DeFi 2.0: Fully Regulated and Compatible with CBDCs
With traditional finance (TradFi), service delivery relies on conventional financial institutions, which run operations and serve as financial intermediaries. By eliminating dependence on financial intermediaries and leveraging other key characteristics of Blockchain technology, decentralized finance (DeFi) has vast potential to reduce cost, improve utility and enable access across the full spectrum of financial services, including savings, lending, investing, payments, and insurance which will ultimately maximize financial inclusion on a global scale. Early signs of this potential have been seen in the last three years with DeFi’s astronomical growth, yet significant limitations remain, which have a major impact on adoption. The next wave of DeFi (DeFi 2.0) will address these limitations and achieve mainstream adoption in what will be one of the most radical industry transformations in modern history. This article looks at some of the characteristics of DeFi 2.0, which will be crucial to this imminent paradigm shift.
One of the most influential and successful waves of blockchain-based innovation has been decentralized finance. DeFi refers to a broad spectrum of decentralized applications that disintermediate traditional financial services leveraging automation, cryptography, and an immutable database distributed across multiple nodes on a public or private network. The decentralized nature of the Blockchain allows for the creation of self-executing, autonomous, and immutable software known as smart contracts that no single authority controls, not even the original developer(s). These smart contracts are the means through which DeFi products are delivered more effectively and efficiently than traditional finance equivalents.
One significant evolution enabling the rise in DeFi has been the global move away from fiat money to digital currencies. Fiat money usually exists in the form of physical cash, which introduces the need for intermediaries who keep custody of the physical notes that pile up as customers make deposits. However, with the Blockchain, monetary value is purely digital. It sits on a distributed ledger from where smart contracts can automatically borrow, lend, exchange, and invest such funds on behalf of beneficial owners transparently and without the involvement of traditional intermediaries. Popular DeFi services like MakerDAO, Uniswap, Compound, and Aave are just a few examples of how DeFi is leveraging the growing adoption of crypto assets to gain significant traction in record time.
In its current form, DeFi is powerful, and the opportunities are limitless, yet just like any new technology or paradigm, there still exist gaps that constrain its full potential. For example, DeFi lending requires collateral which today must be in the form of crypto assets and may or may not be available for borrowers to provide. Due to lack of regulation, DeFi services also suffer limited adoption globally, while in certain jurisdictions, this is worsened by the fact that public cryptocurrencies which serve as underlying liquidity are banned. When combined with perceived complexity and general usability issues, the above factors work together to restrict adoption to a small fraction of early adopters. DeFi 2.0 promises to address these issues and make the experience as friendly and familiar as the experience with traditional finance. If successful, this can help reduce the risk and complications that discourage usage while enabling the trust that will propel mass adoption.
Though DeFi’s greatest strength is how it offers a revolutionary alternative to traditional financial institutions, it is difficult (without regulation) to hold individuals or entities accountable for security failures, hacking incidents, and theft of digital assets within DeFi ecosystems. A critical argument here is not just that regulation is essential but also that regulating DeFi will be generally cheaper, easier, and more effective than regulating traditional finance. This is simply because, with traditional finance, regulation targets ongoing human behavior – which is largely discretionary and unpredictable. With DeFi, regulation will be heavily focused on the driver of DeFi operations, being smart contracts, which are transparent, predictable, and immutable.
From a regulator’s standpoint, DeFi services are non-custodial, so they do not require service providers to hold financial assets on behalf of customers. This significantly lowers the minimum capital required for organizations to have in order to deliver DeFi services, thereby allowing substantially more innovation to be introduced into the ecosystem. Because DeFi services are fully digital, and the Blockchain provides the platform for them to run, DeFi services do not require heavy physical infrastructure or elaborate IT infrastructure. Instead, requirements to deliver a DeFi service will include a decentralized application, supporting software development expertise, financial services domain knowledge, and customer service operations.
To enforce regulatory compliance in traditional finance environments, certain regulators attempt to control the process of launching new financial products into the market by introducing a product approval step that involves issuing a letter of no objection. This approach is not foolproof since service providers may skip the approval and proceed to launch new services or may present inaccurate/incomplete details about the product just to obtain approval. Regulating DeFi services will leverage smart contract transparency and immutability by introducing a smart contract audit process that clearly identifies the specific activities performed by each smart contract and ensures that these activities comply with regulation. The arrangement will guarantee that only audited and approved DeFi products can be rolled out and that, once deployed, the operations of such products cannot be altered.
Finally, the regulatory reporting regime for traditional financial services is challenged by the fact that financial institutions are practically only able to provide reports periodically and may (through the loophole of human involvement) doctor such reports to portray favorable but false positions. With DeFi, on the contrary, the Blockchain provides real-time reports and operational statuses directly to regulators without human intervention and from one single yet distributed and immutable source of truth.
We can think of Central Bank Digital Currencies (CBDCS) built on Blockchain as stablecoins issued by central Banks to serve as legal tender and ultimately replace the existing cash-based fiat money. Even though they are essentially a claim on a central bank, they function pretty similarly to other cryptocurrencies in that payments are certain and final, and the instrument is programmable and non-custodial with no need for intermediaries.
Even though DeFi and CBDCs may seem worlds apart, CBDCs can serve as potential alternative liquidity for DeFi services in a world where cryptocurrencies that DeFi relies on are not regulated and are mostly banned by authorities. This is especially so since even countries skeptical about major cryptocurrencies are issuing CBDCs in their place, with most regulators taking a view that issuance of CBDCs is an easier short-term win than the longer-term goal of figuring out how to regulate digital currencies in general.
