In this article I will explain the definition of DeFi and what benefits this new concept will bring to capital markets. Alongside CBDCs, to the pandemic that’s currently sweeping across the world and causing global markets to crash, we expect Decentralized Finance (DeFi) to make big advancements within capital markets over the next year. The recent crash could work as a catalyst for the adoption of DeFi as companies will be forced to reduce cost and look for efficient solutions. But what is the definition of DeFi and how can capital market rules and regulations work on a public infrastructure?

What is the definition of DeFi?

The definition of DeFi is a concept of a financial ecosystem living digitally on a shared infrastructure. In this world, typical financial services such as borrowing, lending and trading exist, but they operate on a public network, meaning it’s accessible to anyone with an internet connection. Open-source protocols or modular frameworks are relied upon for creating and issuing assets on this network, much like email exists today.

How does this differ to what exists today?

Capital markets, and in particular private markets, currently operate on an infrastructure that consists of many networks that are private, resulting in many companies that are disconnected and siloed. This leads to each company having their own method for certain procedures. Let’s take the example of KYC & AML. Every time an investor wants to subscribe to an offering, they are required to go through KYC & AML checks. Due to companies operating in silos, each party needs to verify the investor due to compliance obligations, so the investor will need to have this check performed each time they wish to subscribe to an offering. This costs money and is a labour intensive process.

In a DeFi world, investors can store signatures or crypto-graphic hashes on the shared infrastructure, proving that the data they are providing is valid and has been checked by a trusted party. In this KYC & AML example, the only shared data is the hash or signature, not the personal information, and can only be accessed by authorized parties. Needless checks don’t need to be processed every time an investor wants to subscribe to an offering, one check is essentially saved and shared as the investor pleases. This process in particular could save the industry around $160 million annually in cost saving, according to Goldman Sachs.

Why use DeFi?

DeFi is impacting a lot of different verticals within finance. At Tokeny Solutions, we think this is due to three significant benefits DeFi holds over private networks:

Trust-by-Design

Many processes have existed because functions need to be performed by trusted and regulated actors such as custodians, escrow agents and paying agents. These actions can now be programmable through smart contracts and executed on the most resilient infrastructure that has ever existed.

Efficient

Such processes are inefficient because market participants work on private and siloed networks. This results in slow functions, duplication and error. By utilising a single and trusted network, many functions that exist today can be drastically improved, leading to higher performing assets.

Global

Private markets are extremely local because the infrastructure makes distribution expensive and difficult. Issuers still struggle to find investors and investors find it difficult to find a project that fits their mandate. DeFi allows issuers to onboard investors globally in a seamless and inexpensive manner.

What kind of innovation can we expect?

By using the features of blockchain, such as the executable trust, DeFi is making new models possible. Although still very much in the experiment stage, an application of DeFi that embodies these benefits are flash loans, and these differ from traditional collateralized loans as there is no need for collateral in order to lend. But how does that work?

A flash loan is essentially a smart contract that stipulates if the borrower does not return the loan in the same transaction with the fee, the transaction will reverse. It essentially allows people to make money and pay back the loan instantly. If they cannot refund the lender, the money is not borrowed. The trust is provided by the blockchain, the smart contracts bring the efficiency that is inherent in programs and lenders/borrowers can be from anywhere across the globe. However, this concept, due to its infancy, is lacking in regulatory clarity, is untested and has recently been susceptible to the incorrect use from attackers.

From our conversations with some of the largest institutions, they are beginning to see the value that comes from this infrastructure, but only if compliance and control is enforced. This concept, which is essentially enforcing securities regulations on a DeFi infrastructure, is the concept of Onchain Finance.