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.
当資料は情報提供を目的として、Robeco Institutional Asset Management B.V.が作成した英文資料、もしくはその英文資料をロベコ・ジャパン株式会社が翻訳したものです。資料中の個別の金融商品の売買の勧誘や推奨等を目的とするものではありません。記載された情報は十分信頼できるものであると考えておりますが、その正確性、完全性を保証するものではありません。意見や見通しはあくまで作成日における弊社の判断に基づくものであり、今後予告なしに変更されることがあります。運用状況、市場動向、意見等は、過去の一時点あるいは過去の一定期間についてのものであり、過去の実績は将来の運用成果を保証または示唆するものではありません。また、記載された投資方針・戦略等は全ての投資家の皆様に適合するとは限りません。当資料は法律、税務、会計面での助言の提供を意図するものではありません。 ご契約に際しては、必要に応じ専門家にご相談の上、最終的なご判断はお客様ご自身でなさるようお願い致します。 運用を行う資産の評価額は、組入有価証券等の価格、金融市場の相場や金利等の変動、及び組入有価証券の発行体の財務状況による信用力等の影響を受けて変動します。また、外貨建資産に投資する場合は為替変動の影響も受けます。運用によって生じた損益は、全て投資家の皆様に帰属します。したがって投資元本や一定の運用成果が保証されているものではなく、投資元本を上回る損失を被ることがあります。弊社が行う金融商品取引業に係る手数料または報酬は、締結される契約の種類や契約資産額により異なるため、当資料において記載せず別途ご提示させて頂く場合があります。具体的な手数料または報酬の金額・計算方法につきましては弊社担当者へお問合せください。 当資料及び記載されている情報、商品に関する権利は弊社に帰属します。したがって、弊社の書面による同意なくしてその全部もしくは一部を複製またはその他の方法で配布することはご遠慮ください。 商号等： ロベコ・ジャパン株式会社 金融商品取引業者 関東財務局長（金商）第２７８０号 加入協会： 一般社団法人 日本投資顧問業協会