Thomas Bacon gives a VC take on what DeFi is doing and will do more to bring the world of finance towards a new system of money. Quick heads up: this is a lengthy one, so grab a cup of something warm first—and let’s dive in.

You don’t need to look very far at the moment to see the buzz being generated by the Web3 community. Facebook has decided to quite literally go meta. Cryptocurrencies have soared in value and popularity. In fact, it seems inevitable that in 2023 we’ll be eating tokenized dinners.

In times like these, trying to separate the wheat from the chaff is not altogether that easy. To some, this is the biggest transformation society has undergone since (and likely including) the invention of the internet. To others, this is a bubble akin to 1999. As with many current debates, the reality lies somewhere in the middle and one crucial job for any investor is working out this middle ground.

In this blog post I’ll focus specifically on what DeFi (DeCentralised Finance) is both doing and will do more if it wants to tease the CeFi (Centralized Finance) world towards this new system of money.

DeFi: Where are we now and what could the future look like?

The two most trodden examples of DeFi are, as of right now, asset management and borrowing or lending. Or in other words, storing a portion of one’s wealth in cryptocurrency to perform some of the key underlying functions of an asset allocator or financial trader. ‘Putting your money to work’ is a phrase that has re-gained popularity recently as a result of a handful of fairly significant macro trends, such as close to 0% interest rates and rising inflation. This is no different for financial institutions, who are constantly looking for ways to maximise returns for their clients. You only have to look as far as the over 500% rise in Ethereum (the first chain on which DeFi applications were built in any significant number) since the beginning of 2021 to see the appeal. And in fact, when surveyed on whether there was an appeal of digital assets, to which 86% of institutional investors responded yes, the high potential upside was the primary reason.[1]

These tailwinds are clearly not going unnoticed, with a number of companies popping up globally to enable institutional asset management, such as Circle who have it as one of their offerings, or Finoa who focus on it more exclusively. The same can be said for institutional lending, with market leaders Aave having recently launched Aave Pro.[2] With 56% of European investors already exposed to digital assets and with future intentions only increasing, to 75% in 2021,[3] one might rightly ask whether there really is a hesitation towards trying these types of solutions at all.

In short, yes there is. Much of the adoption thus far has remained a mere dipping of the toe for many of these institutions. The interest is clearly there, but there is a hesitation in increasing exposure too significantly. Why? I would suggest there are at least three reasons at present:

1. Price volatility
2. Regulatory uncertainty
3. ESG compliance

A closer look at the DeFi dilemma

1. Price volatility

The first and perhaps most obvious is price volatility. One need only look at the graphs for Bitcoin and Ethereum over the last 12 months (see below) to observe that the fluctuations both monthly but also daily are sharp and this means that allocating large quantities of assets remains risky. This is made particularly challenging given the high degree of market risk. Or in other words, at any point there is a fear that the sentiment in the market might collapse causing a considerable drop in the value of the main cryptocurrencies.[4]

With that being said, financial institutions in Asia, who generally have had more experience with and therefore confidence in digital assets, view volatility as a lesser concern given that they have learnt to better understand how to manage the cycles of volatility.[5] This might signal the directional change that other parts of the world like Europe will observe over time.

*Figure 1: Bitcoin price last 12 months

Figure 2: Ethereum price last 12 months

Stablecoins also present an alternative to mitigate this volatility, as they are pegged typically to a fiat currency (most commonly USD). This looks set to encourage the use of DeFi although extreme events could still have an impact that we do not yet foresee. There is perhaps also a slight conflict in their existence. If they are adopted too widely and cause disruption to the traditional global financial system, would this lead to the currencies to which they’re pegged losing value and therefore the stablecoins losing value as well?

Ultimately, price volatility hits at the heart of the paradox surrounding cryptocurrencies more broadly. The significant price fluctuations are a fundamental reason for institutional engagement as clients want exposure to the upside. Conversely, this same volatility will always breed a fear of overexposure in the event the market crashes in a 2017-esque way.

2. Regulatory uncertainty

The question of regulation is one that naturally comes with the decentralised nature of DeFi applications. When there is no custodian and no central authority, what happens in the event of a hack? Or what happens if there is malpractice or market manipulation?

Figure 3: Regulation and crypto remains an unsolved challenge. Photo credit: CoinsCapture

This challenge with regulation is a tricky one to solve and, in some ways, seems inherently conflicted. In order for an application to be truly decentralised, it must not have a traditional regulatory framework interwoven into its fabric; however, this is at odds with the financial system, which has only introduced increased regulation to ensure that good practice is followed. And it is this good practice that ensures there is enough trust in the market to invest. Again, how do you solve this paradox?

The most obvious answer to this is to say that the future of DeFi will not be ‘completely decentralised’, but instead demonstrates some of the core components of DeFi whilst also operating in a licensed and regulated framework. Paxos, Swarm Markets and Notabene are interesting examples of this type of company and at Maki we believe that more companies will start to operate this quasi-decentralised structure in order to increase the sense of trust that institutions have in this market. A more radical approach would be to suggest that in the long-run there will be new structures of self-governance built into the technology itself which essentially constitute digital jurisdictions themselves.

