Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
Executive summary: Forget traditional financial institutions; put users in control instead. This is the promise offered by advocates of decentralised finance. Think of DeFi (the preferred abbreviation) as being a set of protocols that allow for the creation of an open, borderless, autonomous and self-sustaining financial system. DeFi also constitutes part of the broader Web 3.0 revolution, or the democratisation of the internet. Advocates would point to the $2tr digital currency market (primarily Bitcoin and Ethereum) or the fact that more than $30bn was invested in private crypto and blockchain businesses last year. The opportunity to address the currently unbanked – who should benefit from such a financial revolution – might be worth almost $400bn. Despite current interest levels, which verge towards hype in some areas, much still needs to be resolved. Clarity on regulation and security as well as the ability for decentralised networks to scale are paramount. We see certain parallels with the early internet a generation ago. The market is still highly fragmented but winners will undoubtedly emerge. From a public equity perspective, there are very few listed pure plays. Watch this space as things can change quickly.
Read any news source discussing financial innovation and it’s almost impossible not to hear mention of bitcoin, blockchain, crypto or NFTs (non-fungible tokens, for the uninitiated). All fall under the broad umbrella of decentralised finance. This term stands in stark opposition to the current centralised infrastructure of global finance. DeFi, as its advocates abbreviate it, promises a new internet-based, decentralised model for financial interactions with less reliance on conventional intermediaries. Think of DeFi as being part of the broader trend of digital transformation which we are experiencing in all spheres. Despite its appeal, which probably only grows in times of more heightened uncertainty, it is important to proceed with caution. Much of the enthusiasm currently seems based around ideology rather than specifically the potential of the technology.
Decentralised finance is the term given to decentralised applications built on public blockchain infrastructure that facilitate financial transactions. These can include payments, lending, trading, investments, insurance and asset management. The willingness to consider alternatives to the traditional system arose out of the legacy of the 2008 Great Financial Crisis. This event heightened attention on the inefficiencies, structural inequalities and hidden risks of the intermediated financial system. DeFi is explicitly characterised by its non-reliance on centralised intermediaries. Put another way, it is premised on decentralisation.
Have no doubt, the current system is inefficient. Consider that the process to clear a transaction can be anything up to three days, which is clearly a major negative for merchants and how they manage their working capital. Further, the average credit processing cost for a retail business is 1.9-2.1% in physical outlets and 2.3-2.5% online. Elsewhere, in the case of exchanges, commissions charged for trades by brokers typically fall in the 0.2-0.3% range (all data from BCG). There are hidden costs everywhere. For contrast, in the world of DeFi, assets are escrowed in smart contracts on a blockchain. No parties, other than the user, can control the movement of funds unless certain conditions are met.
From here, it is easy to see the other advantages of DeFi. It is permissionless and borderless – anyone with an internet connection can use DeFi services. It is also an autonomous and self-sustaining system. Think of open source as the founding philosophy behind DeFi. Anyone can audit open-source code, often to test for security vulnerabilities. As a result, the DeFi protocols are composable and modular too. Protocols can be built on top of one another in order to enhance functionality. This is where the term Web 3.0 comes in. If Web 1.0 was a collection of static webpages with html addresses and Web 2.0 is the centralised system of interconnections we currently have (where platforms own data), then Web 3.0 should be thought of as a conscious effort to build a ‘new’ form of internet that works for everyone. Its cornerstones include user-controlled data and peer-to-peer transactions. Think of it as the democratisation of data. DeFi and the applications which have emerged from its protocols are the most visible current manifestation of Web 3.0.
Despite its rapid growth and deployment, DeFi is still at a very early stage. Much of the activity to-date is highly speculative and targeted at existing digitally native asset holders. 31% of Americans aged 18-29 say they have invested in, traded or used a cryptocurrency. Conversely, however, 45% of US adults say they have never heard of NFTs and a further 28% say they do not understand what they are for (per an October 2021 survey done by Forrester). Nonetheless, Bitcoin and Ethereum constitute the most tangible examples of the potential embedded within decentralised finance.
Bitcoin can trace its history to 2008 and Ethereum five years later. The latter, arguably, built on the former by introducing the concept of the smart contract (or immutable proof of a transaction logged on a blockchain network). Think of Ethereum as being a decentralised, open source blockchain with smart contract functionality. Ether is the native cryptocurrency of its platform (and second only to Bitcoin in terms of market capitalisation). The Ethereum platform allows anyone to deploy permanent and immutable decentralised apps onto it, with which users can interact.
