DeFi-ing traditional finance

In the old days when music was recorded on vinyl and broadcast over the wireless, there was a meaningful distinction between high fidelity and low fidelity. Hi-Fi and Lo-Fi. Now we have “DeFi”.

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But DeFi is not a musical term rather a diminutive of “decentralised finance” – broadly a financial system without a central point of control, be that the banking system or governments.

"“Let’s be direct: money and finance shall not be operated by coercive government among free people. They shall… emerge voluntarily and without central rule.” – Erik Voorhees, ShapeShift

Cryptocurrencies are DeFi because they circumvent traditional currencies and the managed transaction and authorisation systems mainstream finance has relied upon for centuries.

The reference to recorded music though is not gratuitous. With the advent of the internet, streaming services, digital music more generally, the old model of control by record companies, physical recordings and shops and all the associated distribution and gatekeeping mechanisms have been upended.

Indeed, David Bowie predicted this back in 2002: “The absolute transformation of everything that we ever thought about music will take place within 10 years and nothing is going to be able to stop it. Music is going to be like running water or electricity.”

The music industry today is DeFi.

Outside the system

Many predict the financial services industry, indeed the global financial system, will go the way of the music industry. Instead of banks acting like record companies and government agencies managing sales, cryptocurrencies, blockchains and platforms will allow businesses and consumers to conduct finance “outside the system”.

Underpinning this decrentralisation – and not just in finance but in any industry where physical authorisation of a tangible object is necessary – is the idea of distributed ledgers. Historically a ledger was one document held in a physical place, which was updated and maintained by a trusted authority - say a bank or a government agency for an economy-wide process - to validate a transaction.

Digital technology and the internet have made it possible for that ledger to be securely maintained nowhere in particular and in near real-time by replacing the traditional authority with a huge network of computers, each cross-checking one another. It removes the need for much of the existing, expensive, slower and often error-prone infrastructure involving multiple institutions, in finance today.

Blockchain is the most notable distributed ledger and it is used by companies such as Ethereum to provide the platform for DeFi and its ilk or Bitcoin for crypto.

And according to CB Insights, blockchain funding is at an all-time high: “In just the first half of 2021, companies raised over $US7 billion in equity financing — shattering previous full-year records.”

CB Insights says the explosion in funding was largely driven by demand for cryptocurrencies but listed 58 large industries blockchain could transform – including insurance, law enforcement and ride-hailing.

“From payments to how money is raised in the private market, will the traditional banking industry embrace this technology or be replaced by it?” the firm asks.

“On earnings calls, blockchain mentions have been on a tear in 2021 — and this time there are actual use cases of the technology.”

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One central issue

Needless to say, just as with cryptocurrencies, there is raucous support from those who are anti-establishment.

They are not just opposed to the - very real - high transaction and agency costs in traditional finance but the idea they have to rely on a sanctioned system at all. These groups range from innovators to more full-on disruptors and tech revolutionaries to libertarians and, at the far reaches, extremists and criminals for whom truly anonymous and untrackable transactions are extremely desirable.

And this is one of the central issues with DeFi: regulation.

Even legitimate governments who respect the rights of their citizens are concerned to protect the integrity of their taxation base and the security of their financial systems. They are justifiably conservative about handing over control to the internet.

One of the most notorious of these libertarians is an American named Erik Voorhees who founded the cryptocurrency platform ShapeShift (no boring names like Fidelity Mutual or Bank of Nevada for these guys.).

Vorhees calls ShapeShift a “decentralised autonomous organisation” and to his 500,000+ followers on Twitter (no relying on the lame old notion of MSM or a stock exchange announcement) he said “ShapeShift’s vision is the establishment of an immutable, borderless financial system.”

“Let’s be direct,” he continued. “Money and finance shall not be operated by coercive government among free people. They shall — like language, mathematics, and love — emerge voluntarily and without central rule.” Erik is no relation to Jason, another major disruptor.

Know your customer

As Gary Silverman wrote in the Financial Times, “of particular concern is the fate of a key pillar of the anti-money laundering regime — the requirement on financial companies to ‘know your customer’ (KYC). The KYC obligation means intermediaries are supposed to know their users’ names, monitor their transactions and report activities that raise money-laundering suspicions to the authorities.”

Global regulators are already alert and alarmed. The US head of treasury Janet Yellen and the president of the European Central Bank Christine Lagarde have been explicit in flagging serious concerns.

Yet, like the fintech revolution, the great opportunity of DeFi - be that blockchain solutions, smart contracts or tokenisation - is it brings enormous innovation and the opportunity to actually improve security – with simpler, better governed systems – and efficiency.

Moreover, again as with fintech, not every DeFi proponent is an anarchist. The Financial Times quoted Kristin Smith, executive director of the Blockchain Association, an industry lobbying group: “DeFi poses all sorts of unique public policy questions. The crypto community has ideas on how to [respond]. Our ask of policymakers is, let’s take some time to learn about this.”

All or nothing?

Yet DeFi is clearly a movement of note in the future of finance. The Economist recently devoted a major issue to the theme, covering trading on exchanges and issuing loans and taking deposits through “self-executing agreements called smart contracts”.

According to the newspaper, the value of digital instruments being used as collateral has grown from almost nothing in early 2018 to $US90 billion. Roughly $US2.2 trillion of transactions were processed in the second quarter, around the same sum as passed through Visa.

The innovation, the technology and the intensely customer-focused solutions offered in DeFi can undoubtedly improve financial services.

Nor is this an all or nothing encounter. Just like how fintech has been adopted into conventional systems, DeFi platforms and solutions can - and undoubtedly will - be incorporated into existing ecosystems.

Traditional banks have systems for anti-money laundering and KYC which are essential for regulatory approval and which can provide an imprimatur to DeFi. No doubt DeFi evangelists will argue this denatures DeFi. It doesn’t.

It allows the benefits to be harnessed for the whole of society – including those who may be ripped off by dodgy players, have civil society undermined by tax dodgers or their livelihoods threatened by organised crime if the financial system were to become a free-for-all.

Andrew Cornell is Managing Editor of bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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