What is the necessary plumbing required for banking to become decentralised?
How can the new world of banking brought about by blockchain and digital assets coexist with traditional finance (TradFi)? What is the necessary plumbing required for banking to become fully decentralised? And should banking be fully decentralised at all? All these questions have been thrown up by the arrival of distributed ledger technologies and decentralised finance (DeFi) and the knock-on impact they are having on centralised systems.
One of the hardest aspects of digital assets, particularly cryptocurrencies, from a banks’ point of view is the need to make them work in parallel with the existing financial infrastructure. Those working in FinTech constantly ask why it is so difficult to integrate their assets into legacy systems; while those in TradFi get frustrated at the need to shoehorn digital assets into a framework for which they were never designed.
As digital assets are now clearly here to stay, banks are becoming more occupied with trying to blend these two worlds together. In all likelihood, we are unlikely to see fully decentralised permissionless markets, due to the need for compliance with established controls like anti-money laundering and Know Your Customer requirements.
New marketplaces may emerge in DeFi where very specialist activity takes place. However, in DeFi, the automated nature of smart contracts makes it hard for institutions to engage because it is not clear who has liability when something goes wrong. With algo trading, you can have a kill switch. If needed, traders can hit such a switch and all their instructions get deleted, which provides a reasonable amount of control. As yet, there is no real way to engage in DeFi within a regulatory perimeter, although some guidance and examples are starting to emerge. For traditional players, it needs to be much clearer who is operating the marketplace, who the judge is, and who else is trading.
We might compare DeFi to the Napster phase of file sharing; people are waiting for the commercial version, for the ‘Spotify of DeFi’ to emerge. Does that mean we need a walled garden approach to protect DeFi investors, or something else that we have not yet thought through? Where are the assets sitting? Where is the custody? All these questions are fundamental to bringing traditional financial institutions into the DeFi arena.
In DeFi, there is no longer any Central Securities Depository (CSD) as transactions are peer to peer. So the market needs to find ways to connect up execution venues, custody of assets, and the means of payment. This could mean that a new role emerges for a CSD.
Despite being a new industry, DeFi is now butting up against the same thorny problems that occur in centralised finance, in particular the need to deal with settlement in a robust way. We trust centralised wholesale banks but that does not mean that they are particularly efficient. In 2018, Gary Gensler, now the head of the U.S. Securities and Exchange Commission said that financial services in the United States represents around 7.5% percent of GDP and that blockchain innovation can deliver considerable efficiencies in the sector. If we can be more efficient and create better plumbing, the entire market will benefit. The latest International Monetary Fund financial stability report shows that DeFi is more cost-efficient at scale than traditional financial services because it has almost zero operational or labour costs. If we compare apples to apples — taking into account e.g. Ethereum “gas” fees, capital requirements for stablecoins and so on — does this mean that DeFi is meaningfully better economically than TradFi?
In FinTech the front-end user experience can be very busy but the back-end, or the ‘plumbing’ that sits behind it, sometimes holds it back. In terms of custodians, something holding them back may be the absence of a wholesale Central Bank Digital Currency (CBDC), or some other mechanism for them to plug into government-backed payment rails, which would give greater comfort to banks wanting to engage with digital assets.
One aspect that still needs to be addressed is central banks’ willingness to create the structures that would allow for a wholesale CBDC. It is not necessarily a requirement that central banks themselves operate a digital currency. Central banks can instead set out the controls and guidelines which would allow the private sector to operate. If they also expand their access policy then we could see a world in which you can have many execution venues, combined with decentralised custody. That would really start to make a huge difference to all the players in financial services because the current liquidity requirements are incredibly expensive.
The bigger question, as we move forward, is whether we shift towards a trusted intermediary model or trusted protocol model and what does that mean for the future of fiat currency? As a society do we trust more in third parties to control our assets or should we put our faith in computer code? The answer is still very much being worked out.
To learn more, listen to our podcast series, The Gage Episode 4 — How will DeFi transform banking?