1 July 2020

Decentralised Finance – the end of the traditional financial economy?6 min read

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Banks and financial intermediaries have recently come under increasing pressure. Central banks now only offer negative interest rates, strict regulations tie up internal resources and FinTechs compete for market shares. At the same time, it becomes ever more difficult for investors to find alternative ways of investing in classic financial markets. That said, so-called Decentralised Finance (DeFi) systems could open up completely new opportunities for the financial industry.

Decentralised financial systems offer a whole range of advantages that make them more flexible, faster and less complicated than our classic centralised system. Until now, we have been dependent on entrusting our money and assets to a third party – usually a bank. Similarly, financial transactions between two players are carried out through banks. With the SWIFT system, which dates back to the 1970s and is still in use today, interbank transactions take at best a day. In addition, international transactions involve checks on the legitimacy of the business partners (“know your customer” or KYC) – all tedious procedures that seem antiquated in our digital age.

A financial system without third party involvement

The idea behind decentralised financial systems is to carry out processes without or at least with little influence of the so-called “trusted third parties” – i.e. banks or financial intermediaries – which saves both time and costs. On the other hand, control over the respective money and assets lies mainly or even completely with the individual owners.

The basic principle is very simple: Each participant in the financial system has his or her own wallet, i.e. a digital wallet, in which digitised money and assets are stored. This principle is already widely known through cryptocurrencies such as Bitcoin. Here, too, each user stores his or her assets individually and is no longer dependent on a third party as administrator or intermediary. Trading between individual users also takes place directly, with the blockchain taking on the role of a testing ground to ensure that all parties involved actually have the cryptographic assets they wish to trade.

What does this mean in concrete terms for decentralised financial systems? First, based on blockchains, the classic bank account could be replaced by the wallets mentioned above. In addition to cryptocurrencies, wallets also allow the storage of so-called token – these are assets that have been completely digitised and are mapped in a blockchain to make them forgery-proof. Thanks to tokenisation, securities or assets such as real estate shares and other non-bankable assets (vintage cars, works of art, etc.) can be digitally displayed and can be traded – even proportionately. Once a user has stored all his money and assets in such a wallet, he is no longer dependent on an account with a traditional bank and can transfer funds directly, i.e. “peer-to-peer”. Although regulatory aspects still need to be clarified in this respect and it must be possible to ensure the security of the transactions and assets, it is still necessary to ensure that the wallet can be used to transfer funds directly, i.e. “peer-to-peer”. With a growing understanding of these applications and easier usability and operability, acceptance and thus the number of users will continue to rise.

A second important aspect of decentralised financial systems is the possibility of being able to use all available assets as collateral – virtually “collateralising everything”. Possible lenders and borrowers can no longer be found bilaterally or through a bank and financial institution. Instead, every user can make his or her existing cryptocurrencies available to the money market; they become fungible assets, so to speak. Other users can now borrow cryptocurrencies from this pool as long as they have sufficient collateral – the check for this takes place automatically via algorithms, which is why we are also talking about “algorithmic money markets” here.

The advantages are obvious. If lenders and borrowers no longer have to negotiate the credit terms individually, but instead this is also done automatically via smart contracts, both sides will find each other much more quickly and easily. In addition, the borrower is much more flexible: since the exchange of cryptocurrencies takes place with the entire money market instead of with individual players, no maturity dates need to be observed. Money can be repaid early, either in full or in part.

A third innovation that decentralised financial systems bring with them is the prospect of a derivatives market that has so far been completely untapped. Although derivatives are not new to the crypto industry, there is already a wide range of derivatives based on cryptocurrencies as the underlying. However, these derivatives are usually traded in the classic way, i.e. through a broker. However, providers and experts of decentralised financial systems are focusing on so-called synthetic assets in the future, which are based on smart contracts and accordingly make a third party such as a broker superfluous again – in addition to reducing costs, this also eliminates the counterparty risk. Here, too, the processing of the contract contents takes place directly on the blockchain as a substitute for a “trusted third party”. Thus, such decentralised smart contracts could open up a whole new universe of derivatives, which could basically be based on any underlying asset.

Still a few hurdles for DeFi systems

Despite all these promising possibilities, we also see that a fully decentralised financial world still seems to be a vision of the future at the present time. On the one hand, the crypto industry is currently faced with the task of determining the most suitable blockchain protocol for a decentralised financial economy, i.e. the infrastructure behind the system, and also bringing this to industry standards in order to keep up with conventional transaction systems. The high volatility of cryptocurrencies certainly plays a role in the further development of decentralised financial systems – although there are already various approaches to solve the problem, such as the use of stablecoins based on a selection of various other currencies. Last but not least, there are also financial regulatory issues that must be clarified if decentralised financial systems are to have any chance of success. It is true that the crypto industry has proven for some time that it can function without regulated financial intermediaries. But as long as cryptocurrencies are exchanged into our current currency system, we assume that financial regulators will continue to impose their regulations on actors in decentralised financial systems.

Nevertheless, we are very optimistic for the future that decentralised financial systems will have more and more influence on our traditional financial system. On the one hand, they offer enormous advantages over the previous system, in which transactions and financial operations each require a third party in the form of banks or financial intermediaries. The counterparty risk is eliminated in decentralised financial systems and costs can be significantly reduced – as can the duration of transactions. On the other hand, we can already see today that existing decentralised financial systems work and can ensure the necessary security for transactions and contracts by using the blockchain.

A major and important step towards decentralised financial systems was taken at the beginning of 2020, when the Government in Liechtenstein enacted the world’s first blockchain law, which provides a clear legal framework for all actors wishing to conduct blockchain-based transactions. The transformation to a financial world in which processes and transactions can take place decentral is thus in full swing – although it will certainly take some time.

Author(s)

Max J. Heinzle

Max J. Heinzle is the founder and CEO of 21.finance AG which operates area2invest, a marketplace for securitised and tokenised assets. He studied Business Management and Global Banking & Finance in London and gained extensive capital market experience at one of Austria’s leading Venture Capital firms and as Head of Investor Relations of a listed German technology company.

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