By Bill Wolf, Chief Investment Officer at TrustToken
The decentralized finance (DeFi) ecosystem has taken off over the past year, expanding about 1,200 percent in total value locked. This is no small feat, especially since just a few years ago, most people—including many crypto enthusiasts—hadn’t even heard about DeFi. But if 2021 was the year DeFi got its beachhead, 2022 should be the year it pushes into the domain of traditional financial institutions. The question is—how?
Fortress TradFi
DeFi may be the next stage for the finance world, but so far, this world has largely been doing fine without blockchain. Many of TradFi’s components are pretty efficient. The ones that aren’t, however, from venture debt to real estate, indisputably have a lot of room for improvement—especially when the technology to drive it is blossoming.
For all of its time-earned pedigree, TradFi has a number of fundamental flaws that hamper business activities in nearly every industry. These flaws stem from a variety of factors, such as the outdated technological stack on which banks still rely, and the wariness these institutions have toward the expenses and early adoption risks associated with massive updates. Other drawbacks can be even more structural in nature, such as contractual or regulatory obligations. In more specific terms, these are just a few areas where TradFi could do better:
- Transfer speed. Sure, it does not take long to move money from one account to another in the same bank. Cross-border payments, however, take longer periods and amount to trillions of USD per year, and still have high fees depending on the method of transfer This makes for a clear-cut inefficient market of a colossal scale.
- Swelling overhead. The above point also leads us to another TradFi flaw. The traditional system is prone to accumulating high overhead on nearly every transfer, with each trade or exchange transaction accumulating more and more fees and costs with every middleman.
- Limited reach. Finally, any TradFi service you launch is inherently very limited in terms of its geographical outreach at the onset. It is only available to a limited set of vetted lenders and borrowers, and diversifying one’s portfolio of financial opportunities is rarely an easy feat accomplished from a single platform. Moreover, the transactions are limited in terms of time: Many TradFi activities are constrained to local business and/or market hours.
While the blockchain ecosystem remains largely niche in terms of its overall share of the global economy, the technology underpinning it holds a major promise for the financial world. Both DeFi and TradFi fundamentally revolve around moving value, with the goal of meeting capital supply with the most productive risk-adjusted opportunities.
But TradFi is the proverbial General Motors, an established powerhouse giving people the vehicles that do their job. DeFi, for its part, is the techie startup looking to bring people the cars they don’t know they need. The last thing it should be doing is trying to mindlessly replicate what the competitor does; what DeFi needs is a Tesla strategy.
Kicking into high gear
It’s clear from the first glance just how different Tesla is from regular carmakers. It’s not trying to do the same thing as everyone else, but cheaper. Instead, in the words of its own CEO, Tesla’s vision is “to enter at the high end of the market, where customers are prepared to pay a premium, and then drive down the market as fast as possible.”
To make further inroads into TradFi’s domain, DeFi should adopt a similar approach—a wedge strategy. It should zoom in on a niche user most willing to pay for what it’s selling and work its way into the market from there, adding new features and products over time. Blockchain must press the advantage where there is one, and the good news is that its design offers a functional and effective solution for some of TradFi’s current struggles.
As a trustless protocol, blockchain is effective in eliminating the various middlemen, greatly reducing the overhead for any business operations. This is twice the case for international transfers, where blockchain eliminates the need to move money through a network of correspondent banks, while also expanding its reach to a global audience from day one.
Permissionless chains are also infinitely more accessible than banks for both institutional and retail users. They are global by definition, transcending national borders, but are also flexible enough to support compliance with different KYC rules through tailored smart contracts and other solutions. This makes for almost $80 billion in untapped global liquidity—the total value locked in DeFi as of the article’s writing—immediately accessible to any business just willing to reach out and grasp it.
As helpful as these advantages may be, they are hardly enough to secure a beachhead for DeFi on their own without a clear-cut strategy making the most of them. So where should it start its glorious advance? How can it pull off a Tesla?
Welcome to the Blockchain ICE Age
Moving forward, DeFi developers should be looking for financial services and products that have three key characteristics—Inefficiency, Complexity, and Esoterism:
- I for Inefficient: In this case, inefficiency means lacking broad support from mainstream capital. DeFi must look out for financial products and business models that are starving for funds and failing to secure the backing of the traditional bodies. Think venture debt financing for exotic startups, specialized technology-enabled lending programs, or even crowdsourcing for niche underfunded projects.
- C for Complex: DeFi should look to attract projects with a complex underlying business model, which makes them more difficult to assess from the TradFi standpoint. Think of complex trading strategies of a quant hedge fund automated with smart contracts and brought on-chain for investors to tap into—this is the kind of product the space needs to embrace, and for which it is uniquely tailored.
- E for Esoteric: DeFi should keep an eye for products that take specialist knowledge and are harder to grasp for the mainstream financial crowd. Credit analysts and lenders can struggle with new and emerging tools, or even with things that don’t get that many headlines in the media. Anything obscure and demanding in terms of specialist knowledge, like seed-stage debt funding for startups in a specific niche, lending to businesses in emerging economies, or even specialized B2B insurance, is a welcome guest on the blockchain, for two reasons. Firstly, the managers of such opportunities have a bigger need for solutions—specifically, access to greater liquidity and a larger lender pool. Secondly, because these opportunities are usually quite lucrative, thereby attracting more lender interest.
DeFi has made colossal progress, growing and branching into a diverse and bustling industry. While it is still nascent, especially compared to traditional finance, its potential is just as large as the domain of its rival—and to make the most of it, it should use its momentum to take risks and innovate, not to mimic its rival. Everyone is on a continuous hunt for yields, after all, and in today’s volatile macroeconomic conditions, blockchain’s key strengths stand tall in the spotlight.
About the Author:
Bill Wolf is the Chief Investment Officer at TrustToken, the core team responsible for building the leading unsecured lending protocol TrueFi. A Harvard Business School graduate, Bill worked as Managing Director of Goldman Sachs, HSBC, and Credit Suisse. Prior to joining TrustToken, he was the President & CEO of Lobo Leasing Ltd., a Blackstone-backed helicopter leasing and advisory service.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.