the crypto space often assume crypto assets to be speculative instruments with a greater ease of global transferability when compared to fiat currencies. What is misunderstood here is that these crypto assets often represent different sort of valued incentives or accessibility rights, the ease of distribution is inherent to the Blockchain over which these crypto assets are created, and are not a feature of these crypto assets itself.
For eq — ETH, Ethereum blockchain’s native token actually represents the value of the compute power of the decentralized computation network that Ethereum blockchain inherently supports, for which you have to pay in Wei (1 Eth = 10¹⁸ Wei) from which it can be argued that ETH actually derives its value.
Although the gas prices and transaction processing should considerably improve with Ethereum 2.0, it is still not meant to be used as a native currency, as it caters more to the creation of financial infrastructure use-case.
This represents a marked shift from existing corporate incentive structures, and showcases how an incentivized financial system (gas fee, mining rewards) can be created around a service being provided (decentralized computing) on a technological stack using Blockchain.
DeFi and Financial Engineering ⚙️ 🛠🔧
If we borrow from the terminology of the Institutional Financial space, Financial engineering refers to the development and creative application of innovative financial technology, which includes financial theory, quantitative techniques, financial products, and financial processes.
From a microeconomic perspective, the motivation behind financial engineering is to produce profits for the innovators by finding better ways to address society’s needs, and to create products which can be used to hedge risks currently present in the existing financial systems. Decentralized Finance, generally referred to as DeFi, has been an overnight success which was years in the making.
DeFi is inherently allowing any anonymous market participant to create an incentive driven business platform, often represented and structured as a “financial protocol” running on Ethereum (Decentralized Global Computing Network) where the tokenized incentive can either represent a certain utility / ownership right / control / or a monetary value distribution scheme, while the Blockchain Infrastructure’s inherent transparency , digital ease of transferability and fractional ownership features further allowing its distribution based on a certain quantitative model which can be programmed in any way imaginable!
While the developments and innovations that have occured in Finance over the past 50 years have taken place within the existing financial Jurisdictions often trying to address inefficiencies that exist in the current financial markets or to create new profitable products and business verticals led by Centralized Banks and Established Banking Institutions over which our jurisdiction controlled monetary structures are dependent upon, the crypto currencies space and the emerging DeFi market are inherently trying to reinvent this wheel while providing investors an asset class along-with differentiated financial products (security tokens, crypto assets, governance coins) which are now being used by the Institutional Investors as an hedge to the existing regulated and government / bank controlled financial products.
Crypto critics and relevant stakeholders within the Institutional Financial space are currently highlighting the lack of control and shallow reward / governance promises being made by “scam” protocols based on “Vampire Schemes”, which have now become increasingly common within the DeFi space.
However, what they fail to observe is that Ethereum being completely open sourced and accessible will inherently represent and nurture such a market! Many of the crypto assets being created during the current DeFi craze on Ethereum are actually showcasing the inherent financial innovation capabilities that the DLT infrastructure is capable of, and should be seen as a Financial Engineering innovation.
On platforms like Corda or Hyperledger, you won’t see such things happening. But then again, for innovation to happen, such an environment is needed. Being the field of finance, things will get messy here. Remember that there was no ecosystem in 2010. And it will be interesting to see how this evolves from here over the coming years!
Decoding DeFi Innovation From an Historical Perspective 📜
If we study the factors that have led to Financial Innovation over the past 50 years, these 4 sub-categories usually emerge as the underlying drivers of separation between the past and the present of financial firms and the established monetary systems, namely
- Technology
- Globalization
- Deregulation
- Risk Intermediation
Technology was the 1st force!🖥️ 🖨️️️
Until the advent of personal computers and parallel processing in the 1980s, most technology was too slow to be utilized in the context of the capital markets.
Prior to the advances in technology, mathematical techniques could only be used theoretically in finance as it was not possible to wait hours or days for the answers.
- At the beginning of the 1970s, we did not have the personal computer; instead, handwritten spreadsheets and calculators were used to perform calculations.
- We did not have desktop publishing. Instead, typesetters used to type in individual rows and nights were spent proof-reading the lines as they were changed.
- We did not have mortgage calculators to perform interest and principal calculations. Instead, bankers looked up monthly payment amounts in books that contained tables of principal and interest for different rates.
However, as this period progressed, many techniques whose power was only dreamed about in the early 1900s became employable practically by dealers, end users, regulators, and others. For example,
- Derivatives markets, which were non-existent in 1970 (interest rate swaps and currency swaps), topped $50 trillion outstanding by the end of 1998.
- Structured notes, collateralized mortgage obligations (CMOs), and asset-backed securities (ABS) were introduced during this period.
Advances in technology changed how firms and individuals participated in the capital markets. Transactions became ever less “hard copy and local” and ever more “electronic and global.”
Distributed Ledger Technology (DLT), often referred to as Blockchain, is inherently a Technological Innovation. It combines several IT technologies, including distributed data storage, point-to-point transmission, consensus mechanisms, and encryption algorithms, and is often looked upon as a major breakthrough in data storage and information transmission mechanisms, which can fundamentally transform the existing operating models of finance and economy.
Most of the Established banking / Financial systems have already started working on blockchain based proof-of-concepts, either internally or in partnership with other entities by forming Consortiums. (R3, CLSNet, Corda to name a new) However, these undertakings are too close ended to allow for experimentation, which eventually inhibits innovation.
