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Some Thoughts on Decentralized Finance

“There’s an overallocation of talent in finance and law. [..] We should have fewer people doing law and fewer people doing finance, and more people making stuff.” -Elon Musk, 2020

Based on this quote from Elon Musk, I would like to elaborate on why I believe Decentralized Finance (DeFi) to have the potential to disrupt the financial industry in the coming years.

DeFi is an emerging financial technology based on distributed ledgers aiming at eliminating the need for financial intermediaries by replicating the services they offer in a completely decentralized manner (Sharma, 2022). Smart contract capabilities of decentralized ecosystems such as the Ethereum network provide the basis for DeFi applications, which are essentially computer programs that run on blockchains and with which network users can interact.

Besides simply storing money, the main services for which most people require financial institutions are typically: access to payment systems, investment services, and to take out loans.

With the introduction of Bitcoin in 2008, the first payment system enabling digital peer-to-peer transactions without the need for a central authority and irrespective of national borders was born (Nakamoto, 2008).

DeFi further also allows for so-called asset tokenization, through which tokens are created to virtually represent real-world assets, thereby leveraging the transactional efficiency and censorship resistance of public blockchains. See for example Aktionariat.

Decentralized exchanges (DEXs) such as Uniswap facilitate the trading of such tokens as well as allow for users to provide liquidity and thereby participate in the automated market-making (AMM) process to earn yields when owning them.

Lastly, DeFi applications such as Liquity even allow users to take out loans directly on the blockchain by locking eligible collateral which enables them to mint (=create) protocol-native stablecoins that are exchangeable for FIAT currencies.

While I do not believe that such DeFi applications have the power to make traditional financial intermediaries entirely redundant, I am convinced that they allow for some services to be offered in a more efficient and more accessible manner. To pick one of the presented DeFi applications that I believe to be especially powerful, I would like to elaborate on the potential advantages of DEXs compared to traditional centralized exchanges (CEXs).

Instead of matching buy and sell orders based on an order book, DEXs are based on pre-funded pools of assets (so-called liquidity pools). For each available trading pair, there are two liquidity pools, each containing one of the assets. The constant product formula determines the relative price between the two assets such that the aggregate amounts in both the pools are always of the same total value.

Users that would like to engage in a trade can deposit the asset they would like to sell in one of the pools and in exchange receive the corresponding amount of the asset they would like to buy from the other pool. Since some new assets are added to one pool and some deducted from the other pool, the relative price between the two assets will update such that the constant product formula is satisfied again (Uniswap, n.d.).

According to Barbon & Ranaldo’s (2022) findings, DEXs are only slightly inferior to CEXs in terms of price efficiency, and already operate with similar quality when it comes to transaction cost and liquidity. Hence, DEXs have almost caught up with CEXs already, although they have only existed since late 2018 (Adams, 2019). But while managing and maintaining CEXs is rather costly in terms of necessary personnel and infrastructure (see for example SIX Group, 2022), DEXs function in a completely decentralized and fully automated manner.

Hence, if existing exchanges for traditional financial products find a way to make use of this new technology, for example through asset tokenization, I would imagine there to be immense potential for efficiency gains. It would in addition also enable users to directly interact with the exchanges themselves, i.e., without the need for a trusted broker and custodian, and thereby further reduce the number of necessary manpower and infrastructure within the financial industry.

In addition to the outlined gains in efficiency, not needing a bank or broker would make investing more accessible as well. As of July 2022, 1.4 billion people around the world are completely unbanked (World Bank Group, 2022). These people either live in countries with underdeveloped financial infrastructure or simply cannot overcome the hurdles of opening an account with a financial institution. For them, such DEXs would portray a first opportunity to access investment services.

There are however also some caveats to DeFi applications such as DEXs. Firstly, the possibility for users to transact completely on their owns translates into more responsibility for them as nobody can reverse faulty transactions. Secondly, financial institutions typically also guide their customers to make the right investment decisions, their absence hence also makes it harder for uneducated users to invest wisely. Lastly, financial regulation would have to undergo massive changes. Laws concerning market conduct, KYC, and anti-money laundering would have to be entirely rethought, and thus, financial authorities would expectedly fear to change the status quo.

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