The Use-Case for DeFi in Fintech: Are You Building Enablers or Solutions?
How DeFi Opens and Streamlines Finance.
Welcome back to MondayMunday, your weekly blog talking all things tech and fintech! We are not stopping from talking about the intersection of where fintech meets crypto. Today I wanted to zoom out and focus on the use-case for DeFi in fintech and explain my thinking… In crypto we are so used to seeing tokens and technology take center stage. However, we can look from 1000ft out and see global financial rails makes perfect sense for certain use-cases.
The aim of this piece isn’t to delve down into the minutia of blockchains vs trad-fi (as you may know by now, I believe a duality of systems will be key, and we will touch on this). But simply to highlight and raise discussion on a framework for fintech builders to interact with DeFi.
There has been many a takedown of famous web3 commentators arguing where is the use-case for crypto is. However, this misses the point, the promise of a open financial system built on cheaper and global infrastructure is still a compelling vision and one that has a wide-reaching consequences and opportunities… Let take a look for first principles of what blockchains actually achieve at a high-level.
What did blockchains do?
It’s easy to get lost in the myriad of tokens, projects and debates to not remember to universal maxims of blockchains. They provide decentralised infrastructure which by nature is open access. This allows a new financial system to be built on one common layer, in comparison the mix of layers in traditional financial systems leads to the creation of middleware and central entities to reconcile systems.
Below we compare how Trad-fi and DeFi work in their conceptual forms by exploring a set of common aspects they share and require to build products.
A ledger
A ledger is a statement of payments, asset or any financial instrument in and out of a system. It is key for financial system to function as it allows systems to match what is being ‘credited’ with what is ‘debited’. It is essential to make the system has checks and balances.
How it works in Trad-fi?
In traditional finance every provider has one (or multiple) ledger(s), for transaction between organisations there are either central authorities who reconcile across these networks to provide clarity and accounting integrity.
Internal reconciliation - Financial companies reconcile internal systems, for example a bank may have numerous siloed ledgers and data stores they need to reconcile to get a unified customer view and verify their accounts.
External reconciliation - In order to send money between institutions you need to rely on third parties to reconcile ledgers examples of this are SWIFT who’s messaging protocol allows for post-transaction settlement across borders, or RTGS for interbank reconciliation.
All these reconciliation elements make it difficult to compile a universal state of global finances and leads to fintech builders creating middleware to allow them to build new products or the formation of platform based products to empower other builders.
How it works in DeFi?
Blockchains provide a global ledger of transactions that are immutable and 3rd party verifiable because ‘network consensus’ validates every transaction → This allows any party on a network to instantly settle and verify and transaction creating a base layer for open innovation.
Assets aka ‘things’ to transact
In financial services you need native assets (i.e. sources of value) to transact between individuals and institutions.
How it works in Trad-fi?
Assets like cash, real estate etc are digitised. They are not natively owned on a digital system, this is settled with external systems such as law documents or title deeds for example.
How it works in DeFi?
In DeFi tokens are fully representative of assets, these instruments are ‘bearer’ by nature meaning by holding the token you own the asset. As mentioned in my piece on custody, it why owning the private keys to wallet containing a token is essential for security of ownership.
Workflows aka how to move ‘things’
This allows you to build products, instead of using simple inflows and outflows of payments to build complex workflows to solve actual problems for customers.
How it works in Trad-fi?
In traditional finance workflows are often complicate and require complicated operational systems. Whilst systems are digitized, they are not digital. This is exemplified in capital markets with post-trade processing, whilst trades in capital markets can be agreed digitally, a post trade lifecycle is undergone to ensure the transaction has legal recourse for example.
How this works in DeFi?
In the DeFi smart contracts govern how assets move around, this allows users to instantly settle complex transactions between multiple parties and create universal rules for it. This is achieved as blockchains are global ledgers with autonomous tooling for; consensus, asset ownership and data transfer.
Data aka how to assign and determine value of ‘things’
How it works in Trad-Fi?
A mix of ledgers make a unified customer view difficult for any one institution let alone a market view, this is why banks often undergo large digital transformation projects to get a unified customer view to try and understand users.
At a market level information is often opaque, we saw with the GameStop saga with centralised entities selling proprietary data for traders to profit. Here exist opaque data structures for builders and market participants to navigate.
How it works in DeFi?
In DeFi user data is owned by the user and able to be shared across multiple service providers. Composable data allows users to control the services and information they provide to interact with finance.
Additionally, an open ledger allows anyone to freely access all the information around transactions, it provides a truly open data infrastructure for builders and participants.
Here we can see DeFi brings an open ledger in which users can freely join and own their data to transact assets natively between each other. Opposed to the previous systems which are siloed.
The aim of fintech…? “The unbundling of finance”
As we can see a fintech has arisen to take any part of the banking stack and unbundle it into core products. Following this we are seeing the platformization of fintech stack into developer platforms to allow anyone to build financial services.
We have gone from:
Banks → Fintechs → Fintech developer platforms → Whats next…?
However, the next stage of development in this unbundling of finance is hindered by the existing systems financial systems. I break this down into distribution (how customers get access to finance), Liquidity and capital (how firms get sufficient inflows to create financial products) and composability (the free ability to mix and match financial systems) as the blockers to further development.
