Blockchain for Business Series: Decentralized Finance—DeFi-ing Conventional Business Models

Decentralized finance (DeFi) is the movement in the blockchain applications space that leverages decentralized network technology to disrupt and force a transformation of old financial products into trustless and transparent protocols that facilitate digital value creation and dissemination with fewer or no intermediaries. It is widely understood and accepted that blockchain technology lays the foundation for a trusted digital transactional network that, as a disintermediated platform, fuels the growth of marketplaces and secondary markets due to new synergies and co-creation via new digital interactions and value-exchange mechanisms. While blockchain itself provides the technology constructs to facilitate exchange, ownership, and trust in the network, it is in the digitization of value elements where asset tokenization is essential.

           Although the traditional finance market, instruments, exchanges, and overall governance are centralized, they also are fragmented and laden with inefficiencies because the coordination of the linked business processes and movement of value are divided among a variety of intermediaries. This traditional ecosystem continues to add additional intermediaries or trusted third parties every time it encounters an anomaly that either results in a sizable fraudulent event or loss of value at scale, or a regulatory event due to the anomaly. So, while the regulatory landscape transforms as it attempts to plug every anomaly and ensure the systemic integrity of the financial system, it also creates complexity in the system and paves the way for additional anomalies and inefficiencies. DeFi aims not only to simplify the complex financial ecosystem but also to reduce barriers by lowering costs, increasing transparency, reducing the number of intermediaries, and overall democratizing the creation and consumption of the financial system.

           Many DeFi projects begin with digitizing current assets, flows and interactions, and codify a business function in the guise of smart contracts to adhere to regulations and rules that govern value movement in the form of financial instruments such as securities, loans, derivatives, and even (digital) fiat. The trending blockchain elements, such as digital assets, smart contracts, security tokens, and so forth, are the building blocks of DeFi market infrastructure. These building blocks not only lay the groundwork for new rails to move (digital) assets but also provide a foundation for new actors and new business models. It is conceivable that while the attempt is to disintermediate actors in the traditional financial system, we are creating new digital intermediaries and with them new value, business models, and an economic system that is efficient, transparent, and more accessible for creating new opportunities and value.

Disintermediation is defined as the reduction in the use of intermediaries between producers and consumers, for example by investing directly in the securities market rather than through a bank. Historically, in the case of the financial industry, every transaction has required a counterparty to process the transaction. By definition, disintermediation goes hand in hand with disruption; after all, we are removing the middlemen and changing (in some cases, radically) the business model and incentive economies pegged to mediation. Disintermediation is the investment magnet for blockchain-related ideas, riding on the success of the business and underpinned by peer-to-peer and crowdsourcing models. The promise of blockchain for the enterprise goes beyond its role as an industry disruptor. It also has tremendous potential to improve existing business processes, as well as efficiencies in existing transaction systems, leading to exponential cost savings for the enterprise and the end consumer.

           The term decentralized finance (DeFi) may imply that DeFi applications need decentralized infrastructure, liquidity, identity, participation, and so forth. Some purists also believe that decentralizing everything is the core principle to achieving a truly trustless network, trustless transaction system, and platform to move assets that is accessible to all and devoid of intermediaries, costs, and profit motives. This argument may appeal to the principle of decentralized business structures but falls short delivering on the promise of DeFi and innovation fueled by the movement. DeFi can represent a doctrine that aims to disrupt and challenge legacy infrastructure, which is much in need of an overhaul, and elevate the financial market and infrastructure to keep up with digital commerce, finance, and consumer expectations. DeFi, with promise of a new business structure, can be a hybrid model based on decentralized technology infrastructure and a diverse ecosystem and domain-centric governance. Such a model allows for global reach, digital enablement, and transactional transparency (and data obfuscation), while at the same time adhering to global regulation and compliance apparatus.

While DeFi projects may manifest as an open peer-to-peer protocol centered around business domains such as lending, liquidity and payments, the goal is to develop the building blocks of an open financial ecosystem that can leverage business protocols, new incentive structures, and financial tools in the forms of smart contracts or codified business rules with transparency and trust. The decentralized infrastructure delivers core characteristics such as efficiency, by removing middlemen and their siloed business processes; access, by democratizing the participation of service providers, whether of smart contracts, tokens, or cryptocurrencies; and transparency, by reducing opacity of processing information due to siloed business processes embedded in the current-day fragmented financial market infrastructure. The idea is to have a smorgasbord of these protocols, services, and tools, and the ability of the service provider to craft an innovative product and offering. The new and emerging products and service offerings are woven together to create a tapestry of industry-specific solutions and give birth to new business models and new industry participants and roles. This financial service assembly model should ideally harness the innovation-led evolutionary business models and focus on business architectures that rely on particular technology frameworks and the modularity enabled by lower-layer protocols, including blockchain technology protocols, data obfuscation and privacy protocols, and trust protocols.

Source: FinTech Collective

Some notable examples of the DeFi ecosystem and protocols include lending protocols, security tokens, derivatives, and exchanges, and more. The blockchain-based DeFi network landscape is playing out as one of its most profound and meaningful applications:

-      Open and decentralized lending platforms

-      Token-issuance platforms and exchanges

-      Decentralized prediction markets

-      Decentralized exchanges and marketplaces

-      Stablecoin and other digital assets

-      Identity and payments

-      Insurance and custodial services

While blockchain itself provides the technology constructs to facilitate exchange, ownership, and trust in the network, it is in the digitization of value elements where asset tokenization is essential. Tokenization is the process of converting the assets and rights, or claims to an asset, into a digital representation, or token, on a blockchain network. This distinction between cryptocurrency and tokenized assets is an important construct for understanding the exchange vehicles, valuation models, and fungibility across various value networks that are emerging and posing challenges around interoperability. These challenges are not just technical but also business challenges around equitable swaps of digital assets. Tokenization of assets can lead to the creation of a business model that fuels fractional ownership or the ability to own an instance of a large asset. The promise of asset tokenization on blockchain-based business networks is not just digitization and solving the inefficiencies of time and trust, but also creating new business models and co-creation from synergies of the network participants that did not exist before.

In conclusion, innovation fueled by the blockchain technology landscape and asset tokenization is a catalyst to a decentralized finance movement. It is not all about decentralization or disruption but also a much-needed overhaul of the aging financial infrastructure and markets. DeFi-related innovation stems from open source and often peer-to-peer protocols centered around the business domain. These ecosystems’ protocols, services, and tools provide rich environments for building new financial products, services, and business models. The ecosystems’ value is not only in harnessing the power of innovators, developers, and service providers across the globe but also in creating a truly global financial system and marketplace that improve access, efficiency, and transparency, all within the confines of a regulatory apparatus.