The Innovator’s Dilemma – Disrupting in an Unexpected Way?
As is often the case with the advent of innovative technologies, those that manifest do not meet the inventor’s expectations. Tim Berners-Lee has a say in this observation, e.g., Web3 and blockchain, and he wants people to forget that because the exaggerated version doesn’t live up to his Web3.0 project The goal of returning the Internet to its original promise.
The same is happening with decentralized finance (DeFi). The concept of decentralization is not new, but gained prominence after the 2008 financial crisis and especially after the release of the Ethereum protocol in 2015. DeFi is now widely accepted as the next big evolution in finance.
Pioneers of decentralized finance might wonder whether the adoption of DeFi concepts by institutional investors, central banks, regulators, and centralized utilities is a salvation or a wake-up call for market participants. To many, incorporating DeFi concepts into a centrally regulated TradFi ecosystem must sound like an oxymoron. This is exactly
the opposite of what the inventors had in mind, whose vision was to create an alternative, decentralized financial system without the need for flawed top-down governance and control by central banks and policy makers.
Still, there are many opportunities for DeFi to create positive impacts for all stakeholders by helping to grow the token economy and innovate centralized finance (CeFi).
The decentralized nature of DeFi
DeFi has become a complex ecosystem, distributed in infrastructure services, protocols, various sectors, regulatory technologies and novel contracts, and asset types supporting different delivery and service models in recent years. While the markets for cryptocurrencies, NFTs, and the Metaverse have largely turned sluggish for most of the year, institutional backers of traditional finance (TradFi) have continued to announce and launch new services in the cryptocurrency and digital asset space.
The institutionalization of DeFi is being driven by major international financial institutions and asset managers, as well as boutique firms backed by regulators and industry associations.
Numerous studies can attest to the growing momentum, experiments and pilot projects implemented by central banks and banks under the umbrella of the BIS Innovation Centre, European Central Bank ( ECB ) and other initiatives.
The following example impressively illustrates the invasion of CeFi by the decentralized approach.
- Project Mariana . SNB, together with the BIS Innovation Centre, Banque de France and the Monetary Authority of Singapore ( MAS ), is exploring automated market makers (AMMs) using DeFi protocols for the cross-border exchange and settlement of a hypothetical CHF, EUR and SGD wholesale CBDC .
- Project Orchid . The Monetary Authority of Singapore (MAS) is exploring the potential use of a purpose-built digital Singapore dollar (SGD) and the supporting infrastructure required . 1
- Guardian Project. A collaborative initiative with the Monetary Authority of Singapore (MAS), market participants are testing the viability of asset tokenization and DeFi applications while managing risks to financial stability and integrity. 2
- The mBridge project . The Hong Kong Monetary Authority, the Bank of Thailand, the People’s Bank of China and the Central Bank of the United Arab Emirates conducted a pilot to support real-time, peer-to-peer, cross-border payments and foreign exchange transactions using CBDC.
- Project Icebreaker . The central banks of Israel, Norway and Sweden are working with the Bank for International Settlements to explore retail CBDCs for international payments.
- Project Cedar . The New York Fed has completed an experiment ( Phase 1 ) focused on whether CBDCs have the potential to become a viable option for large-scale foreign exchange transactions. 3
- Commercial Bank Money Token (CBMT). DZ Bank, with the support of three other large German banks, is promoting a CBMT that should have the same properties as classical paper money and be protected by deposit insurance as sight deposits while, for example, enabling companies, machines and small amounts Programmable transactions between payments.
- First issuance of dual-listed digital bonds . UBS has issued the first digital bond to be listed and publicly traded on the traditional SIX stock exchange and digital asset exchange SIX Digital Exchange ( SDX ).
- UK-based Abrdn, an asset manager with over £500m under management, recently invested in Archax , a London-based regulated digital platform .
