You probably have heard about Bitcoin's dipping prices or Elon Musk's comments about a meme coin. Discussions about virtual currencies and their potential for the financial system are everywhere.
However, relatively little is said about the potential that decentralized finance (DeFi) and shadow banks have to define the global economy's future outlook.
In the next paragraphs, you'll discover the meanings, opportunities, and threats of emerging financial systems.
Decentralized exchanges are the trading platforms where DeFi transactions take place. DeFi is a peer-to-peer (P2P) financial system outside of the control of a centralized organization, e.g., banks. Think about a system with no brick-and-mortar transaction rooms or loan interviewers.
DeFi users transact with their peers through an algorithm. Meanwhile, these algorithms source from a secure blockchain technology that powers their operations.
DeFi isn't just Bitcoin or NFTs. It presents a dynamic change to the global financial sector's structure, with promises of novel means of exchanging, saving, borrowing, and insuring assets.
On the other hand, shadow banking refers to financial organizations that aren't primarily connected to commercial banks but offer similar services. Think of pawn shops, mobile payment structures, and payday lenders.
Both DeFi and shadow banks saw tremendous growth within the last twenty years. Academics from a Chicago-based research institute highlighted that toughening regulations on traditional bank lending necessitated the rise of shadow banks.
For instance, U.S. authorities toughened their stance on the local real estate market amidst the 2008 economic downtown. Shadow banks' peculiar structures then allowed them to replace much of the traditional bank lending in the sector.
Additionally, shadow banks multiplied due to the growth of internet technology. Of course, it's also more straightforward entering the market when there's no need to build large buildings or physical offices.
On the other hand, DeFi grew significantly beyond the expectations of most industry players. Different reports reveal that the DeFi sector, which stood at $700 million in 2019, is now worth about $140 billion.
The meteoric rise in the DeFi sector and shadow banks has attracted financial institutions and regulators globally. However, the industries still have some challenges to overcome before realizing their best potential.
According to the authors of the book "DeFi and the Future of Finance," there are five main challenges in the traditional financial sector. One of the most evident challenges of conventional finance is centralized control.
The authors argue that traditional financial systems pose the challenge of centralized control. Governments, central banks, and other large financial organizations command a stealth monopoly over the system. For instance, a nation's central bank determines critical factors like how much money goes into the system and the inflation rate.
The authors - Campbell Harvey, a Duke University finance don; Ashwin Ramachandran, a general partner at Dragonfly Capital; and the founder of FeibLabs, Joey Santoro also explored other limitations of traditional financial systems, like inefficiency, restricted access, opacity, and lack of interoperability.
Traditional financial systems haven't changed much over the last 100 years - regardless of the digitization. In a separate article on a similar subject, Campbell Harvey observed that a Western Union transfer cost about 3% in processing fees in the 1800s.
Today, that's about the same rate that banks charge for credit card transfers, sometimes more. Yet these 21st-century transactions could take several days to complete.
Moreover, it's no brainier that the savings culture with traditional finance globally is almost non-existent. Meanwhile, borrowing rates are as high as ever despite the teeming interest rates. These challenges eventually impact the global economy adversely.
Join me to consider a hypothetical case of an SME business owner who applies for a bank loan. This entrepreneur presents an excellent business model that promises an annual return of 25%.
One of three things could happen. A worst-case scenario would see the bank decline the loan application for different reasons.
However, the bank may think that the business idea is fanciable but feel this entrepreneur is a "small" client. Banks prefer to lend to a large commercial organization rather than 50 small businesses.
The bank could offer to raise the client's credit card limit instead to assist the client. Of course, the interest rate of credit cards is scary enough to deter this business owner from proceeding with their plan.
Lastly, a traditional lender could offer this entrepreneur a loan and peg the interest rate at 22%. Considering the cost of the loan against the anticipated annual profit, this business owner decides to back down on the business project.
This scenario happens now and then across the world. Meanwhile, projects like this hypothetical business model drive economic growth.
But economic friction with traditional lenders often stiffened such budding developments. On the other hand, DeFi and shadow banking institutions help alleviate these economic bottlenecks and drive economic developments.
Harvey highlighted three main advantages of DeFi in his referenced article. They are interoperability, transparency, and the absence of bureaucracy. Blockchain technology is largely more transparent than the opaque traditional financial system, where government and government-related agencies solely monitor the economy.
Of course, clashing interests and the absence of a political will, and even maladministration could limit a government from accurately and efficiently highlighting bottlenecks in the system.
On the other hand, anyone who knows how to improve an algorithm could launch an enhancement within a week and upgrade users' DeFi experience. Moreover, DeFi deals are faster.
For instance, it could take a few days to exchange funds over Western Union or with your broker. Lastly, Harvey observed that DeFi deals don't suffer from the bureaucracy of conventional finance. There are no intermediaries between peers in DeFi transactions.
According to an explainer from Ireland's governing bank, Shadow Banking alleviates the dependency on conventional banks as a provider of credit facilities, thereby diversifying the financial system. Also, an article on the World Economic Forum's website highlights that shadow banking provides more liquidity to the economy.
This addition, the article observed, helps to lower the cost of capital, increase investments, and subsequently the overall economic growth. Meanwhile, the author said that a boom in the shadow banking industry could result in riskier funding for more productive investments. Shadow bankers will often fund loan applications for riskier ventures that traditional lenders would avoid.
First, shadow banks are interconnected with traditional banks because banks sometimes use them to circumvent capital and accounting laws. Therefore, the collapse of shadow banks could not only affect other financial organizations; but the average taxpayer on the street.
Harvey highlighted several risks of DeFi in his referenced writing. One of them is the governance risks, which mean that few persons could hijack an erstwhile decentralized algorithm.
Also, DeFi, at the moment, can't process transactions as fast as centralized systems. Ethereum, for instance, can only currently support about 30 deals in a second. Meanwhile, a recent NFT mint on Ethereum for Yuga Labs' Otherdeed tokens suffered extensively because of an unexpectedly high number of miners who clogged the Ethereum platform.
Per centralized systems, Visa, for instance, could process 1,700 transactions in one second. Thus, DeFi transactions aren't yet suitable for everyday transactions like centralized systems could support.
Another threat comes from a third-party source called the "oracle." Although blockchain technology is a closed system, it needs data from an external source called an oracle. However, someone else may manipulate or alter the information that reaches the oracle.
Soon, as the financial system morphs through different stages, there might be little difference between these nascent asset classes and traditional finance. We may safely expect individual financial services platforms in the future that would create opportunities for both convention and emerging financial solutions.
Creating a well-planned system that merges traditional finance, DeFi, and shadow banking could give enhanced value in the financial services industry to individuals, businesses, and the global economy. However, it might be best if the global financial sector embraced a painstaking metamorphosis - the better alternative - rather than a sudden revolution in driving innovation into its economic systems.