WOLF & CO Insights Is DeFi the Future, or a Financial Industry Flop?

Is DeFi the Future, or a Financial Industry Flop?

Over the last year, Decentralized Finance (DeFi) has grown exponentially. Since August, “Locked In” DeFi contracts have grown 60% from $6.9B to $11.1B. Now, that number may not mean much to those who aren’t privy to the concept of DeFi or don’t utilize it every day, but make no mistake—this isn’t something to be ignored. DeFi refers to financial service applications that use blockchain technology to conduct peer-to-peer transactions without intermediaries (such as banks). If you’re having trouble comprehending this, think of all the aspects of regulated finance companies (like banks, investment companies, and securities exchanges) and replace them with unregulated apps, cryptocurrency, other people with the same apps, and smart contracts supported by blockchain.

Although this technology may seem innovative and transformative, its adoption may not revolutionize the financial industry (even though many users think it will). While many believe that DeFi will become more popular than centralized financial services, this technology might turn out to be innovation for the sake of invention. The newness and coolness of DeFi has increased its popularity, but it has no “real” market, and its diversion from the standard rules of the financial industry is problematic.

What Does the Market Need?

Setting aside the speculative investment value of cryptocurrency (which I think can be excellent alternatives to fiat currency in the long run), the bigger concept of true decentralized finance leaves me questioning why we’d want to leave the world of regulated financial services for the world of unregulated financial applications.

Even for those with easy access to formalized financial services, DeFi doesn’t provide enough incentive to abandon the need (or want) for intermediaries to be involved in these services. It inserts technology into processes that don’t need it, it diminishes control over transactions, and it increases the risk of malicious actions and fraud. As someone who has built his career in financial services (and often criticized some of its traditional processes), if I can’t see the value in DeFi, others should be wary as well.

Do We Really Need A Whole New Process?

Many supporters of DeFi argue that it gives access to financial services to people who currently won’t, don’t, or can’t access formal financial services. This argument doesn’t seem to have a solid base, as many of those people that have access to DeFi usually have access to numerous formal and informal financial services to fulfill their fiscal needs. Really, DeFi only adds unnecessary technological nuance to these existing processes for a fee.

There are many avenues in existing, regulated financial activities that could be streamlined using technology, but we don’t need an entirely new process to modernize already successful methods.

Programming Bias

There’s a lack of control over the process. These transactions are built on a blockchain, which is an extremely complicated realm in itself. As a user, you need to understand these complexities to successfully conduct activity, and you have to place the success of your transactions in the hands of the programming—which creates much more room for error and programming bias. Additionally, errors resulting from problems in the coding of the blockchain process aren’t as easily unwound as they might otherwise be in traditional scenarios.

Rules Still Exist, Even for Technology

The Anti-Money Laundering and Consumer Protection Regulations that “stifle” innovation are there for a reason. That reason is because timeand timeand time again we witness firsthand that many businesses ignore legality for the sake of monetary gain. Even in the regulated “safe space” of financial services, businesses sometimes use technology to skirt the rules for the sake of a few more dollars.

DeFi operates outside of these necessary anti-money laundering regulations and consumer protection rules, creating extreme risk. Whether it’s bad financial actors, criminal regimes, or people looking to make a quick buck, unregulated financial transactions are vulnerable to more systemic corruption than current financial services. DeFi ignores the rules because the technology ‘works better without them.’ But DeFi doesn’t always guarantee a better outcome than using regulated financial services. So why choose the risker option when you can achieve the same (if not better) outcome using safer methods?

Where Do We Go From Here?

Where we go from here is predictable. We’ll probably end up with a hybrid world of regulated DeFi. Even Heath Tarbet, the chairman of the Commodity Futures Trading Commission (CFTC), hinted at this outcome. Recently, the Office of the Comptroller of the Currency (OCC) has started to take progressive steps to provide a pathway for a unified regulatory environment. But until that environment is situated, we should all assume that unregulated DeFi won’t replace traditional financial services.