Cryptocurrencies and DeFi as seen by “traditional” finance. Part 3

    28 Nov 2021

    We finish our description of the cryptocurrency industry through the eyes of “traditional” financiers, primarily bankers. As it turned out, they are not as blinkered as we used to think. Moreover, they can reasonably assess the prospects of a decentralized financial world.

    Strong impression of DeFi

    Decentralized finance has undoubtedly greatly impressed financial market professionals. They especially like the ability of smart contracts to automate the manual processes of traditional finance, such as loan issuing, without a trusted intermediary. DApps are the fastest growing segment of the digital asset ecosystem.

    DeFi is also the area currently under scrutiny by the regulators. According to recent comments by US Securities and Exchange Commission chairman Gary Gensler, it is the case where applications could be considered securities if they provide traditional financial services. The SEC is reviewing DeFi applications and companies to determine if they should somehow be included in their existing regulatory framework.

    Even if they succeed, it will still be an imperfect approach. The very foundational principles of the blockchain-based digital asset ecosystem differentiate it from today’s tech. They allow it to provide cheaper, faster, safer, and more personalized services (promise and challenges).

    There are a few things that “traditional” financiers still don’t really get. First, the blockchain is open and transparent. It does not require permits, as everyone can see it and be sure of the transaction’s validity. Second, it is used to easily create new applications and smart contracts with verifiable open-source code. The software runs on a peer-to-peer virtual machine, unlike today’s software, which exists on a centralized server, or a collection of servers owned by a single entity.

    The global nature of the blockchain means that anyone with a computer or a smartphone can participate in the process anywhere and anytime. In addition, the new financial applications can smoothly and quickly interact with all other existing applications.

    Still, the main feature is decentralization. Digital assets and applications used for finance, supply chains, and identification are not controlled by governments or companies. The development team creates a code or an app, and users are responsible for improving it. This structure, however, poses a challenge for regulators. From our point of view, this is a positive, but bankers view it as an issue.

    Another issue for centralized finance is that blockchain applications could threaten entire industries. Cryptocurrencies were the first implementation of blockchain technology. They provided peer-to-peer payments – a true godsend for many people without access to traditional banking services.

    Then, 2015 marked the arrival of smart contracts (automatic transactions) implemented by the Ethereum network. It became possible to create decentralized applications based on smart contracts. Over the past two years, we’ve seen the next generation of apps: DeFi is further expanding access to financial services, including savings, lending, derivatives, asset management, and insurance products. All of these applications now pose a threat to established industries that fear losing market share and profits. Conversely, many companies today are actively exploring entering the digital asset ecosystem, leveraging its technology, and growing their assets.

    Many financiers and banking lawyers are yet to realize that smart contracts are not just programs, but business directives that are automatically executed when certain events occur. DApps have the potential to remove the need for centralized companies like traditional banks or social media and e-commerce platforms. Decentralized organizations replacing the old models have users-stakeholders who get rewards for using the app, usually in the form of a token. DApps, stablecoins, and NFTs are all examples of projects built on smart contract-supporting blockchains.

    Future iterations of the DeFi protocols are likely to include more automated features, including AI-driven derivatives, risk management, and user assessment solutions.

    Crime and security issue

    One last concern for traditional finance people is the issue of illegal activity associated with cryptocurrencies.

    Digital assets have a controversial reputation, not least due to their anonymity and high-profile ransomware use. However, the blockchain is permissionless and transparent, allowing law enforcement to use the analytics to follow digital asset flows across multiple wallets and track criminals and other offenders. Illegal transactions with digital assets reached their 35% peak in 2012. That rate quickly dropped to a little over 2% in 2019, then to less than 1% of the total number of transactions in 2020. This is owing to the fact that more and more ordinary people in no way connected to the world of crime and free of any unlawful intentions are using cryptocurrencies and blockchain services.

    The popularity of digital assets has not gone unnoticed by governments and regulators. Though the path to them is likely to be long and hard, central bank digital currencies appear to be necessary to maintain control over the payment system and are likely to be used by governments to limit private competition.

    Regulation is likely to accelerate the mass adoption of digital assets, significantly expanding the circle of their adherents (already totaling in the millions). As it stands, more speculative digital assets and those seen as stores of value complement each other, though they still cannot compete with conventional money. As a regulatory framework emerges, clearer rules for digital assets and the associated applications could hasten the crypto adoption rate among the general population.

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