The Growth Of DeFi Heralds A New Era In Financial Services
Programmable smart contracts are reducing the friction and costs associated with finance.
There is increasing discussion around the topic of decentralized finance in the blockchain and finance markets. These new products are bringing opportunities to leverage blockchain technology and improve the process of finance distribution.
Traditionally access to financial services has been limited to the wealthier sections of society and has been facilitated by a centralized finance industry. As new opportunities for financing are emerging it will be possible to spread liquidity to increasing numbers of people and reduce global financial imbalances.
The Ethereum blockchain aims to deliver a different value proposition to other forms of blockchain product. Different blockchains have focused on delivering a variety of core qualities. Ethereum was the first blockchain to be optimized for programmability and it is this innate focus that has made it the largest current system for digital contracts. Programmable contracts are heralding the arrival of a decentralized financial structure which the industry has termed DeFi.
Transfer of digital assets do not need to be direct but can be based upon stipulations built directly into the smart contract itself. Ethereum’s ERC-20 security tokens have emerged as the technical standard for smart contracts on the Ethereum blockchain. The opportunity to dictate the nature of transactions made with ERC-20 tokens is breaking the rules of how financial services can be delivered.
ERC-20 tokens can define six different functions which can be used to regulate them within the Ethereum system. These basic functionalities include how tokens are transferred and how data can be accessed. Standardization of how ERC-20 tokens act enables them to perform uniformly across the Ethereum blockchain. Because of this, almost all wallets which can store Ether as a cryptocurrency can also hold ERC-20 tokens. Other blockchains such as Bitcoin have rules which govern transactions but Ethereum offers the greatest customization.
Programmable smart contracts for crypto-assets have the potential to revolutionize the finance industry. Currently, traditional markets operate in a centralized manner. The mechanisms which facilitate products such as escrow payments or legal trust stipulations all rely on centralized nodes such as banks and lawyers. Centralized services have positioned themselves as facilitating trust in the marketplace peddling it as a prime tenant of their value proposition. With programmable smart contracts, there is less need for trust between parties as the functions of banks and lawyers can be written into the code of digital assets.
The centralized financial services of banks and lawyers create friction and costs for the marketplace. Involving additional parties in a transaction always adds additional time for the transaction to be executed. The services of centralized nodes increase the price of transactions as additional people and processes need to be paid. With DeFi those functions are integrated directly into the asset so transactions are executed with far greater speed and significantly reduced costs.
The DeFi approach to finance is revolutionary in how it manages financial products and is opening up new possibilities for the market. If financial transactions can be mandated to occur only “if” a certain action is taken or “when” a certain time has passed, what further opportunities are there for smart contracts?
Stablecoins are bringing the convenience and transferability of cryptocurrencies combined with the market value of fiat currencies. Both Tether and USDC have seen significant growth recently reflecting the market’s adoption of the technology.
The lending function of banks is now also under threat. Smart contracts for digital assets can be programmed to complete many of the functions that banks traditionally brought to the lending market. This space is expanding and eventually could help to level the playing field for small businesses requiring access to liquidity.
The variety of products and services which are being created within the DeFi environment will contribute to a robust ecosystem. As new products are developed they can be combined with existing blockchain products for new and innovative value propositions. The technology is relatively new and there is significant development happening to improve and strengthen the ecosystems.
As the market matures it will make the process of financial services increasingly streamlined and remove much of the friction associated with traditional centralized systems. It is going to be a fascinating market to watch.
Sonata Capital is registered in the Labuan International Business & Financial Centre, and invests in companies successfully exploiting the vast opportunities of the digital economy.
100% of the equity in our funds have been tokenised, and will be listed on digital securities exchanges in Labuan and elsewhere. The equity of Sonata Capital Ltd (LL16076) has also been tokenised, and the rights to the equity is represented by the SONATA security token issued on the Ethereum network.