I saw an interesting comment from a regulatory body testimony earlier this month about how we’ve developed a finance and banking model over the last two to three hundred years that “reliably… provides support to the financial markets and investing public.”
Fair, but the implication was that truly disruptive financial innovation was not only unnecessary but unwelcome. Can you think of another industry where doing things the way they’ve been done for 250 years is seen as a positive? “This horse and carriage thing is working pretty well for us… let’s keep it.” Or “I’m pretty sure people can get their point across over the phone… this internet idea seems like a little too much.”
Why do I bring this up? Because while I’ve spent my career in capital markets and finance around the world, my current colleagues and I are a part of a small band of people evolving the financial system by building software for decentralized finance, or DeFi. In this article, and over the course of my monthly column for Utah Business, I’ll be discussing ways in which people are using technology to improve access to financial markets while coming up with new ways to build in safety and governance mechanisms. I’ll also hit on the challenges and pitfalls associated with changing the way things function.
So let’s get started. With backgrounds in finance, data science, engineering, and product design you may be wondering how we found ourselves exploring a growing but still largely unknown crossover corner of finance and technology. First, there’s the idea that capital is not matched up well between entrepreneurs and investors, that old boy’s clubs stifle diversity in thought, and that interested investors are excluded from most early-stage opportunities.
One of the biggest impacts someone could make is to improve how investing in private companies works. In many countries, this is open only to what are called accredited investors―in the US that’s people with over $200,000 in annual income for the last two years or $1 million in net worth (excluding the value of a primary residence). Here, regulatory innovation in areas like crowdfunding attempts to expand startup access, but in reality, you don’t see a lot of top tier companies going this route so retail investors are tied to low probability companies that will likely never benefit from the VC feedback loop or attract top tier talent and exposure.
Risky investments with lockup periods are exactly the opposite of what retail investors need. With smaller savings and unexpected expenses requiring liquidity, retail investors need a way to get into de-risked companies with a bite-size appropriate for them, and to be able to access their money at any time if something pops up. Enter DeFi.
The term decentralized finance describes a financial system without centralized institutions like banks, brokerages, clearinghouses, and exchanges that hold a person’s money. In fact, DeFi purists have a saying “not your keys, not your money.” In other words, if your money is sitting in an account somewhere, you don’t really have control of it. Insightful, but what does that mean in practice? The core concept of DeFi is that you keep custody of your money and plug into various applications as needed through web-based protocols.
Basically, instead of having your money in a bank account, your balances are stored in code on a blockchain and only you have access to this “wallet.” If you want to take out a loan, you connect your wallet to a decentralized application (Dapp) providing this service and do it. If you want to trade a cryptocurrency or tokenized stock, same thing. Go to a website providing that service, connect your wallet, make the trade, and disconnect.
The concept of holding your own funds instead of having accounts spread across various institutions may seem like a small distinction, but the implications are huge. First off, all transactions are done on a peer-to-peer basis. A piece of code called a smart contract governs the terms and, put simply, confirms that if Party A performs its requirements and Party B does the same, the transaction is valid and processed immediately. Both parties’ balances are updated and funds are available.
Secondly, transacting in digital assets often allows for lower transaction sizes since some types of these assets are divisible. Think of this in terms of a small investor being able to buy $10 worth of Amazon stock instead of having to purchase a whole share for $3,400.
Perhaps most importantly is the censorship-resistant and borderless nature of a decentralized system. Because you hold control of your assets and are trading purely on a peer to peer basis, in theory, people from all over the world should be able to participate in the same global market without worrying about setting up accounts in different countries or having their governments restrict access to the free flow of capital. Imagine a startup in a country with international capital controls being able to raise money from investors around the world, or a citizen of a country with rampant inflation being able to put his money digitally into a more stable currency.
Removing centralized institutions doesn’t come without potential downsides though. With transactions being controlled only by code, new ways to safeguard market participants must be put in place. The biggest hurdles for new participants to overcome are that if you lose the passphrase to your wallet, your funds are gone. Similarly, if you make a mistake on a transaction, there’s no customer service to call and get a refund. Contracts and the protocols behind them need to be engineered properly to make sure that volatility in the market doesn’t create a cascade of investor defaults. And then there’s the concern around a lack of controls for anti-money laundering and terrorism financing.
The good thing is that there are teams of smart people around the world trying to figure out how to address these important issues while maintaining the decentralized and independent ethos of DeFi.
DeFi has been largely centered around digital assets so far, with functions like trading cryptocurrencies and lending them out for a yield. But that’s where new players are coming in. The industry is at an inflection point where groups are now starting to use the underlying blockchain technology and DeFi principles to solve traditional finance problems.
In my next article, I’ll explore how projects are providing global access to stock markets by “tokenizing” equities and how we’re looking to expand access to pre-IPO companies.
Read More:DeFi is going to change the way we fund companies – Utah Business