DeFi Will Replace The Global Financial System

Decentralized finance, also known as DeFi, covers various financial applications that run on the blockchain, and this year has brought some major milestones and advances in this area.

There's no denying that DeFi will play a major role in finance of the future, and the U.S. Commodity Futures Trading Commission looked at the problems with regulating it this week. 

Canaccord Genuity hosted a virtual fireside chat on DeFi with Galaxy Digital CEO Mike Novogratz and ParaFi Capital founder Ben Forman in October. Analyst Michael Graham recapped the fireside chat in a recent note, and what the experts had to say about DeFi was very eye-opening.

Novogratz sees the long-term investment opportunity within blockchain as impossible to ignore because of the size of the total addressable market. He believes the infrastructure for the entire $90 trillion global economy could eventually be replaced. Novogratz also pointed to the large amounts of intellectual capital that has been invested the space as an indication that the complex problems of DeFi will be solved over time.

Forman compared DeFi to the intersection of open-source software and finance. He sees the next logical step from "uncensorable money," which is bitcoin and other deregulated currencies, as "uncensorable financial services." 

One of the main features of the Ethereum blockchain its is smart contract functionality, which enables developers to program "if, then" statements into the code, supporting financial applications. Forman explained that with a global untethered financial services ecosystem built on smart contracts, the need for middle- and back-office departments would be mostly eliminated because most of those functions would take place in the algorithms. 

He added that a full suite of transparent applications has been built within DeFi covering everything from borrowing, lending and hedging to foreign exchange, insurance and indexing. The system uses no intermediaries, which Forman said would grant users better financial terms than what they would receive from traditional financial institutions. Lenders would earn more than they would from a bank, while borrowers would pay less. 

Novogratz believes DeFi is the single biggest threat to the legacy financial system because it mostly cuts out banks from the functions they currently generate sizable profits from, such as ATM fees. However, he does see roadblocks to adoption, with one of the biggest being regulatory and compliance concerns. Many institutions have strict requirements that will have to be addressed to ensure that all participants are using "clean money." 

The CFTC held a virtual meeting this week to talk about the problems with regulating decentralized finance. The CFTC's Technology Advisory Committee watched a presentation about DeFi from the Virtual Currencies Subcommittee. It suggested that the CFTC could look for the best way to apply liability without stifling innovation. However, the meeting also showed that there still isn't a way for regulators to halt the use of DeFi for illegal activities.

Gary DeWaal, who's on the Virtual Currencies Subcommittee, talked about the possibility of developers of DeFi protocols being liable, but there are some problems with that. Decrypt explained that software development is protected by the right to free speech, but even if it weren't, arresting the developers of a DeFi protocol running on a blockchain won't actually stop the blockchain it's running on.

Another possibility is secondary liability that comes from helping or controlling someone who is carrying out illegal activity, which could be a risk for DeFi liquidity providers, end users, governance token holders and even miners processing blockchain transactions. However, prosecutors in such cases must prove that they willfully assisted the wrongdoing, which could make it too difficult to enforce. 

Aaron Wright, another member of the subcommittee, pointed out that a safe harbor agreement that shields entities from liability if they follow certain guidelines would be a good way to push DeFi protocols to comply with the relevant regulations in the U.S. It would shield protocol developers if their protocols have a lawful purpose and don't entail any fraud. In the end, the CFTC subcommittee decided to take a wait-and-see approach to determine where the risk of illegal activity would appear within the DeFi ecosystem.

Much of the DeFi ecosystem is built on Ethereum because of the smart contract functionality. Graham notes that one of the more prominent DeFi applications is Compound, which enables users to "deposit digital assets into a smart contract and earn a yield in a decentralized, non-custodial, interest-bearing account." Other users can then borrow those digital assets, and interest rates are continually adjusted via algorithms based on how much borrowing is occurring. 

Compound launched in 2019, and there has already been over $2.3 billion supplied and more than $1 billion borrowed by more than 100,000 users. Forman believes there is a chance for the collateral posted to evolve from digital assets like bitcoin to tokenized equities, collectibles or other asset types. 

One way to measure adoption of decentralized finance is to look at the total value that's been locked into the various apps, which is also the total collateral that's been posted across the DeFi ecosystem. Forman said total value has climbed from about $1 billion in mid-June to almost $15 billion in November. Forman believes that if all other factors remain constant, the platforms could scale another five to 10 times on the back of current momentum before needing additional capital.

DeFi could become the foundation of the back end of the entire financial system, and consumers would be relatively unaware that their accounts are even running on those platforms. However, before that can happen, developers must work on scalability. Ethereum currently maxes out at about 14 transactions per second.

(Disclaimer: The author is the founder and CEO of ValueWalk.)