This is where the DeFi space becomes relevant, because by being completely community driven and open-ended, it allows regular individuals to reimagine financial structures and to create new kind of incentivised financial mechanisms and tokenized instruments which may cater to different use-cases and ultimately redefine how we think about value driven econometric systems over the years!
The DeFi space does have its problems and is sometimes over-shadowed by individuals simply looking for quick profits, but Innovation has always been accompanied by problems, which in the long run helps identify shortcomings and improve upon what’s being built.
Globalization was the 2nd force! 🌐📧
With technology arrived e-mail and satellite communications. Information flow became cheap and virtually instantaneous, and cross-border transactions were executed in seconds versus days at the beginning of the period.
A related result was that capital market events began to transcend borders, sometimes causing sympathy crashes or other market moves as traders tried to anticipate one market’s reaction to another’s event.
Another noteworthy development has been the establishment of a global supply chain network empowered by information technology because of which global labor markets converged while labor costs flattened. This development was enormously beneficial for elites while workers in the developing countries also enjoyed growing incomes and social mobility.
On the flip-side, it resulted in middle-class stagnation as well as job displacement for the working class in developed countries, resulting in negative social sentiments and increased tensions stimulating pivotal events such as Brexit and the United States–China trade war.
In these uncertain and divided times, cooperation that is built on trust is more necessary than ever, and blockchain may as well be the new technology stack which can be structured and designed to act as the fundamental infrastructure of globally distributed systems, functioning as a technology as well as a methodology by which we can transform the existing global socio-economic and political paradigm while making social policy-making and execution processes more transparent, robust and efficient by design!
The current liquidity mining craze happening in DeFi inherently shows how “tokenized socio-economic governance systems” can be created on blockchain, which eventually can be scaled to cater to inefficiencies present in the existing systems and create new socio-economic models of the Future!
Deregulation was the 3rd force! ⚖️
In 1971, the Bretton Woods system, which, through government intervention, had worked remarkably well in maintaining stable exchange rates since the end of World War II, collapsed. This was followed by a dramatic increase in the volatility of exchange rates. Banks now had to pay market-determined rates rather than government-mandated rates.
As the Blockchain technology evolves and gets more integrated into the existing financial systems, the existing regulatory and legal frameworks will eventually need to be updated, which will involve smart contract getting legal credibility and the introduction of CBDCs (Central Bank Digital Currencies) with much more, and developments have already started happening in this space!
For Eq — Guernsey, one of the British Channel Islands approved an amendment to the existing law validating the legal effect of smart contracts in 2019. The ability to leverage digital documents that include smart contract code across multiple platforms is a very significant step towards the future digital environment of securities servicing, which is further validated by the Northern Trust (financial services company headquartered in Chicago, Illinois) which deployed legal clauses as smart contracts directly from a digital legal agreement onto its private equity blockchain.
Facebook introduced Libra, a digital currency project which eventually had to face legal and regulatory drawbacks. If facebook had succeeded, it may very well would have had the opportunity to become the very first DAO of its scale. The gram network by telegram is another such project which is currently facing legal blowbacks, which are bound to evolve over time.
Risk intermediation was the 4th Force! 📉
Another contributing factor was the expansion of financial institutions’ businesses to include the intermediation of risk in addition to the intermediation of capital.
During this period, not just banks but mutual funds, insurance companies, brokers, government agencies, and credit unions became ever more likely to stand in between, not only to move capital, but also to move risk from suppliers to users.
The developments (oil shocks, collapse of Bretton Woods, dramatic currency moves) that happened during the 1970s —1990s had made it clear to corporations and financial institutions that active risk management was essential to their financial health and competitiveness.
Whereas it had been acceptable to most shareholders in 1970s for corporations to announce increased sales but decreased profits due to currency exchange losses or volatile raw materials costs, this was no longer the case by the end of the period. Shareholders started demanding that corporations need to employ risk/reward management tools to keep risk within acceptable bounds.
This increased demand led to the creation of new products, notably derivatives (at first called “synthetics”) and financially-engineered securities. They added risk intermediation to the business of capital intermediation.
Blockchain, while representing the evolution of the underlying technological framework over which these products can be created and exchanged, is additionally providing an opportunity to the participating institutions and relevant stakeholders to create new quantitative mechanisms and engineered tools which can be further utilized to create financial products which can enhance risk intermediation capabilities of these participating firms while parallely addressing business problems and inefficient incentive structures through the use of these new tokenized engineered products.
And this is what the current DeFi mania seems to be all about. Various protocols active in the DeFi space are inherently creating these new business models centred around a financial scheme, be it through “liquidity mining” by rewarding individuals who have staked their coins, or through integration with other protocols and leveraging the network effect by allowing participants to multiply their returns through “yield farming”.
Conclusion
While the historical growth and evolution of Financial Engineering has been impacted by various different factors, the DLT architecture by combining these otherwise segregated factors together multiplies the potential impact that Financially Engineered Incentive structures and tokenized models will have over the emerging Financial Space.
“ SIGH FINANCE is part of an R&D undertaking to develop & document Financially Engineered liquidity mining driven econometric models and other engineered financial products driven by A.I on the DLT Infrastructure.
As part of this initiative, we have started this article series where we discuss the developments happening in the DeFi space, how it relates to the overall Institutional Financial Markets, and the inherent potential underlying DeFi which can be tapped into through Financial Engineering.”
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