Who do you entrust with your money? (a) An institution vetted by a democratically-elected Government, or (b) a software protocol created and controlled by a few benevolent members. Whatever your choice, the key components are Technology, Governance, Risk modelling and management, and last but not least, people you trust.
Let’s get a disclaimer out of the way first. Decentralized finance is a nascent industry. A lot has been built in its only 2 years of life. The fact that DeFi protocols are transparent, autonomous, trustless, permissionless, and non-custodial has generated the strongest pull to the sector. People, not robots, are drawn to it because it is accessible to everyone, and all transactions are there for everyone to see. Barriers of entry are low, making innovation (and craziness somewhat) run freely.
Why hasn’t it come to the mainstream then? And why regulators still worry? First, despite a great deal of transparency, the UX is still tricky and not for everyone. Secondly, more tooling is needed to measure risks, and there are plenty. Thirdly, the absence of KYC/AML makes the actions of a few bad actors hard to stop. In fact, DeFi is facing its own paradox, while it allowed disintermediation and boundless creativity, it got light on risk management, passing on the impossible burden to the user itself.
Solutions are building fast to remedy these issues. Governance is a key focus point. In theory distributed evenly to many, governance control lays in the hands of a few. More responsive and shared governance could lead to real-time decision enforcement. This mostly matters to risk management. Whereas, risk management at banks rely on spreadsheets running for hours and subject to human interpretation, DAO could implement agile risk monitoring and remedies.
A decentralized bank could more easily allocate its risks through asset classes, thus optimizing equity allocation for its users, while minimizing their risk. More transparency would allow a better grasp from its stakeholders, whether they are depositors, equity providers, or regulators.
This comes to our final point, can a decentralized bank not be regulated? Under the current state of DeFi, this looks unlikely. As long as risks are not fully grasped, and users don’t all know what to expect, this would pose an issue as DeFi expands into mainstream. Also, as bridges are drawn between CeFi and DeFi – stablecoins rely on the tradfi money market – contamination risks from one sphere to another have to be clearly measured up.
To us, shaping up DeFi into a decentralized multi-chain bank is what the future is. Blockchain gives us the means to all contribute great innovation to make this happen, while equally sharing the benefits of a better risk-controlled environment. Many projects are worth our attention in this space: Compound Treasury – by Compound Labs, Element – a team of DeFi OGs, and Maxos Bank. All of them will contribute to the convergence of TradFi to DeFi by making the latter more trustable and secure, giving $100TN worth of bank deposits a better way to get deployed.
Benjamin - venture partner