The era of Decentralised Finance (DeFi) is upon us. DeFi will disrupt the financial system for the better. But it will take time to gain traction and there are some challenges ahead.
We believe that DeFi will have a profound impact on how financial products are developed, marketed and sold. It can also change the way banks operate by making them more open to new ideas and customers. DeFi may even lead to the end of ‘too big to fail’, as DeFi platforms become so engrained and pervasive that they can weather any losses from their activities in an economic downturn.
But DeFi won’t happen overnight. It will take time for its full potential to be realised, and there are some challenges ahead.
The main one is that DeFi has yet to find its true killer app — something that makes it so compelling that other players in the financial system want to adopt it en masse instead of using legacy methods. We believe this will happen within five years, but we also think it’s important for regulators to help accelerate this process by creating a supportive environment for innovation in which all players — incumbents and startups alike — can thrive. So what does this mean for investors? We think it means looking beyond traditional asset classes such as equities or fixed income, while at the same time keeping an eye on developments in areas like cryptoassets or stablecoins. In our view, these areas offer some of the most compelling opportunities because they combine huge growth potential with low risk and high reward potential over the long term.
Our aim with this article is threefold: to provide you with an overview of what Decentralised Finance means today; to highlight some of the key trends we expect to see over the next few years; and to outline some of the regulatory issues that need to be considered going forward if we are going to realise DeFi’s full potential without running into problems along the way.
What is the state of DeFi today?
Decentralised Finance today is a world of promise, but also of uncertainty. The promise is that financial products will become cheaper and more accessible to the masses. The uncertainty is that the industry may be vulnerable to attacks from within and without. The threat comes from within, as the industry faces a new wave of regulation and scrutiny. But it also comes from without, as centralised systems are increasingly under attack by hackers. This makes it vital for firms in the decentralised finance (DeFi) ecosystem to have strong cyber security defences in place.
Secular trends
Three principle benefits of using decentralised finance are the reduction in settlement times, reductions in fees and reduction in costly reconciliations. Where liquidity or price discovery is impeded by lengthy settlement times (increased market, credit and Herstatt risk), prohibitive fees (too many intermediaries or intermediaries charging rents), or costly reconciliations (every party maintaining their own database) expect DeFi to gain increasing traction. Custody & Securities Lending, Prime Brokerage and Clearing Services all have these three impediments in common. Consequently expect DeFi initiatives in these areas first.
Regulatory Considerations for Defi
Defi seeks to eliminate traditional intermediaries between parties in a transaction. This is to reduce costs, increase settlement times and reduce the need for reconciliations. But this inevitably reduces the impact of intermediaries that have acted as advisers, gatekeepers and enforcers. Similarly some intermediaries provide liquidity, margin and capital controls; all services that protect individual parties as well as the market as a whole. DeFi products are typically promoted by unregulated entities on unregulated channels. Influencers on social media (and blogs?!?) are prominent avenues for promotion. Many DeFi products do not include standard disclosures. Information asymmetry between the purchaser and the promoter increases the risk to the retail investor. While admittedly difficult to enforce expect regulators to require promoters of DeFi to provide appropriate ‘health warnings’.