TL;DR Decentralised Finance (DeFi) is the recreation of financial products (e.g. derivatives) and services (e.g. lending). DeFi will innovate far faster than traditional finance, but will be unable to break out of its niche without the trappings of modern FinTech.
What has FinTech achieved in the last decade?
I am extremely grateful for FinTech. Aside from providing me employment for the last years, the use of banking and financial services are far more enjoyable now than they were a decade ago. When I first moved to Berlin, getting a bank account was a bureaucratic nightmare of paperwork and bad German. Now I use N26 as my bank account, TransferWise to send money abroad and PayPal to settle up, all from my phone.
Despite all that, I would like to pose the question, what has FinTech really achieved in the last decade?
There are still some very big problems left to solve in finance. The 1.7bn unbanked should certainly be mentioned, probably alongside the extortionate fees paid by those remitting money. If you want something closer to home, then think of the financial crises which mean that we now earn 0% (or less) on our deposits.
In a world where we can send a WhatsApp message anywhere in the world instantly and for free, why can we not do the same with a bank transfer?
I would argue that FinTech has disrupted the distribution of financial services, rather than the underlying financial infrastructure. While this has created incremental improvements, to solve the biggest problems we’re going to have to change the infrastructure rather than just the facade; there’s only so much painting lipstick on a pig can do.
I would categorise FinTech into three different buckets:
- N26 — Disrupting the interface of banking, but the same old banking underneath
- TransferWise, Venmo — building a ‘layer 2’ solution because the underlying banking service doesn’t work well (SWIFT, Interbank payments)
- Unbundling & Rebundling — modern insurance apps like GetSafe are providing a service that was previously wrapped up in to a big company. Other FinTech’s wrap up these services into a platform like Revolut.
Why has FinTech been unable to disrupt infrastructure?
While there are players who are focusing on infrastructure e.g. Mambu, Thought Machine who are building modern, composable core banking banking systems. These systems ultimately must implement schemes like SEPA & SWIFT. The progress that can be made by a single company is limited to the extent that our financial system is regulated and interconnected.
The work done has not changed the ‘rules of the game’. The players must take the rule book and make the best out of their turn.
For example, the structure of the current system is highly sequential in the way banks reconcile transactions with each other. One player starts their turn after the other has ended. It’s not really a digital system at all. It’s a ‘silo system’. The silos themselves are often run on antiquated IT systems and the pipes connecting them (SWIFT, SEPA) are not much better. Even if a company like Mambu came up with a design for a much better system, they could not implement it.
So if tech startups can’t save the day, who can? The truth is large banks and regulatory bodies don’t have much incentive to disrupt the status quo. PSD2 & open-banking is a step in the right direction, but nowhere near sufficiently in terms of both pace and size of innovation.
Blockchain and banking are completely different. Blockchain is grass roots, open source, and didn’t take geographical restrictions or the status quo into consideration.
Can you imagine if Satoshi set out to create bitcoin from within the system, figuring out which jurisdiction and license to go for? We would have made zero progress. We only have blockchain and crypto today because it created an entirely different system, rather than try to change the monolith of banking and finance that exists.
Blockchain is the first technology that allows us to create a sophisticated parallel system to modern finance. With cryptocurrency, you can transfer value to anyone with an internet connection. I can send €1000 to someone in New Zealand who doesn’t have a bank account without going through any financial intermediaries. It’s easy to forget, but that’s a pretty incredible breakthrough!
Bitcoin and blockchain were born at the same time and it’s best to think of Bitcoin as being the first ‘killer app’ of the blockchain technology.
If cryptocurrency is the first, Initial Coin Offerings (ICOs) were the second. Enabled by Ethereum’s smart contracts, the infamous ICO craze of 2017 unlocked a whole new kind of fundraising with companies effectively launching a global, unrestricted IPO on the basis of little more than an idea. It was a messy, hubris-filled time but it demonstrated the potential of more advanced applications of blockchain to finance.
The ICO bubble, for all its flaws, was in fact an important phase of development. There was a lot of experimentation and a large amount of capital flew into the system. 90% of the projects failed, but a small number of projects were able to demonstrate product-market fit. Think of how the dotcom bubble gave us Facebook, Amazon and Google. The bear market that followed was also an important time, filtering out the bad projects and paving the way for the next phase of innovation.
Decentralised Finance will be the third killer app
Decentralised Finance (DeFi) is the creation of financial products and services on public blockchains. If you want to take a loan in the real world, you could take a bank as a counter-party and borrow against it. In DeFi the counter-party is the protocol itself, written as a set of smart contracts (immutable code) on the blockchain. This means it’s transparent: you can see how the products are created and funds are managed. It’s also decentralised in the sense that an individual, government or company couldn’t just come in and shut the thing down.
