Legacy Finance took centuries to build, while the Market Infrastructure for the Blockchain Economy is being built at hyper-speed over one or two decades. At that hyper-speed, there are bound to be some accidents. Those invested in Legacy Finance are publicly trash-talking the disruption, while investing quietly to be a player in Blockchain Finance. We have lived with Legacy Finance for so long that it is hard to imagine a real alternative. So in the first iteration, Blockchain Finance will look a bit like a version of Legacy Finance (like the talking heads era when TV imitated Radio).
This is Part 1/Chapter 2 of The Blockchain Economy. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the transition to an economy where value exchange is permissionless and disintermediated. For the index please go here.
The 3 layers of Blockchain Economy Infrastructure, seen from top to bottom are:
- Layer 3: Blockchain Finance Market Infrastructure. This Chapter 2.
- Layer 2: Middleware Services. Next, Chapter 3
- Layer 1: Consensus Protocol Governance Platforms. Chapter 4
This Chapter covers:
- Defi 101
- Blockchain Finance will score where Legacy Finance has failed
- The closest cousin in Legacy Finance is the FX market
- Decentralisation blurs many boundaries
- 3 fundamental needs from 3 types of business
- From vertically integrated proprietary technology to API ecosystems
A much more popular name than Layer 3 is DeFi, which Defi Pulse defines as:
“Decentralized finance, or DeFi for short, is what the Ethereum community calls financial smart contracts, decentralized applications (DApps), and protocols built on Ethereum. Popular DeFi products include decentralized exchanges, lending and borrowing markets, tokenized physical assets such as gold, derivatives, prediction / betting markets, payment networks, insurance, etc.”
Transparency is a core principle, easily achieved on Blockchain platforms such as Ethereum. In legacy finance, it is the banks and regulators who control the flow of information; they choose what information gets disclosed. DeFi enables bank-like services where you can do your own audit at any time.
Building a system using DeFi is like putting together Lego. Three key blocks are:
- Stablecoin: Dai is a decentralized stablecoin pegged to the USD, which can be generated by locking up Ether. Dai is usually referred to as being Crypto Collateralized to differentiate from Fiat Collateralized Stablecoins such as Tether and USDC.
- Credit/Loans: The most popular platform for people to loan out their crypto or to borrow is Compound. Others include Dharma and Nuo.
- Decentralized Exchanges (DEX): Uniswap is a prominent example. Uniswap enables you to create markets for any ERC20 token, reducing the reliance on centralized exchanges.
Blockchain Finance will score easiest where Legacy Finance has failed
Legacy Finance has failed in three markets that become “blue ocean” market opportunities for Blockchain Finance:
- A. Early stage capital raising. Legacy VC ran from early stage risk, leaving a massive gap in the market. This explains the stunning growth of ICOs. Although the Ethereum founders never envisaged this as their killer app, the numbers (amounts raised by ICO using the Ethereum platform vs amounts raised by Legacy VC) speak for themselves.
- B. Financial inclusion. This is both for the billions in the “markets formerly known as emerging” (aka the Rest of the World) and for the millions in the West left behind by globalisation. This window is wide open and will be for a long time as billions of people enter the global middle class, but it is not easy to create a real value proposition “at the bottom of the pyramid”.
- C. SME Finance. SME is the neglected middle child. Legacy Finance did a good job serving the youngest child (Consumers) and the oldest child (Corporates), but tried serving the small business middle child with either a Consumer or Corporate model. The SME blue ocean market connects to Financial Inclusion because the model of Consumers with steady pay-checks from Corporates will be seen from a historical perspective as a bye-product of one era (post WW2 before the rise of the Rest) and developed markets (America, Europe and Japan) and the future will trend towards self employed and small business (thanks to Coase’s Law brought to life by Blockchain).
Given how long Legacy Finance has been serving Corporates and Institutional Investors, those are “red ocean” markets for Blockchain Finance innovation. A red ocean market is good for a venture with a clear “better, cheaper, faster” value proposition; everybody loves a bargain, even if existing vendors offer a viable solution.
The closest cousin in Legacy Finance is the FX market
FX and Blockchain have two attributes in common:
- 24/7. By contrast, equity exchanges have the strange habit of only operating 9-5 and M-F. This has held back regional exchanges from getting global liquidity. Who cares what time it is in XXXX (name your favourite local exchange)? This has driven consolidation in equity exchanges. Equity exchanges that try entering the Blockchain market without going 24/7 will fail, because the crypto market expects 24/7. Running 24/7 is in the DNA of anybody coming from the FX world.
- A Tiered market of P2P OTC Liquidity Pools. FX is a Peer To Peer (P2P) OTC (Over The Counter) market not an Exchange driven market like Equities. It is a tiered market with a few Interbank players dominating liquidity; Credit Suisse gets a better rate from Deutsche Bank than a traveler gets from Travelex for example. Although we have entities called Exchanges in Blockchain Finance, the fundamental structure of the market is P2P OTC. That is the whole idea of a permissionless network. Individuals can trade crypto to crypto or crypto to Fiat without anybody’s permission. The same is true in Fiat to Fiat FX. I can come to London with Swiss Francs and exchange them for GBP through a friend (even if I opt for convenience and exchange money via an ATM or Credit Card). For a bigger transaction one goes to some “liquidity pool” (aka an exchange in Blockchain Finance and a Bank in Legacy Finance).