Financial services represent the natural use case for Ethereum. Applications can be found across the asset management, credit, derivatives and insurance industries. Credit constitutes the largest of these segments (with over $29bn of value-locked assets as of the end of 2020, per BCG – the figure is almost certainly higher now). Here, time-limited interest-bearing instruments are created, which must be repaid at maturity. Businesses including Maker, Aave, Compound and InstaDApp match lenders and borrowers to issue such instruments. Exchanges also play an important role, allowing users to trade one digital asset for another. DeFi exchanges avoid taking custody of user assets, either through a decentralised order book or by matching orders and setting prices algorithmically. Players active in this field include Curve Finance, Uniswap and SushiSwap. Per the same BCG study, around $14bn of assets have been locked in (decentralised) exchanges
Ethereum also allows for the creation and exchange of NFTs. These are non-interchangeable tokens connected to digital works of art or other de facto real world items. The creation of digital assets has made the ownership, trading of, and investing in scarce and authentic (i.e. copyrighted) product markedly easier than in the past. NFTs went mainstream in March 2021 when the artist Beeple sold a digital-only ‘art’ work via Christie’s for the sum of $69bn. Organisations as diverse as Nike and the British Museum (the NFT activities of the latter were profiled in a recent Blog post of ours) have also begun to play in the field. Total NFT sales reached $17.7bn in 2021, up over 200 times relative to 2020’s figure. Over $40bn went in to total Ethereum contracts last year (per BNP Paribas and Chainalysis respectively).
These sums are, however, dwarfed by the c$2tr size of the digital currency market (per Crypto.com). Digital currencies, of course, can be used for multiple reasons, often nefarious or illegal. From a DeFi perspective, think of them as enablers of a decentralised financial system. At its peak last year, the market value of digital currencies had surpassed over $3tr with over 15,000 varieties available. This is the space in which the large payment processors (Mastercard and Visa, but PayPal too) have sought to establish a presence, facilitating the purchase and sales of such currencies and even allowing some variants as sources of payment. At least 14 Central Banks globally around the world have launched digital currency pilots and around 80% say they are considering doing so (per UBS). Beyond needing to move with the times, the development is perhaps unsurprising given that the market opportunity represented by the currently unbanked (defined as those individuals who have neither a birth certificate nor passport and so no access to conventional finance) is worth at least $380bn according to the World Bank.
If it all seems too good to be true, what’s the catch? Have no doubt DeFi is a rapidly growing area, but it remains highly immature. A variety of economic, technical, operational and public policy issues need to be addressed. The broad debate relates to access and trust. Traditional financial institutions have built trust over decades (if not centuries) of boom-and-bust cycles. The standards that exist within the financial services industry are some of the most stringent to be found anywhere. They will not be replaced overnight. Regulators (as well as Central Banks) need clarity on issues as diverse as the legal enforceability of contracts as well as consumer protection. KYC and AML (know your customer and anti-money laundering) factors also need to be taken into consideration. The recent Russian invasion of Ukraine has also brought into focus the topic of DeFi’s much-vaunted neutrality. Imposed Western sanctions have seen the blocking of some Russian-linked IP addresses that own cryptos. Meanwhile Russia also ranks as the third largest miner globally of bitcoin (per Bloomberg).
Scalability is another important factor to consider. Take Ethereum. At its current size, it can process roughly 15-30 transactions per second, or around 1m a day. Contrast this to Visa, which claims it can process over 55,000 transactions a second. Whether Ethereum and other DeFi platforms could cope with similar volumes remains to be seen. There are also issues such as interoperability (Bitcoin and Ethereum are largely standalone platforms today) not to mention security risks (over $14bn of cryptocurrency was subject to scams last year, per Chainalysis) and how quickly any such services will be adopted by the mainstream.
Parallels with the development of the Internet a generation ago have some validity. Currently, Bitcoin adoption levels are tracking along a similar path to Internet trends from the 1990s. The potential is evident, but much remains unclear currently. A deeper technical understanding is undoubtedly required. It is also crucial to separate hype from reality. The market remains highly fragmented and complex, subject also to intense speculation.
None of this has stopped investors from pouring $30bn+ into private crypto and blockchain companies in 2021, some five times 2020 levels. A further $10bn found its way into crypto funds and more than $3bn into NFT projects (all data per Pitchbook). Much of the excitement inevitably lies in the start-up sphere. Nonetheless, the more traditional financial services businesses as well as the mega-cap tech firms are acutely conscious of not wanting to miss out on the DeFi opportunity even if, ironically, it could be considered antithetical to the centralised platforms they have already built. Currently, there are few direct listed ways of gaining exposure to the DeFi trend. Block(formerly Square) represents one possible angle; Conibase (a listed crypto-play), another. Meta (the former Facebook) and Twitter have probably been the most vocal among the major consumer tech businesses. Throughout the DeFi space, build new services and the hope is that the demand will come, eventually. Watch this space
Alex Gunz, Fund Manager, Heptagon Capital
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