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How Blockchain and “DeFi” May Impact Lending in the Future
November 8, 2021
By Nasser Ansari
Pictured: Nasser Ansari
Ever since the early days of blockchain with the 2009 introduction of Bitcoin, cryptocurrencies have been prone to periods of high and low valuation. After going through another “crypto-winter,” or period of low prices, lasting three years, cryptocurrencies have once again caught the attention of a broader investor community.
Since the second half of 2020, the sheer number of new cryptocurrency offerings and the price volatility have been breathtaking. For example, Ethereum—the number two cryptocurrency and blockchain platform by market cap—grew by 800 percent from October 2020-October 2021. As new investment vehicles for Bitcoin are introduced in the United States, the hype is at an all-time high.
Add to these developments the emergence of DeFi or “decentralized finance” as a means by which various financial services are operated digitally on a public blockchain, and we enter a brave new world. But more on DeFi shortly.
In the classic manner of "this time it's different," many experts are pointing to the factors that will eventually lead to widespread adoption of cryptocurrency and the underlying blockchain technology.
New asset class: Investors are looking at cryptocurrencies as the new “stores of value” that can provide diversification from other asset classes while promising a higher rate of return in the future. Investors are also drawn to the potential large upside if this nascent technology achieves widespread adoption.
Next generation of virtual money: Blockchain promises to become the platform for the digital currency that can seamlessly move across borders, reduce friction, and minimize delay in financial transactions. The various competing blockchain platforms are vying to become the de facto standard for this space. Even sovereign governments are eyeing their own version of digital currencies (in some cases in conflict with Bitcoin, Ether and other cryptocurrencies). Overall, the increased activity of these competing platforms has resulted in greater interest in cryptocurrency and the likelihood of society moving to a digital currency and legal tender.
Next step of internet evolution: Another way to look at blockchain is to see it as the next evolution of the internet and connected world. Over the last 30 years or so, the widespread adoption of internet-based applications has gone through several generations. At first, the focus was on basic communication like email, then we moved to serving content and information online. This was followed by applications that are more interactive. With the advent of mobile phones, internet access became widespread and applications became location-savvy. With the help of blockchain, smart contracts and secure identity, the online experience could become even more seamless, enriched, and automated.
Enabler of the next generation of social media: Social media companies have started talking about the next generation of social media, called “metaverse,” which provides a much more immersive experience that leverages virtual reality. This technology will require further “tokenization” of products and services that can be consumed and traded within their virtual experience. A secure, blockchain-based identity and payment system that is not tied to a specific social media company like Facebook or Google would be highly preferable and likely result in a better, seamless user experience.
Of course, the detractors would point out significant uncertainties that lie in the way of broad adoption of blockchain technology.
Government regulation and oversight: Just looking at the recent examples of China banning Bitcoin transactions and the United States considering more regulation of crypto-based investing shows that we have a long way to go in figuring out the right balance of regulation and investor protection—without jeopardizing the growth of this emerging industry. The recent signs also show that governments across the globe are eager to understand, leverage and regulate this industry. While it may seem that regulation may slow down the adoption, even large crypto players like Coinbase are actively lobbying for much-needed regulatory guidance from the federal government.
Energy consumption and other technology challenges: This area represents another red flag for widespread adoption of cryptocurrency and blockchain. The current methods of validating blockchain transactions are notoriously energy-hungry. Blockchain’s considerable energy consumption is raising widespread environmental concerns that could turn back the progress on reducing the demand for fossil fuels. Major blockchain platforms are shifting to more efficient ways to validate transactions. This trend should certainly help with adoption and help scale the technology.
Network effect and the need for consolidation: As seen with any emerging technology in its early stages, there are currently just too many platforms to run blockchain applications. Blockchain’s widespread adoption will depend on separating platform winners from losers so more people can converge on a smaller set of platforms and create a “network effect” that is necessary for adoption.
Regardless of the uncertainties, the underlying technology is quickly maturing into a viable platform that is poised to create significant changes in the financial services industry. Even if you don’t buy the hype for the rush to cryptocurrencies—the new “store of value,” the new “gold,” a new “asset class,” etc. —blockchain applications are here to stay and, from the financial industry future perspective, it is wise to understand and adapt to stay relevant in the marketplace.
In the spirit of proactively exploring potentially disruptive blockchain applications in the financial services industry, let’s take a closer look at DeFi.
DeFi (or “decentralized finance”) is a new term that describes various financial services that are operated digitally on a public blockchain. These services have traditionally been provided by brick-and-mortar banks and make up the bulk of what one would consider to be typical for financial institutions. The major difference in DeFi and traditional services is the “De” part, where the services exist in a decentralized fashion, that is, without the need for an intermediary. This peer-to-peer model has the potential to dramatically change financial services as we know them.
Peer-to-peer financial transactions are obviously not new and predate the evolution of banking in our society. Modern banking and the current way of conducting financial transactions likely grew out of the necessity to have a systematic way of establishing the exact identity of individuals and businesses, thereby creating trust between transacting parties and, ultimately, producing a system of laws that govern the enforcement of a financial contract between parties.
Blockchain technology offers new ways of addressing these issues with lending. For example, the identity and trust can be achieved with a tamper-proof, virtual, global network that can span borders and regulatory regimes. Similarly, the ability to create “smart contracts,” where actions can be taken automatically, based on the current metrics of the contract, provides a new way of enforcement. As a result, peer-to-peer transactions can take place without the current guardrails of having trusted clearinghouses or a host of intermediaries. DeFi apps look to take advantage of all these features to enable financial transactions in a whole new way.
Let’s look at the “DeFi” features that may require changes in the established lending practices.
Geographical coverage and scale: A blockchain, by definition, is global in nature. The system providing the necessary replication and immutability of transactions requires that the nodes are geographically distributed and not controlled by a single entity. This means that DeFi applications running on a global network can be accessed by users all around the world. It is a marketplace that is always open for business and participants can transact 24/7.
Turnaround time: Given the pure online nature of transactions, the time to make lending decisions is significantly compressed. Traditional ways of conducting due diligence that can take weeks to complete will not work in this marketplace.
Regulatory compliance: The financial services industry is very familiar with having service providers register and comply with local and regional regulations. While the good news is that they can extend their services beyond traditional geographic borders, the bad news is that the compliance and regulatory requirements will exponentially increase.
Collateral management: Blockchain and DeFi will lead to financial transactions that deal with new set of digital assets. As we spoke about the tokenization of products and services in the “metaverse” environment, lending will bring in a new set of collateral that can be instantly authenticated and evaluated on the blockchain and thereby used as collateral. Another Blockchain concept of maintaining a digital “chain of custody” will also help in devising new ways of collateral management.
Enforcement: Blockchain and DeFi leverage smart contracts that can build a lot of measurement and intelligence into the contract, where predetermined, automated actions can take place based on the measurement and covenants of the contract. This capability will require a new way of thinking about lending contracts.
For those working in the financial services industry, it is time to pay extra attention to this innovation. While they won’t solve all the issues and challenges in the immediate term, technologies that constitute DeFi certainly present the potential to positively disrupt the status quo and unlock many new possibilities.