Why Regulating DeFi is Necessary: The $20 Trillion Dollar Opportunity
The financial sector has historically been slow to embrace technological evolution but cryptocurrencies are a catalyst for change. With the vast majority of central banks exploring Central Bank Digital Currencies (CBDCs), the coupling of Decentralized Finance (DeFi) and the banking sector has already begun.
The strongest example of such is the list of open investigations into blockchain and cryptocurrencies commissioned by the Bank of International Settlements (BIS) — the central bank of central banks. With more than twenty projects conducted through its Innovation Hub, the BIS is helping invigorate an industry that has mostly stayed the same since our parents' time.
Spared of any major technological disruption in decades, the global banking sector has finally met its match with crypto — and it is time to regulate decentralized finance to fully embrace it. For banks that are prepared to "ReDeFine" finance and effectively manage the looming infrastructural revamp of the industry, there is a $20 trillion USD value creation opportunity to build on.
In spite of major technological innovations across economies and industries, upon closer examination, it is apparent that the underlying global financial infrastructure has resisted the digital revolution. Certainly, there have been technical breakthroughs with payment rails.
Financial consumers like you and I may visit our local bank branch less often, using cash less and less. The user interface (UI) and user experience (UX) have both improved drastically from analog to digital, affording round-the-clock account balance checks and seamless digital payments that modern consumers most likely take for granted.
The reality is, however, that these changes are merely surface level. Traditional banks struggle to keep up with the pace of technological change in other industries. For reference, a report by McKinsey estimated that traditional banking institutions only account for half the valuation of the total market capitalization of the global banking sector, with specialists and fintech companies capturing the remainder.
Although it functions well, legacy banking infrastructure is complex and slow. The intricacy derives from the numerous layers involved to ensure that the order and payment match, from payment order through to execution and reconciliation. The time between order and execution is what elongates the process, taking several hours or days depending on whether the payment will travel across international borders or not.
Blockchain is a back-end technology that can alleviate these plumbing issues. It works well, and it is simple, fast, and cheap. Simple — because the order and the payment are the same, they are not dissociated, which eliminates reconciliation costs. Trade is settlement! Fast — because the transfer or payment takes place at the same time as the order is made; it is almost instantaneous. And cheap — because you only pay for the transaction once validated and recorded on-chain.
Banking is inherently a costly endeavor too, as it necessitates the payment of fees, account maintenance, additional charges relating to foreign exchange, as well as establishing and maintaining institutional relationships. That is why the BIS is assessing the use of blockchain to issue CBDCs, particularly with Project Mariana, the purpose of which is to determine the viability of automated marker technology (AMM) for the cross-border exchange of hypothetical Swiss franc, euro, and Singapore dollar wholesale CBDCs.
Blockchain lays the foundations for tomorrow's finance
The emergence of decentralized exchanges (DEXs) that are predicated on AMM tech, such as Uniswap, demonstrated that the digital exchange of securities can be programmed and executed using algorithms at scale. However, it is important to acknowledge that DeFi has its limits. The crash of Terra Luna and its UST algorithmic stablecoin, the losses of which were likened to those of the 2007 financial crisis, illustrates that unregulated innovation can be dangerous for the end user, which in this case is the financial consumer. In the same vein, the door is open for criminals to use these new financial services without regulation.
With wise regulation, DeFi has much to offer. It gives a legal framework to innovation, prevents crooks from creating useless and dangerous protocols, and limits money laundering and illegal financial practices. It makes finance simpler, faster, and cheaper. Plus, it has the potential to bring affordable financial services to as many people as possible. BIS’ Project Mariana builds on DeFi-induced innovations, merging the benefits of established regulatory principals with efficient automated processes and greater financial inclusion.
Where do the Central Banks and BIS fit into the crypto industry?
As reported by the Boston Consulting Group (BCG), the fundamentals of the overall financial services industry are strong. In fact, BCG tracked $2.3 trillion USD of net profit in financial services at a rate of 18 percent, one of the highest profit margins across industries. Still, the industry itself struggles with innovation and customer experience. More than half of the world’s population remains unbanked or underbanked, and technology continues to unlock new use cases in leaps and bounds.
On the other hand, the fintech sector, representing roughly 9 percent of all financial services valuations globally, has been driving innovation and transforming the customer experience. As such, in laying the foundations and beating a path down for private financial players to optimize their operations with blockchain-based infrastructural solutions, the BIS is assisting central and commercial banks to stay competitive. This is called institutional DeFi. This is finance ReDeFined.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.