The Path to Decentralized Finance

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Indexes
  1. ORIGINS TO PRESENT DAY
  2. BUBBLING TENSIONS & BLOCKCHAINS
  3. INCLUSION & OPPORTUNITY
Decentralized Finance. Photo by GuerrillaBuzz Crypto PR from Unsplash

Dramatic Departures

How did we get here?

ORIGINS TO PRESENT DAY

It is no surprise that the financial services industry has been a fertile valley for technological disruption. The rise of online banking powered by bank mainframe computers was an early testament to this. It fundamentally altered the relationship between end-consumers and financial institutions by rendering branch visits no longer necessary. Eventually we reached a point at the turn of the 21st century where the bulk of internal processes and external interactions of banks had become fully digitized. Today we witness:

  • Electronic trading platforms that facilitate trades on capital markets in real time
  • Mobile payment offerings which exchange funds have become commonplace as smartphone penetration reaches record levels around the world
  • Robo-advising platforms that provide algorithmic-based portfolio recommendations, lowering costs and enhancing alpha through the automated analysis of enormous volumes of data
  • Cloud-enabled CRMs that allow banks to monitor their relationships with clients, creating a stronger feedback loop which helps improve offerings

In short, great strides have been made to augment both top and bottom lines.

BUBBLING TENSIONS & BLOCKCHAINS

Interestingly, this has all occurred amidst the backdrop of increasing societal distrust of the financial system, particularly in the aftermath of the 2008 Global Financial Crisis. While consumers have definitely benefitted from these innovations, institutional players themselves have been the biggest winners from these developments.

For decades, this consortium of legacy players has served as the foundational layer of trust and been robust to external shocks. At the same time, the necessary existence of these intermediaries has allowed for significant rent extraction (for instance, on only 55–65% of insurance premiums typically go towards paying claims, while 45–35% is accrued to administrative costs and corporate profits)

While substantial profit margins are not inherently something to condemn, does intermediation in of itself still create value in line with broader economic growth and fair market evolution, especially now that technology is starting to remove its necessity?

In response to this sentiment, we are now witnessing a new paradigm within finance, one that synthesizes financial products with decentralized networks. Decentralization refers to ecosystems where administrative power is not concentrated in a single intermediary, but rather distributed across actors that are economically incented and cryptographically bound to cooperate harmoniously. Such a system of organization has gained immense popularity since the launch of Bitcoin in 2009 and the subsequent obsession with exploring the applicability of blockchain ledgering and other types of distributed ledger technologies (DLTs). In this model, software code seeks to become the new layer of foundational trust. This is manifested by immutable smart contracts verified and timestamped on a blockchain (a kind of distributed database that requires redundancies and the absence of a single central coordinator), such as Ethereum or EOS, that virtually anyone can create (with a little know-how) and no malicious actor can unilaterally appropriate (ideally). The promise of this disintermediation is vast indeed, as it implies two crucial elements:

1. The democratization of access as, anyone with an internet connection can access financial services regardless of the wealth, relationship, location, and other requirements typically imposed by intermediaries.

2. The security of trustless operations as blockchain-enabled transactions provide security and retain custodianship of user assets, without validation from a central party — a crucial feature for those living in areas of poor governance or under the duress of a surveillance state.

Why does it matter now?

INCLUSION & OPPORTUNITY

The extent of this rapidly materializing opportunity is apparent by the sheer multitude of people who currently exist either outside of or on the extreme periphery of the current global financial system:

  • ~ 1.7 billion adults around the world (roughly a third, globally) have trivial to no access to formal financial services.
  • The vast majority of the unbanked can be found in emerging markets
  • This majorly comprises women and individuals from households ranking in the bottom 40% by income of their respective countries
  • Often, these individuals tend to lack personal documentation and IDs that would allow them to engage with the current financial system (e.g. rural dwellers and migrant workers) which further perpetuates their condition of poverty
  • Interestingly, this phenomenon is present even in high-income countries, like Singapore, for example, which sports an ID-less rate of an alarming 37%

Therefore, it is not a surprise that bringing the entire unbanked population into the fold of the existing formal financial system can generate an estimated whopping $380 billion in new revenues.

That being said, it is critical to note that the unbanked populace still leads an active financial life through informal financial services, such as the local pawn broker or village money lenders. Thus, the savviness and cognizance of financial wellness exists, at least latently. Furthermore, the expansion of brick and mortar infrastructure carries little economic feasibility in many of these geographies.

Consequently, pre-existing smartphone and internet connectivity now offers a unique avenue of entry for decentralized networks to reach the unbanked. Again, they are unbanked but not unaware. The informal economy is a testament to their understanding of the importance of financial wellness, as well as the roles and responsibilities of various parties in a transaction. Given that blockchain-ledgering can allow for the creation of digital identities, decentralized financial applications can begin catering to the needs of these 1+ billion people from the outset. They can keep costs low through the exclusion of expensive intermediaries and provide transaction security regardless of someone’s level of personal documentation.

Exhibit 1. Illustration of identity creation and management on a DLT-powered platform that banks can tap into

Our prediction is that decentralized networks will capture much of the wealth generated as millions more are lifted out of poverty and subsistence living, as a result of macroeconomic factors and projected global economic growth in the decade to come. In fact, the global middle class is expected to increase 2.7 times from approximately 2 billion in 2009 to 5 billion in 2030, indicating a jump from $21 trillion to $56 trillion in global middle-class expenditure. As decentralized finance will be the beachhead infrastructure for those on the cusp of entering the middle class and the banked world, it will also be one of the primary arenas where this wealth accretion will occur. Players looking to move into the space now will be in a unique position then to capitalize on it. This will include new revenues through the provision of investment opportunities, lending options, insurance policies, and a whole host of financial products that become more relevant as disposable incomes increase.

Ultimately, by recognizing:

1. the unique trustless value proposition and digital reach decentralized finance has to offer, and

2. the sheer quantity of people who exist outside of formal finance but are financially aware, and

3. the projected explosion in the world-wide middle class

we can now appreciate the enormous and long-lasting social and economic dividends available through this radical inclusion enabled by decentralized finance.

Head over to- https://www.keplercannon.com/decentralized-finance/ to read more about the future of Decentralized Finance and its impending challenges.