Daily Fintech

Layer 3: Creating the Blockchain Market Infrastructure at Light Speed using Defi

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:

This Chapter covers:

 

 

 

 

 

Defi 101

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:

 

 

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:

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:

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:

The competitive dynamics between these three types of business will define the market.

There are 3 fundamental needs that these businesses need to address:

Decentralisation blurs many boundaries

Crypto Finance Market Infrastructure is being built in two phases, as is the norm in disruptive waves of innovation.

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).

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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).

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