Decentralized finance (DeFi) is on the verge of a major paradigm shift. Since its inception, blockchain development has been recognized worldwide for its open-source approach to problem-solving and stunning innovation. DeFi, the conceptual decentralization of financial controls, has proliferated, reflecting the ambition of many blockchain “purists” to achieve complete disintermediation of traditional incumbents through “trustless” automation of financial processes. Recent developments, however, have illustrated that complete disintermediation may be illusory, as the absence of responsible individuals/ organizations may be unattractive when things go wrong. What is emerging from this cycle of growth is a stage of innovation that, while acknowledging the need for prudent controls and risk management, is no less exciting in its promise to embody the ethos of decentralization and enhance global accessibility to assets and markets. As DeFi enters this exciting next phase, we have the opportunity to ensure the system benefits all those who choose to interact with it. Society is conceptualizing the capital markets of tomorrow; the work that will build the open and democratized markets of the future has already begun.
Today: Market Volatility and Regulatory Activity
The current DeFi and crypto crisis wiped out 60% of the total value locked (TVL) in DeFi. With TVL estimated at approximately $70 billion at the time of writing, the contraction is both clear to see and difficult to fully comprehend without recourse to overly simplified and often pre-conceived narratives. The promise of agile finance and infrastructure free of unnecessary friction remains alive, but users are reckoning with the reality that easy DeFi yields and incentive-fueled DeFi token offerings (IDOs) come with risks that must be mitigated to unlock the promise of blockchain.
It should be clear that the market has been calling out for regulation for some time. Volatility levels that came to characterize the 2022 bear market ignited a flurry of regulatory activity in the sector, with regulators focusing on crypto, stablecoins, and DeFi protocols through know-your-customer (KYC), anti-money laundering (AML), and risk management. But, while 2022 saw regulators come to the table with newfound focus, this work was already long in progress.
The Dawn of Convergence
Right-sized regulatory activity has the potential to add much-needed muscle to the digital assets space, and recent moves by governments, regulators, and businesses are ushering in nothing short of a new age in digital assets. This new age will be defined by the convergence of traditional institutional finance and DeFi in a manner that requires everyone to take meaningful steps toward each other. The innovation we’ve seen in crypto could imbue future capital markets with innovation and never before seen financial speed. For the first time in history, we can make assets both smart and relevant – assets that contain within themselves the systems and policies by which they are governed.
This infrastructure has demonstrated a remarkable capacity for unlocking liquidity across existing fragmented markets. Introducing regulated digital assets to such a platform could offer people the best of both worlds: dynamic, agile, and responsive global liquidity combined with the confidence that comes with responsible oversight.
Tomorrow: 3 predictions for the future of DeFi
- Enhanced Transparency and Risk Management: At the core of any regulatory regime are disclosure, risk measurement, market credit, and operational risk management. As DeFi advances, protocols will become more transparent to their users, not by simply referring to smart contract code but by providing detailed risk disclosures, analytics, and active (semi) automated risk management: Protocol-level hedging and insurance mechanisms.
- New sources of yield and the emergence of true business models for DeFi protocols: Protocols are notoriously bad at capturing value and rely almost entirely on speculation in their protocol tokens. Governance tokens will be replaced with security tokens offered to investors in the protocol and used both for governance (voting) and dividend distribution. These dividends will be based on PoS staking and liquid staking revenues. The move to PoS by Ethereum will further accelerate the trend toward a multi-trillion decentralized fixed-income market. We also expect real-world asset (RWA) integrations like gold and other digitally-native securities like credit portfolios.
- Integration of DeFi into banking and FinTech: Financial institutions are attracted by the efficiencies, composability, and global connectivity of DeFi protocols, while DeFi protocols are interested in the vast client bases of banks and Web 2.0 companies. This merging will truly take it into the mainstream, fundamentally improving people’s lives in the process. Individuals will see better and cheaper access to savings and credit. On the business side, companies will similarly benefit from better financing options and processing speeds, bootstrapping financial agility, and freedom.
The opportunity presented by DeFi at this moment is the possibility to create a financial ecosystem that works for all who choose to engage with it. For many across the world, that means improved banking services. For many more, it means access to services for the first time. Put simply, a DeFi that works for everyone – not just speculators and whales.