3 fundamental needs from 3 types of business
It is unlikely that Banks, as they exist today, will control the Blockchain Economy. As Bill Gates famously said as far back as the 1990s, “we need banking, but we don’t need banks anymore”. We need many of the things we get from banks, but a bank is an entity that exists at the pleasure of the state. A banking license is literally a license to print money via Fractional Reserve Banking and many Governments view a permissionless financial system to be a threat (to the ability to print money and control the flow of capital).
However we need many services that look a lot like banking. These services will come from 3 types of business:
- Banks that move into Blockchain Finance. In some jurisdictions, the Government is more Blockchain friendly than others; for example, Lichtenstein and Switzerland are relatively Blockchain friendly, so we already see moves by some banks in those countries into Blockchain Finance.
- Regulated Blockchain Native businesses. Coinbase, for example is pretty similar to a bank – fully regulated and you need to trust them – but Coinbase is also clearly a Blockchain Native business.
- Unregulated Blockchain businesses. The point of a permissionless network is that anybody can offer a service and anybody can choose to use or not use that service. Some will choose the government approved safety of Regulated Blockchain Native business. Others will choose to take the risk of a service offered by an unregulated Blockchain business.
The competitive dynamics between these three types of business will define the market.
There are 3 fundamental needs that these businesses need to address:
- A safe place to store assets both short and long term for big and small amounts. In Legacy Finance terms, we would call these checking/current accounts (short term, small amounts), deposit accounts (longer term, small amounts) and custodian accounts (longer term, large amounts). In Blockchain Finance we call these hot and cold wallets. Customers want the convenience of both, just like we get in Legacy Finance, because we want assets for two purposes – asset appreciation and spending. This is where the boundaries between wallets and exchanges blur. A wallet in Blockchain Finance means a place where you keep small amount of spending money. These are different categories with different companies in Legacy Finance but increasingly one category/company in Crypto Finance. For example, look at what Coinbase is doing; they combine functions of wallet and exchange and custodian. The difference between a wallet and a custodian becomes more a continuum than a hard distinction; one might keep small amount of spending money in a wallet and large amounts in a custodian service with ability to move assets between long and short term storage.
- Quality Filtering for investors. Just because something can be traded, does not mean it is a good investment. Blockchain based real time settlement and tokenisation opens up many more assets to invest in. That makes the filtering job even more important. Firms that work exclusively for the buy side – meaning they get paid by the buy side rather than than the sell side – will prosper in the Blockchain Economy as the filtering job will become even more important.
- Liquidity for exchange matching and settlement. Tokenisation offers instant trade-ability. The moment a Token is issued it can be traded. However without liquidity, that is only theoretical. In practice, without liquidity you can only sell at a price that is unattractive ie you won’t sell. The big benefit of Blockchain based trading is that exchange and settlement happen at the same time – eliminating all the cost and risk in the time gap between trading and settlement. However that is also useless without liquidity. Liquidity comes through a) enough people wanting to buy and sell these assets in volume b) venues where buyers and sellers needs are matched. The names given to that matching process and the functionality will change depending on the amounts being traded – exchange, brokerage, trading venue, dark pools – but the critical function will remain. Technically, matching is very easy on the Internet, but success is defined by how many buyers and sellers use the network.
Decentralisation blurs many boundaries
Crypto Finance Market Infrastructure is being built in two phases, as is the norm in disruptive waves of innovation.
- Phase 1: the talking heads phase. The term comes from when the early days of TV initially simply imitated Radio. Today it is common to take a category from Legacy Finance, with all its associated business models and attach the name Crypto in front (such as Crypto Hedge Fund or a Crypto Exchange or a Crypto VC Fund).
- Phase 2: a crypto native infrastructure emerges. This is when boundaries established during the Legacy Finance era become blurred. For example, in Legacy Finance, Trading and Settlement were different categories with different companies. In Crypto Finance, when we move closer to Real Time Settlement, Trading and Settlement become one category/company.
From vertically integrated proprietary technology to API ecosystems
Legacy Finance was a vertically integrated business. During the era of Fintech before it was called Fintech, the only way to make money from financial technology was to sell/license technology to Banks. Those Banks took all the risk and all the reward. The Bank built a vertically integrated proprietary technology stack all the way from Customer Experience (CX) to back office books and records. For a long time, Banks viewed that vertically integrated proprietary technology as an asset. Increasingly today it is seen as a liability; the technical debt and need to maintain old legacy systems is a constraint on innovation.
Modern Fintech ventures have APIs to the south and north of their stack. They build out their functionality by connecting through APIs to partners to the south (the layer below them) and they grow functionality and market reach by connecting through APIs to partners to the north (the layer above them).
If speed defines success, this API ecosystem model will always beat a vertically integrated proprietary technology stack.
The move from vertically integrated proprietary technology stacks to API ecosystems is already changing the first generation of crypto Exchanges. As they move from centralised to decentralised, they become much more open to partnering with specialists.
One example of where we see this is in stablecoins. Tether/USDT, the leading stablecoin, is owned by Bitfinex, a Crypto Exchange. The business logic is simple. A stablecoin facilitates active trading and Crypto Exchanges make their money from active trading. There is no reason for each Crypto Exchange to manage their own stablecoin. (For more on stablecoins, please see this chapter).
Bernard Lunn is the CEO of Daily Fintech and author of The Blockchain Economy. He provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services).