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Highlights
- As decentralized finance (DeFi) has grown, investors now easily participate in private markets. DeFi has many benefits as opposed to centralized finance.
- Enhanced transparency, increased democratization of investors in the markets, reduced risks - these are some of the advantages of DeFi.
- We explore the potential application of DeFi in capital markets, the regulatory concerns, and how this space will evolve.
In this article
Introduction
Globally, capital markets have transformed considerably over the last decade.
The change is thanks to the introduction of new instruments and shifts in investor preferences and demographics. The concept of decentralized finance (DeFi), and by extension, digital technologies, have played a crucial role in this transformation. They have made access less exclusionary for retail investors to participate, leading to democratization in the industry. In capital markets, democratization happens when centralized institutions are replaced by peer-to-peer relationships allowing more investors to participate in the market. With DeFi, intermediaries define the rules and conditions that provide access to investors. Through disintermediation, investors can find new investment avenues in private markets. The democratization of capital markets has the potential to accelerate wealth creation globally and is unlikely to be disrupted due to uncertainties.
What is DeFi?
DeFi is built on the confluence of distributed ledger technology (DLT) and various financial products such as derivatives, asset-based securities, and lending.
It is also developed based on the foundations of cryptoassets and stablecoins. For example, investors can invest in cryptoassets in real time through automated exchanges to match them with counterparties. With DeFi, borrowing and lending in digital assets occur more efficiently, as the blockchain-based mechanism and central bank digital currency (CBDC) or stablecoins enhance trading transparency. With extended access, investors can participate in peer-to-peer transactions without the need for regulatory authorities like market infrastructure entities. DeFi provides a platform for entities requiring long-term capital and investors who are keen to explore modern assets.
Despite the promise DeFi presents for investors, there are still some challenges that prevent it from becoming a more mainstream investment avenue. The total value of assets in DeFi contracts also referred to as total value locked (TVL), dropped by 85% from $303 billion to around $50 billion in January 2023. This decrease was attributed to investor concerns on liquidity, transparency, and regulatory oversight.
Applications of DeFi
DeFi can disrupt traditional financial structures.
It is relevant in a variety of capital markets uses cases, as mentioned below:
Decentralized exchange (DEX)
DEX provides a marketplace for peer-to-peer transactions between cryptotraders, where there is no intermediary involved. In 2021 alone, DEXs executed more than $1 trillion in trading volumes. DEXs use smart contracts as trading algorithms and liquidity pools – instead of order books – to which investors provide assets.
DEX can exist in various forms as on-chain order books or off-chain order books, automated market makers (AMMs), or DEX aggregators. The DEX provides various benefits for trading since it requires no know-your-customer (KYC), no counterparty risk, simplified processes, and low-security risks. The trading volume in DEX has fallen relatively to centralized exchanges (CEX). However, the fall is temporary due to recent market events, and volumes are expected to increase. Some leading DEXs are dYdX, Kine Protocol, and DODO (Ethereum).
Lending
Borrowing and lending in the DeFi age will enable better efficiency, access, and transparency as compared to centralized finance (CeFi). Some of the top DeFi lending platforms are Aave, MakerDAO, and Compound.
Asset tokenization
DeFi enables tokenization of financial securities issued against underlying assets. Issuer companies can dematerialize assets through digital securities in DeFi, and investors can invest through digital subscriptions. Further, DeFi enables compliance for all securities and accelerated investor onboarding, allowing issuers better control over the issued securities. Investors can manage their investments through crypto custody services. Here, digitalization can improve accessibility for new investors looking to invest in newer asset classes. It also expands the market for issuers. NASDEX is a DEX for trading tokenized equities on the blockchain and is designed to serve as a bridge between the crypto and equity worlds.
Tokenized derivatives
Crypto derivatives and other decentralized derivatives offer better risk management to investors through hedging and generate returns without the need for investment in the underlying asset. The value of DeFi derivatives is linked to cryptocurrency markets or to the value of Fiat or commodities. Other traditional DeFi derivatives leverage the use of smart contracts.
Asset management
In DeFi, users have more control over their assets, as it provides tools for buying, selling, and transferring their digital assets at their own will. Investors are the custodians of their crypto funds. DeFi apps like MetaMask offer secured storage of encrypted passwords and private keys locally under the control of the investor.
Regulatory concerns over DeFi
Regulators such as the US Securities and Exchange Commission (SEC) consider DeFi as a platform with multiple opportunities.
The products and offerings on a DeFi platform are similar to traditional financial securities. However, authorities are concerned about the platform’s unregulated nature, as it poses critical risks and challenges for regulators, investors, and the financial markets.
Another concern of regulators such as the SEC around DeFi is the returns asymmetry between sophisticated and retail investors and the anonymous nature of transactions. Such can lead to price manipulation. Thus, it becomes imperative for stakeholders in the DeFi space to answer the following questions:
- Should DeFi be self-regulated?
- Is there a need for federal regulators like the SEC?
The future of DeFi
DeFi is touted to become the platform of choice for investors and issuers in the near future.
However, sufficient regulations need to be put in place. It is crucial to note that it is still in its infancy, and there have been several failed experiments, with impediments such as KYC and regulatory compliance. The recent collapse of the CeFi platform will create more opportunities since customers prefer platforms with better control and transparency. With its reduced risk, DeFi will inevitably grow, making it mainstream in the next few years.
