By Philippe Bekhazi, CEO of XBTO Group, one of the most active participants across Cryptofinance; and CEO of Stablehouse, a first-of-its-kind clearing house for cross-blockchain payments.
DeFi (decentralised finance) refers to digital assets and smart contracts that live on the blockchain, mainly Ethereum. To a layperson, this is akin to crowdsourcing lenders to a variety of borrowing use cases, predominantly speculative and employed by those deep inside the crypto machinery. Most loans in DeFi are currently overcollateralised (usually with a pledge of bitcoin) with an automated liquidation mechanism if the value of the collateral falls below the loan to value amount (LTV) – akin to a margin call.
This marketplace has grown at an impressive clip and is fast approaching $9 billion in total locked value, according to DeFi Pulse. While that is not an eye popping number in traditional finance circles, the rise and rapid growth of DeFi has captured the imagination of the crypto community enhancing this burgeoning digital asset ecosystem.
Many astute commentators in this space have drawn striking parallels between DeFi and prior financial innovations on Wall Street, reinforcing that this is far closer to an evolution than a revolution. As such, DeFi should be treated with the same bold mindset and visionary vigor to spark its true potential.
Moreover, most experienced industry players have decried the most prevalent current use-case of DeFi, “Yield Farming”, as unsustainable and one that will end in pain for many speculative participants that did not do enough due diligence. That said, most maturing asset classes have watershed moments that wash out weaker players and DeFi will prove to be no different.
However, what is much more exciting and thought provoking is the long-term value of DeFi and the far reaching implications it could have across both Wall Street and Main Street, a topic that is less discussed to date among a myopic crypto community.
Consider the number of applications for DeFi to be etched into the capital markets fabric at both the retail and corporate level, which would have an indelible impact on shaping and improving the future of finance. It is also perfectly positioned to provide inclusivity for those without traditional banking access – which the Global Findex database places at 1.7 billion adults.
According to Statista, transaction value in the consumer marketplace lending segment is projected to be approximately US$85trln in 2020 and is expected to grow to almost US$100trln by 2024. The number of alternative loans is valued at approximately $31trln, expected to increase to $38trln by 2024.
When it comes to tapping this universe, there is no better mousetrap than a blockchain to ascertain the creditworthiness of a borrower globally. The particulars of borrowers, such as their name, age and address are not important in assessing credit. What is critical are leverage ratios and income and repayment statistics, all of which can be stored privately on a blockchain. This will enable someone to easily receive credit in real-time that is set by an algorithmic interest rate which could be calculated dynamically according to a number of factors, such as supply and demand.
One could also crowdsource to obtain the most favourable borrowing terms. For example, one could offer bitcoin as collateral for USD. These transactions need to be overcollateralised and there is little to no leverage. The benefit to the borrower is that they can hold onto their bitcoin so long as they pay the agreed upon interest rate.
Trade finance is a gargantuan industry currently dominated by major investment banks who can assign large credit lines to borrowers, such as oil traders. The issue with trade finance today is that it is opaque and expensive. One could envision stablecoins being used as collateral for a loan for physical oil without having to resort to unnecessarily clunky Letters of Credit (LCs).
Firstly, LCs are not available to everyone and can be prohibitively expensive because of legal costs, red tape, and layers of intermediaries clipping fees. It is often-times backed by collateral that does not exist and there are many examples of loopholes and criminal creativity leading to fraudulent activity. On blockchain, these transactions will be more flexible and transparent, ultimately reducing fraud and spurring greater efficiencies. As an example, an oil trading firm can offer up bitcoin or a stablecoin (often tethered to USD) and ask for 1:1 ratio on oil. Once oil delivery is recorded on the blockchain, the swap for the digital currency is made automatically, totally disintermediating the brokers and their associated costs and bottlenecks. This would ultimately simplify supply chain logistics and have a domino effect across more segments of finance.
While the third use-case is much further adrift, we do see mortgages eventually falling into DeFi’s orbit. While there is immense work to be done to solve for this holy grail, the sheer size of the opportunity and magnitude to disrupt will be well worth the brainpower and resources. The long-term promise of DeFi (like other benefits of decentralisation) is to disintermediate brokers and banks in this $11 trillion residential and commercial mortgage market (in the US alone).
The current issue with DeFi for mortgages is that it requires two digital tokens (the borrow coin and the collateral coin) that must have fairly liquid markets, since DeFi relies on oracles – a distributed decentralised pricing source – to ascertain the value of the collateral, thereby pricing both legs of the transaction. There is no other mechanism at present to assess who is credible, and anyone with a crypto asset can borrow or lend to anyone else in the cryptoverse. For mortgages to fall into DeFi’s realm, there would need to be independent valuations of the credit of the borrower and the value of the home, which will be developed over time as data providers emerge to amass and verify more real-time information.
So with all the deep dive ‘insider’ talk of harvesting Yams and Sushi, as it relates to the current play of DeFi – we need to step back, harness, fuel and foster the next chapter of DeFi – which will emerge as a disruptive financial innovation with an impact as or more profound as anything that came before.