Most industries fear disruption, and for good reason.
Kodak identified that the film business, where they made their profit, would be ruined by the digital camera, and Blockbuster, who made their profits on late fees, was brought down by online streaming.
No industry is immune to the effects of disruption including the finance industry and decentralised finance (DeFi) has the potential to be the cause of significant friction and frustration as this industry charters new territory.
Disruptive technologies emerge based largely on frustration with the status quo. Technologies are rapidly adopted when they can automate or satisfy what has historically been a hard or onerous job.
DeFi removes the interference of traditional institutions, giving participants greater access to global financial instruments, removing the blockages often caused by banks and governments, and enabling rapid and low-cost investment that is also trusted and transparent.
The potential for DeFi to impact traditional or centralised finance has not gone unnoticed. The OECD reports on risks and benefits associated with the transition to DeFi.
Transparency and trust go hand-in-hand. A DeFi provides de-identified records of transactions, the shift to a more democratised handling of finance takes power away from financial institutions which would be making many of them decidedly uncomfortable.
In the various world economies there are many participants who believe that ‘cash is king’ and express a lack of trust in using centralised digital currency. However, with DeFi the best of both worlds is provided; a digital wallet that is protected from the all-seeing gaze of government and long-standing financial institutions.
The Risks
As attractive as the potential may be for a financial instrument that is distanced from traditional regulations, the shift to DeFi also puts economies at risk. If a significant share of investors ceases activity in the traditional economy, the lack of investment could cause traditional institutions to recall borrowings. After years of long-term economic growth, failure to participate in the economy could lead to a similar effect to the stock market crash of 1929.
There is also the potential for businesses to close and homes to be vacated. The lack of safeguards and security associated with traditional finance could then impact DeFi, causing a crash of two economies.
The answer for traditional institutions may not be so difficult. While DeFi and centralised finance may seem to be at odds, there is the potential for the two systems to work together.
There have been many attempts at cryptocurrencies becoming linked to traditional finance and markets, such as stablecoins that are tied to gold or the US dollar.
Current participants in the digital economies and DeFi acknowledge the instability of cryptocurrency but also want to enjoy the many associated benefits including low-cost transactions and transparency.
Traditional Finance working with DeFi
Traditional institutions have the potential to work with DeFi in providing new products to consumers and even businesses. The average person may find it difficult to access DeFi markets and have difficulties trusting a digital currency.
Banks have the opportunity to provide improved accessibility and DeFi products to make digital currency more accessible and accepted in the new era. Adoption of DeFi technology by traditional institutions may help to provide the benefits of both systems to the open market.
The adoption of DeFi also brings into question government regulation and how borrowings could be managed in this new economy. The main benefit of DeFi is meant to be anonymity from institutions.
However, DeFi is not fully anonymous as de-identified account numbers are recorded in the open-source community ledger. For example, an agency may be able to link a series of unique purchases and investigate a way to track a user from a shipping address associated with a DeFi transaction.
There is the potential for financial institutions to provide a DeFi product offering this anonymity, while also providing proof of ownership when required by the user. In cases of insolvency within the traditional economy, the DeFi asset could still be insulated.
The challenge for traditional financial institutions will be how to navigate murky policy with this new financial instrument.
The Future of Government Regulation
With a constantly evolving infrastructure, DeFi is shifting more towards adopting regulations similar to centralised finance. The question is, how soon will financial institutions adopt these emerging technologies? The answer may well be sooner than we think.
All eyes are now on how the government and regulatory environment intend on handling these complex requirements. We can all imagine a future where payments are made using DeFi as a trusted method.
The traditional institutions most impacted by the shift will likely be the government. How will the government be able to track tax payments if individuals and businesses are using digital currencies? What implications are there for DeFi funding illegal activity?
With DeFi making the shift to regulation, and traditional institutions turning towards acceptance of DeFi technology, the only missing piece is satisfying the government regulations and ensuring that DeFi can still support public infrastructure.
Tagged in: DeFi, digital currency