The DeFi market has captured the imagination of investors after multiplying in value 18 times in the last 12 months, reaching $244B in total value locked (TVL) on Nov. 1, according to DeFi Llama. Traditional investors are now seeing the immense opportunity that DeFi has to offer as well as the returns. But there is a lot of work to be done. The DeFi projects have to match the sophistication of traditional financial services in risk diversification and eradicate the red tape and bias toward the wealthy that has long plagued traditional finance (TradFi).
First off, DeFi is not just TradFi 2.0. There are core differences, which is one reason I stepped away from my TradFi job as the Head of FX & EM sales to set up Tranchess, a decentralized yield-enhancing protocol with varied risk-returns solutions. One key reason is that DeFi is truly liberating.
However, TradFi is not a system that welcomes or promotes innovation, at least not at the speed necessary for investors now. With its open and permissionless characteristics, DeFi is free of bias. Anyone who can get their brain around DeFi can jump in for lucrative returns. There is no emphasis on prioritizing the wealthy, and the barriers to entry are relatively low.
What should DeFi learn from TradFi?
The major obstacle right now is DeFi’s complexity, which we are working to break down every day. There is a reason why DeFi, for all its growth, is still poorly understood by many outside the converted. It’s a big niche market, when you compare its TVL to the total U.S. Equity Market Value of $48.5 trillion as of 30 September 2021. Why is DeFi intimidating to so many?
To answer that question you have to look at how DeFi is starting a whole new financial framework without the complexities of procedures, old thinking, and limited access to investment. DeFi needs to be structured and clear with simplified options. In TradFi, we don’t see a smorgasbord of too many options, confusing the uninitiated without clear directions on where investors should put their investments and what are the risk levels. For more traditional investors to take a leap in faith, we need to simplify it to give investors clear and simple options: hold, earn yield, or go long or short with risk levels indicated.
Another entry barrier is that DeFi platforms require investors to have in-depth knowledge and understanding about the market to benefit from it. Newcomers should not be provided with a hundred different options from platforms, but rather clear choices, like an express lunch menu. Faced with too many options, new investors won’t make the best decisions, prompting many to shy away from DeFi.
The high volatility and possibility to earn more and earn faster is, of course, the big draw in crypto and DeFi. However, DeFi still faces resistance from both institutional and retail investors because it requires a higher risk appetite. TradFi investors can do much more with digital assets as long as they are confident in their ability to manage risk. There are limited DeFi products to engage users of various risk appetites, which is a bottleneck that needs to be quickly addressed and resolved if institutional and retail adoption is to take off.
Creating a welcoming environment to DeFi is not easy and it isn’t that TradFi is doing this exceptionally well either. The bureaucracy of TradFi is impeding innovation with its red tape. However, the sophistication of this system is something that we can learn from and bring to DeFi.
We all agree that DeFi is still in its early days but not all DeFi offerings are highly volatile. In fact, DeFi players are already addressing these obstacles, trying to cater to a welcoming environment by introducing more simplified, stable and less volatile offerings. For example, DeFi platforms are using stablecoins, such as USDC, for yield farming which is a safer and less volatile way for investors to earn steady returns. It is less volatile than memes coins that are susceptible to unpredictable stimuli such as a tweet from Elon Musk.
Under the volatile regime, there are platforms that introduce risk-related products using a TradFi concept known as risk tranching. The concept is used in structured finance to derive different risk-return characteristics from a primary fund. These tranches are designed to offer segmentized risk returns which fits in investors with varying risk appetites.
These risk tranching platforms offer users a one-stop service with varied risk options of yield farming and leveraged trading from one underlying asset, in which investors can either pursue a low risk or high risk strategy or a combination thereof within the same platform for simplicity, stability, cost efficiency.
With more corporates and financial institutions adopting crypto this year including Visa buying NFTs and Mastercard offering crypto services, we see the gradual mainstream acceptance of crypto. We see more sophisticated crypto products being catering to financial institutions and retail investors, including the recent Bitcoin futures ETF, or JPMorgan offering crypto funds to high net-worth clients. And regulators like Singapore are approving crypto payment service licenses.
Yet, risk segmentation in crypto is a bottleneck that needs to be quickly addressed and resolved. The education of DeFi may take time, but DeFi’s automation and many other functions, including the ability to align risk products with investors’ needs will be an important development for both TradFi and DeFi.