While bitcoin is increasingly considered as a store of value and a payment method, many players are recognizing Ethereum as the cryptocurrency to building a new financial infrastructure. Ethereum is the world’s second-largest cryptocurrency after bitcoin. It originally expanded on bitcoin’s blockchain, by adding a programmable functionality.
Put simply, the blockchain technology is a record of transactions that does not require an external authority to validate the authenticity and integrity of data, or in the words of blockchain experts Don and Alex Tapscott, it is “an incorruptible digital ledger of economic transactions that can be programmed to record not only financial transactions but virtually everything of value”.
This blockchain technology is now used to create an ecosystem of mostly decentralized protocols, that aim to provide many types of financial services in a decentralized, non-governed way. This trend is typically referred to as ‘decentralized finance’, or DeFi for short. Broadly speaking, DeFi players are trying to recreate existing traditional financial services in a decentralized way using blockchain.
DeFi players are trying to recreate existing traditional financial services in a decentralized way using blockchain.
Figure 1: USD 40 billion in value is currently locked in DeFi
Source: DeFi Pulse, Robeco. Data as of March 2021. Locked value in USD billion.
Decentralized lending and borrowing
Lending and borrowing are key services provided by the financial industry. These activities typically require an intermediary – a bank for instance – and some level of trust. DeFi aims to disrupt this area by using smart contracts and a decentralized system of processing and validation. In short: lending without a bank.
To provide a concrete illustration, Compound is currently the largest DeFi lending protocol. Through Compound, lenders create a liquidity pool where interest rates are determined depending on supply and demand. Both lenders and borrowers can exit the loan at any time.
Currently, the core use case for decentralized lending and borrowing seems to be (margin) lending to speculate in cryptocurrencies. Yield farming may be another motivation for lending and borrowing of cryptocurrencies, as one gains the governance token (COMP in the case of Compound) and that could exceed the spread between lending and borrowing rates.
Exchanges like the NYSE and Nasdaq are examples of centralized stock exchanges. Similarly, most cryptocurrency exchanges, such as Coinbase and Binance, are centralized. These exchanges are part of a chain of third-party entities that normally ensure and oversee the transfer of assets – such as equity, bonds or foreign exchange instruments – from one party to the other.
Meanwhile, transactions made through ‘decentralized exchanges’ (DEXes) are administered via a blockchain/distributed ledger. This essentially removes third parties, which saves time and costs. Besides, DEXes are marketplaces with no central point of control, making it much less vulnerable to hackers.
Uniswap, SushiSwap and Curve Finance are the most prominent DEXes currently operating. All three have just over USD 4 billion of value locked. Curve Finance, for example, is considered as the ‘FX for DeFi’ play, as it provides one of the best avenues to swap stablecoins.1 Curve Finance is an exchange liquidity pool with an execution price determined algorithmically. It uses an automated market maker (AMM) protocol, designed for swapping stablecoins with low fees and slippage.
NFTs are much more than digital art
On a smart contract platform like Ethereum, it is possible to tokenize anything imaginable. This includes media content like pictures, music and virtual gaming items. The result is called a non-fungible token (NFT). These digital assets are tradeable and provable representations of their underlying asset.
As such, NFTs are one-of-a-kind digital collectibles, and could have huge repercussions for IP protection and royalty collection in the art and media segment. NFTs recently hit media headlines when digital artist Beeple sold the NFT of his work ‘Everydays: The First 5000 Days,’ for USD 69 million at Christie’s.2
But NFTs could also be used as collateral for loans or accounts receivables. Another extremely interesting potential use of NFTs is for digital identity purposes. In an increasingly digitalized world, such digital identification services seem bound to become critical. Since NFTs are as unique as one’s identity, they can literally represent any good, service or person.
As DeFi emerges, traditional financial institutions will have to change their mindset.
What’s the impact for financial institutions?
Digital innovation has disrupted major industries, from retail commerce and media to hospitality. Although fintech newcomers have started to eat into the market shares of incumbent financial services providers, the underlying business models have so far not really been challenged. Big banks still dominate the competitive landscape.
This is partly due to the fact that their moats are protected by regulation. They have access to deposit insurance systems, and they are generally are trusted brands to safeguard money. Today’s financial system is still heavily reliant on banks and other financial institutions that play the crucial role of central intermediary that ensures the network operates relatively efficiently and in a trusted way.
This pull towards the largest, most trusted entities, strengthens big bank moats and helps explain why many fintech firms end up partnering with incumbents instead of trying to displace them. But as DeFi emerges, traditional financial institutions will have to change their mindset. Some, like Square, with its CashApp that allows the trading of cryptocurrencies, have already started making this shift.
For instance, DeFi may help lower counterparty risk by providing guarantees around the execution of transactions, using opensource software in a public environment. Blockchain offers the promise of a more transparent and secure system, that does not rely on complex regulation-driven relationships. It could also open new markets, allowing increased choices in terms of products, cost and risk.
A ‘picks and shovels’ approach
While we remain in the very early stages of DeFi, it is crucial to track developments. The seeds of the potential disruption of major businesses around savings, payments, lending, investing, capital raising and insurance are being planted. As part of our FinTech equity strategy, we have a small and growing position in companies that enable the trading, managing and storage of digital assets.Read the full article
1 Stablecoins are virtual currencies pegged to assets such as fiat currencies, cryptocurrencies, or commodities such as gold and silver.
2 See for example: Germano, S., 11 March 2021, “Beeple collage smashes digital art record with $69.3m sale”, Financial Times article.