The Future of Finance Cannot Deny DeFi
Over the last few years of blockchain innovation, the technology has been promised as a sort of nostrum for whatever area of society might be riddled with opacity and inefficiency: business supply chains, elections and voting, identity verification and security, and healthcare, among so many others. But while blockchain technology will, no doubt, make important impacts in these industries in time, finance will be the first great arena where blockchain technology will meet mass-market adoption.
The rise of blockchain has dovetailed with an overall arc of finance democratization that has occurred over the last 20 years due to the rise of democratized communication and the internet. The internet took society’s intrinsic interest in money and financial speculation and distributed it across the world in the blink of an eye. These synchronous transformations have given us the move to online trading, faster settlement, fractional transactions, and round-the-clock markets, not to mention the crypto boom of late 2017, the mass adoption of a trading app like Robinhood, automated smart contracts, and, most recently, DeFi. “DeFi” is a portmanteau of Decentralized Finance, but it could just as easily mean Democratized Finance because by improving transparency and execution through eliminating the middlemen, DeFi helps level the playing field for Main Street investors compared to current practices that favor Wall Street professionals.
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As difficult as it might be to predict what finance and trading will look like in 2040, given what we’ve seen over the last 20 years, the DeFi revolution seems like the next logical step on this journey over the next 20 years, and not just because it is the latest crypto buzzword. Decentralized Finance will allow greater velocity, autonomy and automation of trading. What’s more, in continuing the democratization of trading we’ve seen since day traders used screeching telephone modems to swap stocks online, DeFi will further reduce the edge of the professional trader class, with power ceded to ordinary users augmented by artificial intelligence, bots, oracles, and smart contracts.
It is the very nature of finance that makes it so susceptible to change. Finance really has one simple scorecard: how much money was made? This metric can be improved through better yields, less risk or lower fees, but in the end it comes down to one simple metric and whatever process is able to generally improve that metric–as DeFi is already showing it can–will steal the customers from those that cannot.
Not just eliminating obsolete practices, but obsolete instruments
Among the many revolutions created by the internet in the last two decades, from commerce to information to politics, few are larger than the revolution of the finance industry. There are many people still working in finance who can remember the days of literally calling down to the trading floor with orders. This cumbersome process carried its own professional classes, fee economies, and rigid structure such as the inability to create and invest in fractional shares and additional fees for trading in “odd lots” (orders not multiples of 100 shares). Such practices are unimaginable today and many of these parts of the industry and their associated high fees have now almost wholly evaporated, replaced with the mainstreaming of innovations like computerization, automated trading, robo-advisors, trading bots and after-hours trading.
While the past two decades have been focused on reducing the latency of traditional and entrenched finance processes, they still serve a legacy paradigm of highly modernized but still centralized exchanges with trusted parties managing the trading of instruments issued under expensive, time-consuming rules rooted in the 19th century. What we’ll next see is the blowing up of this legacy paradigm and the financial instruments altogether. Financial instruments are, after all, “dumb” contracts in that they rely on an entire outside system for verification, interpretation and enforcement. DeFi smart contracts have the ability to incorporate all of these functions within their own code, thereby eliminating execution risk and negating the need for the greater part of verification and enforcement bureaucracies and their cadre of investment bankers counterparts. Once verifying a smart contract-based financial instrument becomes a process of just running an automated code audit, and all execution and regulatory rules are enshrined in this code, the need for armies of regulators and underwriters ceases to exist. Similarly, once these DeFi offerings are completely transparent and available from blockchain oracles to compare in innumerable ways, the importance of ratings agencies like Moody’s will lose relevance.
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There isn’t one part of the enormous spectrum of investment instruments available to the average investor, from bonds and equities to options contracts and deep derivatives, that won’t be completely transformed by DeFI. Options and bonds already exist as “contracts” and automating settlement of them as smart contracts will not only democratize access, but improve their functionality. Smart contract settlement automation will allow a whole raft of new options-type products because no one needs to create a new market for each one. The need for options contracts to settle at standard increments and monthly intervals, for example, is just a way to tame complexity to keep it manageable for human brains. Smart contract-based options will be able to create ad hoc options for any amounts and intervals and freely trade them on secondary markets managed by rules that don’t need to be easy for people to keep track of because they’ll be automated and algorithmic.
Most significant might be what DeFi can do for derivatives, where market makers can manipulate prices that should be purely data-driven. Anyone who watched the film The Big Short, a dramatization of the real story behind the investors shorting the broken system of mortgage default swaps that crashed the economy in 2008, will remember that the most tense part of the story is when the underlying assets have lost their value, but the swaps derivatives the protagonists invested in have not risen in value as they should have in a non-manipulated market. This situation was only visible because it was so extreme; less detectable versions of this occur in real markets all the time and will continue until these instruments are true decentralized derivatives with no centralized parties in a position to meddle in their execution.
As the oracles of DeFi eliminate information latency, the power imbalance will be further reduced. Integrating traditional finance with smart contracts will vastly increase the velocity of money and the speed and attractiveness of DeFi offerings will force traditional equities, options, and bonds to rapidly adopt these tools.
DeFi the world
Every current form of financial instrument will have some sort of direct DeFi analogue within 18 months from now. We’re already seeing early DeFi versions of bonds (Mainframe’s “tokenized bonds”), equities (Uphold’s fractional shares in the world’s largest companies), options (Opyn/Compound’s put options), and derivatives (Synthetix’s Ethereum derivatives) become available to investors. It won’t be long before sovereign debt and other traditional stalwarts are also tokenized.
In a world where even the rate of tech acceleration is, itself, accelerating, and economies are now defined by information as much as manufacturing, there is still one constant: people really like money. With that constant comes the added benefit of growing financial IQ, augmented by the instant knowledge engine of the internet. Younger millennials and Gen-Z had access to complex online financial tools not long after they were playing Minecraft. As these demographics move into the majority of the working-aged populations, adoption of these new technologies will rapidly rise for these tech savvy investors.
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With the continued popularity of Robinhood, cryptocurrency and DeFi, direct “downloads” of financial literacy will only increase, accelerated by the easier access of DeFi. Just as traditional financial firms had no choice but to cut fees once online trading came on the scene, the entire industry will now have to follow the most progressive DeFi adopters because of how easily customers can switch from their existing providers to those offering the new services they want. If customer loyalty ever actually existed in the finance world, it is certainly dead and buried after the numerous schemes by these companies against their own customers that have been brought to light. As a result, the traditional finance industry will race to their own extinction. In ten years the services we see today are likely to only still exist for some aging Boomers. Even extremely conservative pension funds and endowments will have chased yields into DeFi.
DeFi presents almost a perfect culmination of online gam(bl)ing and finance over the last couple of decades, with increased investor access continuing to now reward the best players among the many, not just the few. Naturally, in these early days there are code hacks, regulatory concerns, and the whole gambit of FUD. In due course, these will be resolved through legal frameworks, standardization and investor education as all past innovations have been. With both greater risk and reward, the pinnacle of democratized finance represented by DeFi is simply too much for the entire investment community to resist, let alone ignore.
