Where are the real risks and opportunities?

The world of finance is filled with risky projects. Ventures are founded, funded and abandoned faster than regulators and banks can understand them. Fintechs have helped the financial lives of many people, but there are still projects with opaque fundamentals that leave customers in the dark.

A closer look at the underlying mechanics can be very illuminating. Here is one example:

TradFi has problems which need solving

Joking aside, Traditional Finance (TradFi) has a number of problems today. In this article we examine some of the issues for customers that show the economic model between them and their bank is broken.

Customers pay high fees just to use their bank account

Even in countries where a checking (or current) account is ‘free’, banks need to charge you to pay for their costs. This is made up through fees and spreads, and we can see that these add up over time.

This is because running a bank costs money

  • Having hundreds of thousands of employees costs money
  • Paying CEOs tens of millions of dollars per year costs money
  • Paying fines for institutionalized criminal activity (see HSBC, Goldman, JPM, Deutsche…) costs money
  • Keeping arcane interbanking systems from another millennium running costs money

Renting districts of skyscrapers in the most expensive parts of the most expensive cities on costs money.

On top of that, banking has massive social cost

The benefits of economies of scale are outweighed by the social costs of “too-big-to-fail” players in the financial system.

Following the credit crunch of 2008, the top three French banks were faced with a potential loss of 19% of their ‘assets’ as Greece, Portugal, Spain and other European nations were struggling to serve their financial obligations. Just 3% would have bankrupted them. The French government needed €562 billion to save them or risk losing their own lenders. Instead of letting the banks go bust, the costs were rolled over to European taxpayers, effectively indebting generations with trillions of loans that they are not going to be able to repay. [link pp. 23–27]

In their 2016 paper in the journal of Banking and Finance, Boyd and Heinz found clear evidence that:

“While the policy of too-big-to-fail has received wide attention in the literature, there is little agreement regarding economies of scale for financial firms. We take the stand that systemic risk increases when the larger players in the financial sector have a larger share of output. When distributional and intergenerational issues are considered, the potential benefits to economies of scale are unlikely to ever exceed the potential costs due to increased risk of a banking crisis.”

DeFi solves these problems…

DeFi is innovating rapidly to provide solutions to these challenges

Innovation in DeFi is exponentially faster than in TradFi. Banks are being challenged by challenger banks on customer experience, but the underlying operations have remained similar. Now DeFi is reinventing the fundamentals with more automation and being more transparent, more open and permissionless.

Open (sourced) innovation and permissionless protocols bring faster innovation. Anyone can build a protocol and integrate with the other ‘lego blocks’ of DeFi without asking for permission. This is a contrast with innovation in TradFi that takes years of agreement between different regulatory bodies and financial institutions.

DeFi has low costs and low fees

DeFi protocols have lower operating costs than TradFi institutions by orders of magnitude. By being open source and relying on each other, each protocol can specialise and focus on adding value in specific areas. This allows relatively small teams with low overhead to create advanced financial products. Automated protocols are competing their fees down to zero and the end users profit from the efficiencies.

DeFi deliver more profits to customers

Low fees and the fair distribution of rewards mean that customers profit from financial activity to a much greater extent. The typical sources of income in TradFi (lending and trading) are democratized and users get more back from the funds they put into the system. For lending, this means higher returns for lenders and/or lower cost of capital for borrowers. It is peer-to-peer lending with the thinnest possible intermediary. For asset exchanges, it means a tighter spread that benefits the buyers and sellers.

A simple formula: disintermediate the banks and give more back to customers. This is what DeFi offers.

DeFi distributes losses more fairly

The other side of profit is loss. Unlike TradFi, both the rewards and the costs are distributed more fairly to those who generate the value and those who took the risks. There are no central bank bail-outs. Depositors can earn like market makers and overleveraged traders pay for their own liquidations. Those who take risks take any downside themselves — instead of passing it on to regular taxpayers.

…while also growing safer by the day

DeFi is highly automated

The smart contracts of DeFi are deterministic. Processes are highly automated as people are replaced by automated software protocols. Because of this, the longer a smart contract has been safe, the more likely it is to continue being safe. This is also known as the Lindy effect.

Traditional finance is often arbitrary and can change as opinions do. It is affected by human decisions and actions that come and go as people change. A financial institution’s likelihood of survival does not increase with old age.

DeFi is robust to market shocks

In May of 2021 the crypto markets saw a drop of about 50% in market cap with some tokens losing 70–90% of their value. Traditional markets would have collapsed without government and central bank intervention. DeFi systems sailed through the storm. Decentralized exchanges had 100% uptime and generated revenue for their liquidity providers. No bailout needed. No ‘too big to fail’.

DeFi lending is typically overcollateralized

Overcollateralization means systemic risk levels are much lower than in some of the highly leveraged asset bubbles that have existed in the past decades in TradFi. Due to the very nature of how smart-contracts and the trustless web3 work, no person or entity can blow up more than they have.

DeFi is opening up finance and enabling people to get more from their money

DeFi is seen as risky, in part because it’s associated with ‘crypto’, and in part because it’s a young industry moving at lightning speed. In fact, TradFi is suffering from many well-known problems. DeFi is addressing several of them while opening up finance to be more accessible and reliable, and it’s doing so faster than anyone realises.

Time to get serious about DeFi.

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