Distribution
Whilst the internet has made distribution easier acquiring customers is still difficult. Users have vendor lock-in to pre-existing systems used to operate in the world as we live today. initiatives such as UK Current Account Switching Service help solve this inertia problem of moving from one finance provider to another, there is still a barrier to entry to acquire customers.Liquidity and capital
Fintech platforms by the nature of having to attract users have a cold-start problem for liquidity and aggregation of capital. New fintechs have to acquire a large volume of users to aggregate capital and networks effects. Whilst some fintechs have cultivated this such a Block (f.k.a Square) with CashApp and Stripe with their merchant solution, the road is harder for new upstarts.Composability
When building solutions your are control of platform providers or the nature of the ‘spaghetti’ mess of current systems, you are inherently bound in what you can build using existing infrastructure
DeFi creates new primitives to further unbundling
DeFi unbundles primitives and ownership using the aforementioned ledger, native assets, workflows and open data.
Participants join a shared ledger with common onboarding. We see with blockchain users onboard with a common approach due to the permissionless nature, any actor can join the system.
Builders use protocol rewards to bootstrap networks As noted in the often mentioned A16Z economics flywheels of crypto, protocols use ‘tokenomics’ to drive network effects and adoption for their decentralised application. These two points above solve the distribution conundrum for fintechs.
Native liquidity to transact, the rise of tokenomic driven business models has led to native liquidity with bearer instruments to transact, you now have a large base of users who have tokens they can use with any application on a blockchain.
Composable products, the nature of smart contracts built on a common blockchain infrastructure allows you to ‘mix and match’ these services in a fully transparent way to build the services you need.
The Convergence
However, we would be naive to say DeFi will consume all aspects of finance… the same network effects that DeFi enacts to create its benefits are felt in traditional finance. If we look back to history of finance each successive innovation has grown due to backwards compatibility with existing financial infrastructure e.g. credit card networks compatibility with traditional finance rails.
Crypto is the same, we have seen this with the largest crypto companies being CEXs like Binance and Coinbase, the on-ramp of Trad-Fi to DeFi is the initial backwards compatibility we discuss. This is also highlighted in compliance. These solutions are enablers for the joining for the two worlds of finance.
The point here is to understand who the enablers allows fintech firms to access this new financial system as a building block. But the real uses-cases will emerge where fintechs build solutions to augment or supplant traditional systems to make the most out of DeFi in a financial construct.
Augmenting can be defined as using DeFi to add additional functionality to an existing application.
Supplanting can be defined as using DeFi to create a new system in which to interact.
Lets take a look at a few examples..
AMMs vs Order books - Order book models are how markets trade traditionally interact, an individuals place an order to buy and sell assets, a central ‘market maker’ collates these orders and tries to match them to execute a trade. An AMM does this by creating liquidity pools of users capital to match trades (i’d highly recommend this read to learn more). This is an example of supplanting traditional finance system, here decentralised finance provides an automated way to execute trading providing a more efficient experience compared to trad-fi.
Wallets vs Bank accounts - Bank accounts are still essential requirements for transacting in countries, many governmental and employment systems require a registered bank account. Here, wallets roles may to augment a users financial stack, they provide a second source of ways to manage finances and novel products that traditional finance cannot offer. We can see this rise with CEXs, neobanks and other fintech app offering crypto products. This is a case of DeFi augmenting traditional finance offering a new alternative for companies to manage their money.
Stablecoin payments vs Fiat payments - we have seen stablecoins rise in usage for cross-border mechanisms and usage of develop over time. Furthermore, in countries such as Argentina they are large parts of the economy due to circumstances on their native economic system. These uses-cases show how stablecoins supplant trad-fi. However, in developed economies, they often play a role in DeFi which augments users in their financial journey.
The case is not cut and dry and how to enable DeFi and use it to supplant or augment traditional finance use-cases, but understanding your place in this is a crucial element for builders. We can see this mapped out below in the diagram below.
A Guide for Builders
Given the framework, below is guidance for understanding where you fit in the landscape.
Are you building an enabler or a solution? Many products at the intersection of fintech x crypto are actually building the enablers for solutions in the DeFi world to interact with trad-fi. If you are building this part of the stack you should consider
How am I simplifying the stack?
How do I abstract away complexity?
How do I ensure backwards compatibility?
Do I provide a great onboarding experience for solution builders?
Asking these questions allows you to serve up the stack more efficiently, to solution builders who may no have the expertise in bridging how trad-fi intersects with DeFi.
If you are a solution builder, understand are you augmenting or supplanting financial services. Knowing your place will help you understand how you need intergate with trad-fi.
Augmenting needs constant feedback with trad-fi systems as users live in both financial worlds in this case.
Supplanting there is lower need to have constant trad-fi feedback, once users are onboarded to your platform they gain the full value from your services.
Understanding where you play is key to build the most appropriate onboarding, UX and financial service you build.
DeFi moves the boundaries of how finance works, fintechs with the appropriate partnerships with enablers can onboard users to this new wave of finance by understanding the appropriate solution side they are on (i.e. are they augmenting or supplanting traditional finance) fintech builders can understand where to focus their efforts when building.
If you are fintech builder or investor feel free to reach me by replying to this email or DM on Twitter or LinkedIn, I’d love to chat! 🙏