Although experimental, these projects demonstrate that blockchain-based distributed ledgers for (cross-border) payments, issuance and settlement of digital assets can be faster, synchronized, safer and less risky. The distributed ledger system design can realize the payment of digital currency and the settlement of digital assets, and it is the basis of 24/7/365. Interoperability between independent, homogeneous ledger networks of various financial and public institutions, including central banks and private banks, shows the potential of an integrated digital economy.
We now turn to the potential of digitizing private market assets.
Private Market Assets – The Biggest Potential of Digital Assets?
According to BCG , in 2021, the asset management industry passed the >$100 trillion assets under management (AuM) mark. Jonny Fry of the blockchain team argued in his 2021 blog post that this represents a huge opportunity for digital assets.
An interesting area of investment is the fast-growing private market asset class, which is, by its nature, a long-term and relatively illiquid asset class. Most of these so-called alternative assets are issued and managed through a myriad of paperwork and manual processes that require time and effort, involving many stakeholders.
The infographic below shows the situation for private market assets (assets under management)
The money flowing into these markets is evidence that, despite endless uncertainty, investors are ready and willing to deploy capital into risky assets when they have reason to believe they are likely to earn relatively positive returns. 4The Next Big Wave of Investors May Will come from the wealthy retail crowd, which has largely stayed on the sidelines as the private market expands. The democratization of alternative investing came closer last year when the U.S. Department of Labor issued a letter backing private equity investing in defined contribution plans, where individuals can pick and choose their own funds.
The cryptocurrency industry has paved the way by issuing and making native cryptocurrencies and non-crypto tokens tradeable on centralized and decentralized exchanges. But after the hype of 2021 and the collapse of large market players, we are in a tough period where some exchanges are seeing volume drops of more than 90%. Interestingly, this has not stopped the rather slow but steady progress of the tokenization of financial assets. Compared to most cryptoassets, which are speculative in nature, digital assets show huge and growing potential in terms of existing and newly issued assets.
The asset management industry is starting to understand the benefits of digitization and offer digital funds to investors. The underlying funds remain the same, but are available in digital packs. These new digital funds enable greater transparency, stronger risk management and compliance controls, and enable some funds to be sold to new investors. While being quoted by various new digital exchanges, digital funds also provide a huge market for existing stock exchanges.
After the B2C-fintech boom fades, professional investor-focused wealthtech in the professional space is taking off. This trend towards digital platforms is supported by the growing popularity and demand of private market assets. As noted in Mercer’s 2022 Global Wealth Management Investment Survey report.
“Tokenization of private assets can demonstrate benefits and lead to higher adoption without the regulatory uncertainty of native cryptoassets and cryptocurrencies.” (Translated) (Translated from English)
Platforms such as Titanbay, Petiole Asset Management, and wealthtech and fintech companies such as GenTwo, Vestr, Stableton and Swisspeers demonstrate the growing need for digital issuance, structuring and distribution platforms that can be easily integrated into current advisory processes and distribution channels. 5
Is DeFi meeting CeFi an oxymoron?
Adopting the DeFi concept in the CeFi system, is the direction of central management correct? Regardless of the answer, applying DeFi protocols to CeFi can help it innovate. Expanding new technologies and approaches on top of the huge existing asset base will help to (re)create a solid and resilient financial market infrastructure.
“As we build tomorrow’s financial market infrastructure, we need to be vigilant. Not everything shiny new is better than TradFi. Design still matters; we need both the new and the old. There will be an era of convergence .” Olaf Ransome (Translated)
The reality is that we will continue to live in a heterogeneous world with many more systems co-existing in the future. Is real DeFi a reality? Only time will tell.
- This is not a CBDC, but a privately issued “purpose money” (PBM), i.e. money programmed by smart contracts on a distributed ledger (DLT), e.g. government payments and vouchers.
- See more in Oliver Wyman’s paper ” Institutional DeFi “, 2022.
- The experiment brought clearing and settlement down from the current average of 2 days to under 15 seconds.
- Mercer, 2022: Private markets – Top considerations for 2022
- CB Insights, Future of Investing Report , 2022