Decentralized finance (DeFi) protocols offer reviews and insights into the future of the capital markets network, for the people that are willing to pay some attention. The incumbents dominating the traditional capital markets, and new entrants seeking to capture market share, should consider the innovations within the cryptocurrency ecosystem cumulatively referred to as DeFi.
These advanced innovations present an excellent model for the direction that the old capital markets might adopt in the coming years as regulators stamp their authority on the capabilities of distributed ledger technology (DLT). The technology is refined via “in-the-wild” usage.
Decentralized exchange protocols, or automated market makers (AMMs), are among these innovations that have been widely adopted in the cryptocurrency sector.
Instant Settlement Brings More Attention To The Space
Trades are settled in almost real-time when using AMMs. When that is compared with the two days needed to settle some of the most liquid securities in the current advanced capital markets, users appear to prefer cryptos. This real-time settlement seen in the AMMs offers two major benefits that include improved balance sheet management and reduced counter-party risk.
Financial institutions that operate in the capital markets should set aside some cash on their balance sheet to cover exposure to the risk that comes with non-delivery by their trading counterpart. The reserve needs are defined by the parties that are in the trade and until a transaction is settled, they need to commit some cash on their balance sheet to compensate for the risk that is involved.
With real-time clearing and settlement having been enabled by the DLT network that is demonstrated by decentralized finance protocols, the reserve needs are a segment of the amount needed to hold in reserve with 2-day clearing and full settlement.
In case the AMM-like protocols get adopted in the traditional capital markets, the widespread majority of capital intertwined on the balance sheet currently may be utilized in economic use in the capital markets, turning an otherwise opportunity cost into economic gain.
Adopted at a large scale, the real-time settlement also has the power to mitigate systemic risk. Since the major financial crisis of 2008, while responding to regulations aiming to minimize the risk of systemic failure, major global central counterparties (CCPs), were primarily adopted as intermediaries.
While CCPs are seen to deploy complex risk mitigation strategies, they have become interconnected to the point that they bring up risks they were meant to eliminate. Based on a 2018 report from the Financial Stability Board, the 11 biggest CCPs are linked to between 16 and 25 other CCPs.
Notably, the two biggest account for about 40% of the total pre-funded financial resources provided to all the CCPs. The default of one CCP will majorly affect many accounts and may result in some cascading defaults that might be worse than those that came with the 2008 global financial crisis.
Reduced Rent-Seeking And Speedy Bootstrapping
Apart from the real-time settlement, the decentralized exchange protocols mitigate operational costs and lower rent-seeking using disintermediation. The network that makes up the exchange is minimized to code and distributed across the participants. Interestingly, the participants themselves provide all the necessary liquidity. The latter feature can bootstrap capital formation and democratize access to capital that is currently being seen in the burgeoning crypto-native automated market makers space.
The AMM protocols have surged explosively in popularity in the ‘Wild West of crypto markets, where self-custody and anonymity are the default. By last month, spot volume traded via AMM protocols surpassing $164 billion within one month, which represents more than 10% of the total spot trade volume in the bigger crypto markets.
It Is Not Only Exchanges
Other decentralized finance (DeFi) protocols have also been gaining some steam in the past year. One great example is lending, where the users lock up digital assets within the collateral pools where they can be borrowed. Compared with traditional lending, automated management of custody, settlement, and escrow minimizes the rent that is charged to fully perform these actions.
Debt that is outstanding in DeFi lending, which is a key metric for tracking adoption, rose from around $500 million in mid-last year to surpass $25 billion by May 2021. Aave, Compound, and Maker protocols lead this race.
Apart from lending, more complex derivative instruments like futures, options, and synthetic assets are getting deployed. Generally, DeFi protocols are speedily creating a mirror-image version of the traditional capital markets, but one with considerable benefits.
How It Affects The Traditional Capital Markets
Decentralized Finance at the moment is noncompliant from a regulatory point of view as a result of its pseudo-anonymity and the extensive reliance on self-custody. Nevertheless, that fact should never dissuade traditional finance startups and incumbents. There is already a definite roadmap for how the innovations in the decentralized finance space can be adapted to the traditional capital markets network.
The large players operating in the traditional capital markets have discovered these shifts and are making moves. For example, they are now piling huge amounts of money into the digital asset custody space. One notable incident is Standard Chartered’s investment in Metaco, a Switzerland-based digital asset custody solution company. Metaco just closed out a twice-oversubscribed $17 million Series A.
Furthermore, several forward-thinking jurisdictions have already created regulatory sandboxes, which encourage experimentation and innovation with various DLT-based solutions for the capital markets.
Some of the examples include Saudi Arabia’s Capital Market Authority’s FinTech lab Monetary Authority of Singapore with its FinTech sandbox and Sandbox Express, the ADGM RegLab in Abu Dhabi, and Europe’s regulator sandboxes and innovation hubs for FinTech.
An increasing number of new entrants are leading the way out of the sandboxes. One Singapore-based regulated digitized securities company iSTOX came up from the MAS’ FinTech Regulatory Sandbox. That made it become one of the first DLT-based capital market platforms that got approval and were fully licensed by a major regulator.
ISTOX closed a $50 million Series A in January 2021. That brought investments from several Japanese state-owned entities, like the Development Bank of Japan. Furthermore, the JIC Venture Growth Investments invested in iSTOX. JIC Venture operates as the venture capital arm of the Japan Investment Corporation. These investments are another major sign that capital markets incumbents perceive DLT-based infrastructure to be a winning play.
What Opportunity Is Available?
In most cases, with a major and structurally critical system including modern capital markets, the changes will be incremental. The custodians are legally and widely entrenched in the structure of the capital markets. It might take ten years before disintermediation of custodians can happen at scale since regulations have to change.
Also, the DLT-based market infrastructure has to be developed, tested, and widely adopted, as it is said in the report titled “Opportunities for Blockchain Technology in Capital Markets.”
It means that there is a lot of opportunity for the incumbents and most of the new entrants alike to establish themselves in the current world of DLT-based capital markets. For the forward-thinking traditional finance players, today is the time to make considerable moves.