Traditional finance can learn a lot from DeFi

Traditional capital market owners as well as new entrants looking to gain market share should watch out for innovations in the cryptocurrency ecosystem, collectively known as Decentralized Finance, or DeFi. These innovations provide a model of the direction traditional capital markets are likely to take in the coming years as regulation catches up with Distributed Ledger Technology (DLT) capabilities and the technology itself expands. Perfect through use “in nature”.

Decentralized exchange protocols, also known as Automated Market Makers or AMMs, are one of those innovations that are widespread in the cryptocurrency space.

Real-time billing is a game changer

We can immediately see that with AMMs, trades are being processed almost in real time. Compare this to the two days (T + 2) it takes to liquidate most of the most liquid stocks in today’s advanced capital markets. The timely settlement of MMAs offers two main advantages: reducing counterparty risk and improving balance sheet management.

Traditional finance can learn a lot from DeFi
Traditional finance can learn a lot from DeFi

Financial institutions participating in capital markets must reserve cash on their balance sheets to cover the risk of non-delivery by their commercial counterparty. The reserve requirements are determined by the parties to the transaction. Until a transaction is completed, they need to immobilize cash on their balance sheet to offset the risk. With the real-time clearing and settlement functionality enabled by the DLT infrastructure (demonstrated by DeFi protocols), reserve requirements are a fraction of the amount required to add to a two day clearing and settlement reserve in reserve stay. If protocols similar to those used by AMM were applied to traditional capital markets, the vast majority of the immobilized capital on the current balance sheet could be used economically in capital markets, converting opportunity cost into economic gain.

With a sufficiently large takeover, real-time processing can also reduce system risk. Since the 2008 financial crisis, large global central counterparties (CCPs) have been used as intermediaries in response to regulations designed to reduce the risk of system failure. Although CCPs employ complex risk mitigation strategies, they are now so interconnected that the risks they should mitigate are exacerbated. According to a 2018 report by the Financial Stability Board, the 11 largest CCPs are linked to 16-25 other CCPs, with the two largest “accounting for nearly 40% of the total pre-funded funding made available to all CCPs.” … “The failure of a single CCP negatively affects most accounts and could lead to cascading failures even worse than those associated with the 2008 financial crisis.

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Less rental searches and acceleration of bootstrapping

In addition to real-time processing, AMM protocols (Decentralized Exchange) reduce operating costs and rent searches through disintermediation. The infrastructure that makes up the exchange is reduced to a code and distributed among the participants, whereby these provide the necessary liquidity. This last characteristic has the power to fuel capital formation and democratize access to capital. This is exactly what we are now seeing in the burgeoning space of native cryptocurrency.

MMA protocols have gained popularity in the “wild west” of cryptocurrency markets, where self-governance and anonymity are the norm. In April, spot volume traded via AMM protocols exceeded $ 164 billion in a single month, representing more than 10% of total spot trading volume in the broader cryptocurrency markets.

Related: The Rise of DEX Robots: MMAs Fueling an Industrial Revolution in Retail

It’s not just about sharing

Other DeFi products have also gained in importance over the past year. One example is the loan, where users keep digital assets in guarantee funds where they can be borrowed. Compared to traditional loans, the automated custody, settlement and trust management reduces the rent for the implementation of these measures. Debt outstanding on DeFi loans (a key metric in tracking adoption) rose from $ 500 million in mid-2020 to over $ 25 billion in May 2021, led by the Compound, Aave, and Maker protocols.

In addition to loans, more complex derivative instruments such as options, futures and synthetic assets are used. In summary, DeFi protocols quickly mirror traditional capital markets, but with significant advantages.

Related: The new decentralized digital economy needs to be academically validated

What does this mean for traditional capital markets?

Of course, DeFi – as it currently exists in the world of cryptocurrencies – does not comply with the regulations due to its pseudo-anonymity and dependence on self-administration. However, This fact shouldn’t put off traditional finance owners and startups. There is already a clear roadmap on how innovations in the DeFi area can be adapted to traditional capital market infrastructure.

Related: DeFi is the future of banking that humanity deserves

The big players in the traditional capital markets have already recognized the change and are taking a step. For example, they aggressively enter the digital asset custody game. For example, Standard Chartered’s investment in Switzerland-based digital asset custody solutions provider Metaco, which has just completed a Series A valuation of $ 17 million, was twice oversubscribed.

In addition, several forward-thinking jurisdictions have already created regulatory sandboxes that encourage experimentation and innovation with DLT-based solutions for capital markets. Some examples are the Monetary Authority of Singapore with its FinTech and Sandbox Express test center, the innovation centers and test centers of the European regulators for FinTech as well as the FinTech laboratory of the Saudi Arabian Capital Market Authority and the ADGM RegLab of Abu Dhabi.

Related topics: Europe is waiting for the implementation of a legal framework for crypto assets

Outside of these sandpits, more and more newcomers are showing the way.. The Singapore-based regulated digitized securities platform iSTOX completed the FinTech Regulatory Sandbox from MAS. This made it one of the first DLT-based capital market platforms to be approved and licensed by a major supervisory authority.

ISTOX closed a $ 50 million Series A in January and contributed investments to a variety of Japanese state-owned companies, including Japan Development Bank and JIC Venture Growth Investments, the venture capital arm of Japan Investment Corporation. These investments are another clear sign that capital market owners see DLT-based infrastructure as a profitable move.

The opportunity

In a complex and structurally critical system like modern capital markets, the changes will of course change gradually. Consider the example of custodian banks, which are legally and practically anchored in the structure of the capital markets. It will likely take a decade for custodian disintermediation to take place on a large scale, as 1) regulations need to be changed and 2) DLT-based market infrastructure needs to be developed, tested and widely deployed, as described in the Opportunities for Blockchain report -Technology “set out” in capital markets.

This means that both traditional and new operators have many opportunities to establish themselves in the world. Stream of the DLT-based capital markets. Now is the time for forward-thinking traditional financial players to take a step.

This article does not contain any investment recommendations or recommendations. All investments and operations involve risks, and so do the readers should do their own research in making their decision.

The views, thoughts, and opinions expressed herein are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.

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