The “trust-layer” is now software instead of financial intermediaries.
The current use cases of DeFi
DeFi is definitely entering hype mode and we see a number of use cases evolving.
What: Stablecoins e.g. MakerDao
Why: Enjoy the benefits of cryptocurrency without the volatility.
What: Decentralised exchanges & liquidity pools e.g. Uniswap
Why: Trade any token instantly without the counter-party risk.
What: lending & borrowing e.g. Compound
Why: Lend your crypto and earn yield / borrow against your crypto.
What: automated trading strategies, token baskets e.g. SetProtocol
Why: Invest in token indices/ETFs and smart baskets. Auto-balance your portfolio.
Why: Protect DeFi deposits against smart-contract bugs, hedge your price risk.
2020 has been cited as the Year of DeFi. There has been a tremendous growth in a number of key metrics:
- Total value locked in DeFi protocols has growth to $6.53b (up from $0.7b at the start of 2020)
- DeFi usage growing fast to 250k users in 06/2020
- Strong ecosystem growth with 75+ DeFi protocols and many launching by the week
- Stablecoin market cap at $15b
- DeFi is becoming a major focus of Venture Capital (eg. a16z Crypto Fund II)
DeFi will innovate faster than traditional finance
Of all the benefits of DeFi, for me there is one that by far dwarfs the others: the rate of innovation.
DeFi will win out over FinTech because it is far easier to create new solutions creating and combining new protocols than to go through the regulated path of traditional finance. The properties of DeFi that enable this are standardisation and composability.
Standardisation — as public blockchains are permissionless, it’s like every API is open by default and contactable in the same way. Today when someone creates a new token, it is highly likely to be on the ERC20 standard meaning that from day one, a whole ecosystem of wallets, exchanges and applications support it. Even when not using a common standard, it’s possible to look at the source code and build an interface very easily. Ethereum is described as the ‘world computer’ and you interface with the programs or smart contracts in the same way, whether it’s a game based around collectibles like CryptoKitties or the governance of a new monetary system like Maker DAO.
Composable — services can be composed together to create new products out of the component parts. DeFi is often likened to financial lego where you can easily build these blocks together. For example, if you borrow in DeFi, it’s typically a Lombard loan — a loan where you borrow against the value of your collateral. In order for this system to function, the protocol needs to be able to liquidate the collateral if it falls below a certain value — a margin call. Rather than have to create this functionality from scratch, the protocol can just plug into one of the decentralised exchanges that is already up and running and that has sufficient liquidity.
Both of the above properties are aided by the fact that DeFi is almost entirely open source. The code used to build these protocols is transparently shown enabling the community to learn and copy from itself.
Why DeFi needs FinTech
DeFi has a massive usability problem. If we define adoption as:
Adoption = Value - Friction
I would argue that on the value side, DeFi can take care of itself. The ecosystem is burgeoning and more and more use cases are being created each week.
It is on the friction side, however, that we need to make improvements. When I talk about usability, I’m not focusing so much on the UI/UX of the various solutions, although there is quite some work to be done here as well.
I would argue that for DeFi to break out of its niche, we need three things:
An integrated on/off ramp
Users are going to continue to think in terms of euros and dollars and not ether and gas. The mainstream customer will not go first to an exchange to get the assets that they need to then interface with DeFi. The customer needs to be able to enter and leave the system in the fiat currency of their choice.
Customer service and hand holding
There’s a golden rule in FinTech customer service: answer the question “where’s my money?”. It’s all well and good touting the benefits of decentralised protocols run by DAO’s, but customers want to be able to email or chat with someone who can holistically guide them through the process.
A trusted counter-party
As much of a heretic as a I sound, I believe that the mainstream will always demand some kind of trusted counter-party. While the transactions themselves should remain trustless where possible, the customer has been trained to look for a trusted counter party in financial services. They want a strong brand, TrustPilot reviews and trusted education sources and onboarding.
I believe in a fundamental level of decentralisation in the long run, but for now customers are going to looking at DeFi as a possible substitution to their FinTech diet and, to begin with, they will use the same evaluation criteria.
Bitwala aims to bring DeFi to a larger audience
Bitwala aims to bring DeFi to the early majority by acting as a guide and curator through this cambrian explosion of innovation. Today, our customers can buy ETH directly from their bank account and onboard into DeFi. As the ecosystem matures, we will continue to democratise access by making most pertinent use cases available to our users in a safe, easy and meaningful way.
I invite the pioneers to sign up to Bitwala, buy ether and take their first steps down the DeFi rabbit hole.