Today Boston Consulting Group’s (BCG) digital division Platinion published a report on Decentralized Finance or DeFi in conjunction with Crypto.com, the cryptocurrency exchange.
DeFi applications include payments, trading exchanges and lending, which operate in a permissionless environment. That means that only some onramps to convert fiat to cryptocurrencies are governed by anti money laundering rules. Once the user holds the cryptocurrency, there are few restrictions.
BCG says with the centralized financial (CeFi) system, SMEs often present a poor risk-return profile to banks in part because they fail regulatory checks. As a result, SMEs have less access to finance and where they can get loans, it’s expensive.
“The next wave of demand for capital and financial services will stem from emerging economies and an SME industry underserved by traditional finance,” the report says after noting incumbent banks’ rent-seeking behavior.
Likewise, for the underbanked, “Know Your Customer” (KYC) and “Anti-Money Laundering” (AML) processes lock out parts of the population. The World Bank puts the figure at $380 billion.
The challenges
The report highlights some of the challenges of DeFi. These include poor current scalability of permissionless networks and high network usage fees. Despite significant growth since June, current DeFi funds available stand at $9.5 billion, which is just a fraction of cyrptocurrency market capitalization of $275 billion. As a result, there’s still limited liquidity.
Smart contracts that automate the DeFi processes occasionally have security vulnerabilities that can cost the users their funds. Unlike centralized finance, there is no recourse and there are often scams.
In reality, many of the participants are relatively wealthy. This contrasts with the third world underbanked that the permissionless system theoretically could help. Part of the reason is to participate in the lending system requires over collaterization.
The Ethereum network is currently the dominant network for DeFi. As a result, if there are technical issues such as network bugs or congestion, this represents a risk to the entire system.
A major question is what might happen in terms of regulation. Will the onramp KYC/AML compliance suffice? Or will regulators seek to make the trading more permissioned?
The paper says that, for now, according to FATF rules, most DeFi is in the clear. If a DeFi protocol is sufficiently decentralized and an entity is not involved in everyday operations, it won’t be classified as a Virtual Asset Service Provider (VASP). Hence doesn’t have to comply with the Travel Rule.
Disruption potential
The paper then explores the three areas of payments, lending and exchanges. With payments, it points to low potential transaction costs because there are fewer intermediaries than card transactions. Plus, there is no scope for chargebacks, which is both a pro and con, depending on your perspective. The report highlights opportunities in some regions such as APAC, LATAM and Africa where there is limited card penetration.
Turning to lending, the difference in models in centralized versus decentralized finance are explored. For example, in DeFi, lending rates are dynamic depending on the cash available in a pool. If the pool of capital is almost lent up to its limit, the rate becomes high, including for those who have already taken out loans. Because lending is collateralized by depositing cryptocurrency, there is no need for credit checks or KYC. And on that point, because there is no KYC there is no cost associated with that and overheads are limited. Hence, up to 95% of the interest paid by borrowers is passed on to lenders.
The third application explored is exchanges. While there are order book based decentralized exchanges, the most popular ones don’t use order books and the market making is automated. Instead, there are pools of liquidity provided by users and traders can buy and sell based on the liquidity provided.
The rest of the paper explores decentralized governance, which is like a more active version of shareholder voting. And an overview of how incumbents might get involved.
Boston Consulting Group explores DeFi, blockchain financeBCG has been fairly active in the blockchain space. It has a digital venture arm that was involved in the De Beers TRACR blockchain diamond tracing solution. The same venture arm also partnered with WWF Australia for a sustainable supply chain initiative OpenSC. And it previously published a report on blockchain for commodities.
