DeFi: Emerging Technologies and Institutional Adoption
Returning for its sixth edition, the Singapore FinTech Festival brings together global knowledge sharing from leading academics, practitioners and thought leaders to discuss key trends in finance and technology. This year, Nasdaq served as one of the media partners for the Singapore Fintech Festival, providing coverage on Nasdaq’s TradeTalks with Global Markets Reporter Jill Malandrino. Nasdaq’s TradeTalks sat down with Michael Karbouris, Head of Strategy for Nasdaq’s Anti-Financial-Crime Technology, to discuss the emerging technologies in Decentralized Finance (DeFi) and how they can achieve institutional adoption.
What is Decentralized Finance (DeFi)?
Decentralized Finance (DeFi) is the application of the Peer 2 Peer model to the institutional financial world. This means less reliance on centralized financial intermediaries and instead, a reliance on smart contracts, principally living on Ethereum but increasingly also on other blockchain protocols. One way to think about DeFi is as the internet for money. DeFi allows users to do many of the things that we do in the traditional financial world – lend, borrow, trade assets, and more – without the use of a third party, in an ecosystem that is global, operates around the clock, and runs with little to no conventional operational costs. DeFi is a fascinating leap in technological innovation with the potential to help facilitate the democratization of the financial world.
What emerging technologies have you observed in DeFi, and what opportunities do they present for the capital markets and financial services?
DeFi is evolving at an incredibly fast pace. It is largely self-regulated, and there are no intermediaries. The ecosystem is proving to be large and growing with now well over $200 billion in value locked into its various protocols.
With respect to DeFi’s opportunities, I think it is fascinating to watch largely all of the financial primitives we have in the traditional world today being built in different ways – trading, lending, borrowing, collateralization of assets, as well as new and novel approaches to governance. In addition, we now have the innovation in non-fungible tokens (NFTs). In traditional financial markets, market infrastructure is mature and has been built around fungible assets (such as shares); however, market infrastructure is not as advanced surrounding non-fungible tokens, such as property titles or car rental contracts. We are now seeing the same sort of financial primitives being rebuilt for NFTs. It will be interesting to see how this evolution might unlock value in a host of new asset classes.
As for now and in the future, the convergence of the traditional and DeFi worlds will largely be defined by regulation. We’ll want to look out for what regulatory and technology solutions might evolve to solve the challenges ahead, as well as how they will reconcile the differences between the disintermediation that DeFi offers and the current regulatory standards applied to protect today’s financial markets.
What challenges are the regulators and the industry seeing with these new decentralized technologies?
Crypto markets are increasingly eyeing expansion beyond the retail community and into the institutional realm. In order to achieve institutionalization and gain the trust of investors and regulated institutions, as well as for the financial industry to fully adopt DeFi, there are a number of challenges that need to be solved.
One challenge is accountability. DeFi at its core has no centralized intermediaries. In the event of a disaster (such as a hack or major theft of funds), there is no company or institution that facilitated the transaction, so there is no one to go to for recourse – we just have an ecosystem of smart contracts, with no ‘rewind’ button built-in and where all transactions are final and immutable.
Another challenge preventing DeFi institutionalization is reliable and scalable infrastructure. Different from almost every other type of asset class, crypto markets are almost always on 24/7/365. As investors can access DeFi markets and protocols at nearly any point in time, it is critical to have resilient infrastructure and confidence that there will not be a major exploitation of an underlying blockchain or protocol that would lead to a collapse of the ecosystem. It is critical that DeFi adopts infrastructure that is reliable, scalable and provides confidence for retail and institutional investors alike.
Lastly is the challenge of compliance. Regulators and investors need protection against financial crime and some form of certainty that money laundering, fraud, and terrorism financing are not being committed. Without accountability, resiliency, and compliance, you run the risk of exposing the system to both financial crime risks and systemic risks. Ultimately, regulation will help define how far traditional financial institutions may be able to use DeFi themselves or offer DeFi to their customers and investors.
How can technology help the industry solve some of these challenges of accountability, infrastructure and compliance? What will the technology solution and the landscape look like?
To inspire confidence in DeFi markets, we need to see fairness, transparency, and market integrity as the cornerstones. Even before regulatory clarity exists for DeFi, the industry should explore solutions that uphold market integrity and have processes and technology in place that safeguards the market and protects investors.
When looking at the solutions the industry is exploring, we see a variety of approaches that help solve the compliance and accountability challenges. Various approaches can be taken to adopt existing regulatory laws for the crypto space – For example, looking to adopt a Know-Your-Customer (KYC) or accreditation layer at the protocol level brings traditional banking regulations to the crypto industry, and for the most part, applies to centralized financial service providers. However, it is worth noting that the industry has already made major progress in the monitoring of blockchain transactions and beneficial ownership for a fully decentralized DeFi world. Today, there are surveillance tools that help identify bad actors in crypto. These sorts of tools are evolving so that they can be effective even when it comes to a sophisticated DeFi user or in a cross-chain or multi-Layer 1 world.
Overall, the question, “How do you fully regulate decentralized software” is a hard one to answer. It is different from regulating the flow of funds in a centralized ecosystem, and when it comes to DeFi, the situation gets nuanced.
Another important question within the DeFi industry is about how DeFi can be held accountable to the same safety standards we have in financial markets without losing the freedom afforded by DeFi. The truth is we, do not really know how that will unfold, but the passion of the builders in this space and growing audience of users allow us to remain positive that it will lead to solutions where we’ll see the traditional capital markets and the DeFi worlds start to converge over time with fairness, transparency, and market integrity.
