Financial Markets

Interest in decentralised finance, or ‘DeFi’, is booming in the technology world. The term has invited enthusiasm, scepticism and curiosity, in equal measure. There is no doubt that the technology could be host to a number of exciting applications. At its core, DeFi rests upon the central principle of disintermediation, and this could have many benefits, including the democratisation of finance. By David E. Rutter, CEO at R3.

But let’s not get ahead of ourselves. The idea that DeFi is ready to replace the existing, centralised or traditional financial system, or ‘CeFi’, is wildly overstated, especially at a time when governments are increasingly favourable to regulated financial markets and institutions. The disruption that DeFi promises will simply not be permitted by public sector actors whose job it is to ensure orderly and stable market conditions, and, importantly, to protect consumers along the way.

The latest example of this tension has come from the Financial Action Task Force (FATF), the international standard-setter for anti-money laundering. The FATF has stated that creators, owners and operators of decentralised finance services and solutions should comply with rules designed to combat money-laundering and terrorism financing – a demand way beyond what most DeFi applications are designed to handle. In fact,  many DeFi solutions are not attached to any jurisdiction, person, or entity. The danger of this is that DeFi operates in a regulatory vacuum, with no accountability, offering little to no protection for consumers.  

Despite this, DeFi has many interesting applications. So, how can it be integrated in such a way that businesses and end users in complex and highly regulated industries can benefit from its potential, without being exposed to its inherent risks? The answer lies in permissioned, enterprise-grade blockchain platforms that connect DeFi and traditional, centralised finance.

Shades of grey

Technology research firm Gartner states that there are many grey areas where CeFi and DeFi can work in tandem. For example, DeFi applications might use assets issued by CeFi players, such as banks. Alternatively, banks may offer DeFi solutions to their customers, thus broadening their reach. DeFi’s core premise of leveraging programmable smart contracts and removing costly intermediary processes can be integrated into the existing financial system to improve efficiency, cut costs and reduce systemic risk. Imagine the amount of capital that would be freed up for investment when large middle- and back-office operations at regulated entities are significantly streamlined.

It’s important, however, to note a key attribute of the CeFi stakeholders who are critical to the success of this hybrid approach: they are regulated and ensure appropriate standards and governance when trading in these assets. Some, like clearing houses or central security depositories, may exist by legal mandate. Others fall within the oversight authority exercised by conduct or prudential authorities. Those that serve retail clients bear substantial consumer protection responsibilities. Global entities have spent decades learning to navigate competing demands across jurisdictions. Essentially, this hybrid model recognises that regulators and central banks have a vital role to play in maintaining fair and efficient market conditions and customer safeguards. For DeFi to succeed at scale, it needs partners within central or traditional financial market infrastructures, to unlock markets currently off-limits.

Ultimately, real change in financial markets is driven by collaboration. Improvements to the way money and assets flow through the global financial system have almost always been achieved by successfully integrating a new technology with the existing infrastructure and institutions within it. A proxy or leading indicator on how DeFi may develop is the history of bitcoin and the response it triggered among key commercial and government stakeholders. 

Building bridges

Bitcoin and other public blockchains triggered a reaction from both private and public sector entities and drove various use cases – such as central bank digital currencies and stablecoins. Although central bank digital currencies and stablecoins have yet to reach maturity, in terms of regulatory compliance and safeguarding, they are closer to incorporating systemically critical intermediaries in a more sustainable way than cryptocurrencies. DeFi can follow a similar trajectory. But DeFi with no connection to the existing financial system could struggle to meet security, operational and compliance requirements. The real danger for DeFi, therefore, is that it fails to reach its full potential and instead, is a niche solution that is regulated out of existence in developed financial markets. 

A DeFi-CeFi bridge – built on robust, enterprise blockchain technology – provides the right level of access and decentralisation that people want. This enables new services and innovation, in line with the network of regulated institutions that offer central financial services within it. For all its bold experimentation, DeFi will eventually mature and coexist with the financial services ecosystem we have come to know and trust. Only then will its users be able to rely on the same protections that we have become accustomed to as investors.

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