Decentralized Finance Drives Internet Credit Markets

Imagine a world in which moving money is as easy as sending an email or a text message, without an institution as the intermediary or a regulator as the watchdog. As Circle CEO Jeremy Allaire told Karen Webster, it’s a world that exists today mostly for institutional investors and savvy crypto traders who have embraced the decentralized finance (DeFi) ethos — the power of software, programmable contracts and blockchain infrastructure — to create the cornerstone for a new, accessible, internet-based credit market. According to Allaire, the combination of DeFi and CeFi — blockchain-powered payments that provide a regulated intermediary for those with a different appetite for risk — will be a critical trend to watch as the intersection of FinTechs, blockchain-based payments and finance platforms promise to bring financial services to the masses, globally and at scale.

The impact of  DeFi could be significant, noted Allaire. With software acting as the financial intermediary, it’s possible to take the key building blocks of the financial markets and market infrastructure — activities like borrowing and lending, or trading and exchanging and settling — and create software that runs on the internet, independent of any institution.

For example, instead of depositing money in a savings account in a bank, a cryptocurrency holder could place funds into a decentralized lending protocol to earn interest — typically at a much higher rate than traditional savings accounts.

“In other words: Trust the tech, if not the people on the other side of the transaction,” Allaire said.

Even though the “transport rails” are different, those who use them rely on a familiar method of payment, using stablecoins (such as Circle’s USDC, which can be used for DeFi and CeFi) that reside in a crypto wallet. Those digital coins then connect to smart contracts through a web browser.

“End users transact using a familiar interface,” maintained Allaire.  “[They] can lend [their] dollars to the protocol — and on the other end, someone else is going to borrow, as an individual loan goes to an individual person, complete with an interest rate.” Risk and collateral management becomes more transparent with the absence of the additional steps or intermediaries that are part of traditional lending conduits, he contends.

Yet, to scale and mature, Allaire noted that the concept of intermediaries in the DeFi world will have to evolve — if for no other reason than regulators will require it.

“The role of intermediaries [going forward] will be key,” he said. “In particular, as [decentralized protocols over blockchain rails] becomes more mature as an infrastructure for financial market activity and payments activity, the regulators will want firms that are intermediaries to cover consumer protection and monitoring for financial crimes.”

To that end, Allaire said new types of intermediaries will emerge, innovating on top of an infrastructure that offers new payments and financial services functionality at scale.

Who’s Doing It  

The last few years have seen a marked evolution and embrace of DeFi, said Allaire. Where buildouts and development were the hallmarks of 2018, launches and early adopters were key in 2019. Last year, “there was an explosion of activity, and we’re now on a full-on, massive expansion phase,” said Allaire. “There’s a bull market around the technology itself.”

On the retail side, demand is being driven by individuals who are already comfortable with cryptocurrencies and crypto wallets. Allaire estimated that there are probably 100 million such individuals across the globe. A significant number of those individuals might be relatively sophisticated, perhaps working in hedge funds or banks, observed Allaire.

The appeal is the opportunity to convert dollars that are earning zero interest in a traditional bank into the decentralized, internet-based credit markets, which can earn as much as 10 percent when converted into digital dollars that become lendable assets at high-interest rates.

“That’s a good economic offer,” Allaire said. “The base layer is just like a market, and anyone can connect and participate.”

There’s also a lot of institutional activity online, where firms may look to trade actively — and there are also enterprises that want to borrow or lend on a large scale. Here, noted Allaire, firms trafficking in high-dollar, perhaps high-volume transactions may wish to “face” CeFi institutions.

“They want to have regulatory assurances that are what you’d think of as ‘classic’ Wall Street risk management, just as you’d ‘face’ a prime broker dealer,” he said.

The evolution can be seen with firms like PayPal, which are taking steps to move beyond legacy financial system infrastructure, which underpins consumer and business products.

“Up until recently, PayPal was an end-to-end version of that,” said Allaire. “It was a really great consumer and merchant platform that worked on top of the existing rails and made it easy, providing this great ‘assurance’ layer to people. It was its own walled garden.”

But as its February earnings call confirmed, PayPal is creating a blockchain division in an effort to move more fully into digital currencies (though, notably, they’ve yet to enable customers to transact over blockchain). As soon as they do that, PayPal will give end users access to these decentralized financial markets. Other recent announcements, such as with the Visa Crypto API, seek to bring the benefits of crypto and an onramp to DeFi to the more traditional banking world.

What’s Next

Allaire predicted the bifurcation between CeFi and DeFi will converge over time. Regulators will likely require commercial banks and other institutions to provision and provide DeFi services over time to their corporate clients. Some things won’t change, he said — there will have to be proof that buyers and sellers are transacting in a liquidity “pool” that has know your customer (KYC) protocols in place.

“The market itself is still running without an intermediary, in the traditional sense, but people can prove to each other that they are in fact compliant,” projected Allaire.

For now, as noted earlier, there is a continued need to have CeFi (and intermediaries) in place, as he told Webster, because businesses and individuals are not going to want to become their “own” banks — taking on the risk of managing their own private keys, and in effect running their own risk management. As financial services move toward DeFi, said Allaire, the blockchain is sufficient to operate at scale for the volumes that the shift will demand. Speaking of Circle’s own stablecoin transactions, blockchains can handle thousands to tens of thousands of transactions per second, settling in milliseconds.

“That’s the scale of a major network,” explained Allaire, akin to the leaps in speed seen when dial-up modems gave way to broadband.

Looking ahead, as stablecoins, cryptos and blockchain bring financial services to new distribution models, DeFi can leverage the key strengths of the internet itself: servicing the long-tail users, yes, but ultimately servicing everybody.

After all, on the web, anyone who makes a craft, or writes a book, or plays a piece of music can distribute it or find a person to buy it, Allaire said. Stablecoins and blockchain can all work together to foster prosperity through programmable internet commerce.

“This is going to be also an infrastructure that allows someone without an official identity — someone who works in some context in some emerging market who has a smartphone — to download a piece of software and plug into the global digital economy and transact,” he told Webster. “And they won’t have to get crushed with exorbitant fees or time delays. They’ll participate as a value creator in the world economy.”