3. ESG Compliance

ESG has gained substantial traction over the last few years, both thanks to the growing global emphasis on sustainability and social issues that are playing a more prominent role in recent times.[6]

Figure 3: COP 26 in Glasgow has been a prominent feature in the news in recent weeks. Photo credit: Sky News

A now well-known reality is that the mining of bitcoin is highly energy intensive; it consumes as much electricity in one bitcoin transaction as the processing of 722,705 Visa Card transactions.[7] With these environmental concerns also comes cost. And significant cost. For even basic DeFi applications at present, the average transaction fee (also known as a gas fee) has soared as of late to around $50 due to significant scaling issues that Ethereum has encountered. This is due in large part to the process algorithm that is applied in the bitcoin blockchain, called Proof of Work (PoW), which in essence requires all the nodes in a blockchain to validate a transaction before confirming, creating a hugely energy intensive process. Proof of Stake (PoS) is an algorithm that was developed to tackle this significant environmental problem and Ethereum is transitioning to the PoS algorithm in 2022. This, alongside layer 2 scaling solutions such as Arbitrum and Optimism, who are aiming to target these scaling challenges, should help to solve this problem but the extent to which this will be eliminated remains to be seen. It’s also worth noting that financial institutions who deal in large volume transactions, unlike their retail investor counterparts, will assign less concern to this particular issue.

Some have made the case that cryptocurrencies rate poorly on certain measures of governance. For example, the idea of a decentralised solution is in many cases far from the reality, with cases of obscuring the connection between the currency and the beneficiaries of said currency.[8] Given these cryptocurrencies underlie DeFi applications, it is not hard to see how this might generate hesitance on the part of institutions and therefore must be addressed, particularly amidst the groundswell of the climate change debate and activity.

The role Insurance, KYC & AML and Security have to play

Know your customer (KYC) and Anti money laundering (AML) will prove paramount in giving regulators comfort that the money inside any DeFi applications is not fraudulent or elicit, a concern that is amplified by the fact that DeFi solutions by definition offer anonymity and personal privacy in a way that would be forbidden in the centralised financial system. For some, this flies directly in the face of the true rationale behind crypto and serves merely as a means for governments to stymie competition,[9] however for others it is seen as an opportunity. There are companies emerging in this field such as Umazi and Coinfirm and we at Maki expect this trend to continue.

Issues of security plague DeFi, with news of hacks and other vulnerabilities quite regular, typified by Lendf.me in China being hacked to the tune of $25m. In the fallout from each hack, more stringent audit checks both internal and external are introduced and there are improvements to underlying code to try and prevent further problems. We also believe that there is an opportunity to continue innovating in the security space and companies like Cheqd and Rexs will need to continue appearing if they are to bring more widespread comfort to the DeFi industry.

Finally, cryptocurrency insurance is a nascent area that we at Maki are particularly excited to track, with Bloomberg stating it is poised to become a ‘big opportunity’.[10] Often coming hand in hand with security, the role of insurance for institutions as their safety net is imperative if these institutions are to get comfortable with more exposure to the DeFi industry. The traditional insurance industry is not totally new to the world of cryptocurrencies, with Lloyds of London discussing them back in 2015 and B3i, an initiative set up to explore DLT and blockchain technologies by some of the world’s leading insurers, being formed back in 2016. However, there are a number of challenges for traditional insurers being able to engage directly with this new asset class, not least because of an inability to price the risk as accurately as they would like, given they lack the historic data they would typically require.

This has left room for startups to think up creative ways of engaging in the industry, with companies like Nexus Mutual developing a people-powered cryptocurrency solution, or Nayms, building a platform to allow cryptocurrency investors to reinsure crypto-risk. In order to serve the institutional market, either these companies will need to grow significantly, or traditional insurers will need to find ways to overcome the challenges currently posed, perhaps by working with regulators. This creates a slight chicken and egg scenario however and this is why we believe that new startups can fill the void quicker and more efficiently.

So, is the mating ritual working?

The fundamental question to ask when looking at any given DeFi application is: why is this better than the current system? In other words, what are the areas in which a DeFi solution really does improve on what exists rather than just replacing it?

Interestingly, Covid-19 may have pointed to one answer to this, as banks initially struggled to lend to small and medium sized businesses, which may have been avoided with the monetary system being decentralised.[11] The upside of cryptocurrency valuations is clearly another. However, what if CeFi improves its efficiencies (for example the huge strides made with Transferwise, Revolut etc). Or, crucially, what if cryptocurrencies stop rising in value? These and other questions bear thinking about as we map out how the monetary system might look in 50 years time and if we truly want that new system to be better than the current one.

While the trend seems to be moving towards increased adoption of DeFi, this transition takes time and the get-rich-quick attitude that is prevalent in some areas of the crypto community will only serve to alienate the general populace who don’t stand to gain. This also runs contrary to the initial vision of cryptocurrencies as a way to better distribute wealth and reduce control and power in the hands of a few. The future is bright, but let’s take this one step at a time.

We’d love to hear from any founders that are trying to tackle the challenges associated with more widespread adoption of DeFi. Please reach out to thomas@maki.vc or paavo@maki.vc in the event that person might be you!

References:

[1] The Institutional Investor Digital Assets Study: https://bit.ly/31s9FJq p. 19

[2] Aave to debut institutional DeFi lending via Aave Pro: https://yhoo.it/3pWkKvN

[3] The Institutional Investor Digital Assets Study: https://bit.ly/31s9FJq p. 7-10

[4] World Economic Forum – Decentralixed Finance (DeFi) Policy-Maker Toolkit, White Paper, June 2021, p. 14

[5] The Institutional Investor Digital Assets Study: https://bit.ly/31s9FJq p. 23

[6] Can investors embrace both cryptocurrencies and ESG? https://bit.ly/3zuJG0x

[7] Can investors embrace both cryptocurrencies and ESG? https://bit.ly/3zuJG0x

[8] https://bit.ly/3Ge5Abb

[9] There's a Bigger Scam Than Anything in Crypto, It's Called KYC/AML: https://bit.ly/34f7g5S

[10] Cryptocurrency Insurance Could Be a Big Industry in the Future: https://bit.ly/3JIxlKU

[11] The Code Is Key: https://bit.ly/3mZWuqK