While CBDCs offer a viable alternative as liquidity for DeFi services, a few drawbacks still exist. First, some platforms upon which CBDCs are issued may not support robust smart contract operations. Secondly, interoperability across CBDCs is limited such that each CBDC platform can only issue and store units of its own CBDC. This restricts the ability to convert from one CBDC to another while creating a significant challenge for DeFi services that need to function across multiple CBDCs. With the highlighted potential and limitations of CBDCs, the primary question has to be; how do we augment CBDCs to overcome these limitations and work seamlessly with DeFi?
In blockchain terms, wrapping is a way of transferring a digital asset from its native network to a third-party network. A wrapped token represents a cryptocurrency from another blockchain protocol that is backed by (and worth the same as) the original cryptocurrency. Unlike the original cryptocurrency, the wrapped token can be used on applicable non-native blockchains and later redeemed for the original cryptocurrency. Applying this concept to CBDCs means CBDCs from a native platform that may not have smart contract capabilities or a robust developer community can be transferred to a compliant and regulator-approved layer-1 Blockchain protocol that is more suitable for building and running DeFi products.
Once CBDCs are integrated into DeFi services, their adoption will increase significantly because of the superior economics and reduced friction associated with digital currencies and DeFi on the one hand compared with fiat money and TradFi on the other. This will create an environment where significant balances are held in CBDCs just as well as in fiat money. Such an environment will require that payment systems support the acceptance of CBDCs alongside fiat money while providing seamless real-time conversion from one instrument to the other during payment processing. Specifically, a buyer should be able to originate a payment from their balance of CBDC sitting on the Blockchain while the seller instantly receives value in fiat money delivered directly into their Bank account.
Tokenized Assets as Collateral
Decentralized apps have enabled crypto lending by automating processes and providing access to a broad user base. As such, crypto investors can now use DeFi lending as an instrument to invest their funds, just like a savings or fixed deposit Bank account. In return for staking their assets on such platforms, investors typically earn interest income that significantly surpasses what TradFi institutions pay. In the same vein, borrowers can access loans at more friendly interest rates than are offered in TradFi. The primary limitation with DeFi lending is that borrowers must pledge specific cryptocurrencies as collateral. This requirement excludes the vast numbers of potential borrowers who may not own crypto assets yet hold substantial amounts of other traditional assets like property, shares, and commodities.
Tokenization allows physical assets to be represented in digital form with secure and trusted ways to establish and transfer ownership. By incorporating tokenized assets into DeFi protocols, real-world assets can be seamlessly used as collateral in DeFi lending products. Such DeFi lending platforms will work hand in hand with decentralized token exchanges and their corresponding liquidity pools which will provide instant liquidity during automatic auctioning of tokenized assets belonging to loan defaulters.
By increasing the options for collateral, DeFi lending products will be able to expand the base of borrowers that qualify for loans and yet still exclude a significant base of potential viable borrowers who do not have sufficient collateral. To overcome this limitation, DeFi lending products will have to evolve ways of lending to borrowers without collateral. To achieve this, Defi Lending products must implement three important mechanisms to completely mitigate the risk of investors losing any portion of their capital.
Automated Credit Assessments– By incorporating automated credit assessment algorithms potentially offered by third parties, DeFi lending products can leverage data on borrower profiles, history, and cash flow to accurately predict eligibility. Results of such assessments can be utilized by relevant DeFi smart contracts to decide whether to approve or decline loan requests or determine what risk premium to charge a borrower for the loan.
Universal Direct Debit- Direct debit mandates usually enable services to collect post-dated and recurring payments from specific accounts of payers. A universal direct debit service allows organizations that have been authorized accordingly to charge any fiat account or digital currency balance owned by an individual. Universal direct debit services work with the expectation that every regulated store of value will be linked to the unique ID of each beneficial owner, which means that having an individual’s ID can provide access to all of their funds. This capability will allow DeFi lending protocols to collect loan repayments from whatever funds a borrower has, irrespective of their willingness to repay.
Credit Insurance– Credit insurance provides a means for traditional insurance providers or DeFi Insurance protocols to underwrite the risk of loan default in exchange for a small fee paid as an insurance premium and charged to the borrower or lender. This arrangement replaces the situation with TradFi, where the Bank that has custody of depositors’ funds underwrites each loan.
In non-collateralized DeFi lending, automated credit assessment and universal direct debit services reduce the risk being incurred by an insurance provider, thereby reducing the premium to be paid by the borrowers or lenders. Also, investors in DeFi lending protocols can rest assured that their funds are secure irrespective of which borrowers are approved by the protocol and whether the borrowers have provided sufficient collateral or not.
DeFi 1.0 has been a successful pilot run for DeFi, with adoption restricted to advanced crypto users. To achieve scale, unlock mainstream adoption and maximize financial inclusion, DeFi2.0 will build on the same core concepts of DeFi while infusing critical elements highlighted in this article, i.e., regulation, CBDCs, concepts from TradFi, and other innovative DeFi principles.
To accelerate this process, companies like Appzone are building out platforms like Zone, which are next-generation Layer-1 Blockchain protocols with native regulatory compliance, support for issuing CBDCs, interoperability with Fiat, and in-built integrations to legacy information systems. We at Appzone believe that this new breed of DeFi infrastructure will serve as the rails for an emerging golden age of finance.