Decentralized Finance overview - icoinic
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Andy Wong - Fundamental Analyst - Icoinic B.V.
Andy Wong
Author
Analist

Decentralized Finance

The world as a whole is estimated to produce a GDP of roughly US$80 Trillion in 2017 in over 180 different countries. However, the top 10 economies account for 67% of the total GDP or a little over US$53 trillion. The WTO and UNCTAD Secretariat estimate that in 2018, the world merchandise exports totaled US$ 19.48 trillion and commercial services around US$ 5.80 trillion. Roughly speaking around 30% of the GDP is generated with exports. One would assume that with these absurdly high numbers incredible effort is put in to make the trade process as efficient as possible, eliminating fraud, low transaction times and fees, and loss of paper documents. However, this is often not the case. Transaction speeds vary vastly between countries, institutions, and banks. A WTO report concluded that of the US$ 18 trillion in trade transactions and related payments, a significant amount is subjected to fraud. With emerging technologies like DLT and the likes, these challenges could be a thing of a past.

Current situation

Domestic payments between people and businesses are getting faster and more efficient with time. Instant and real-time payments are nowadays more the norm than the exception. This advance is made possible due to the fact that domestic transactions usually work inside a closed infrastructure. Cross-border transactions, however, involves bridging different infrastructures coupled with complexities presented by difference regulatory jurisdictions, not to mention differing operating hours and operations for the entities in question handling the transaction. Bridging the gap between the different infrastructure raises the cost per transaction. The world bank estimates that an average cost of remittance of US$500 is just under 5%. The cost of transfer between G7 countries is still around 2%.

Decentralized finance

The costs are high for numerous reasons; margins, inefficiencies, manual labor, operational costs, and such. The Financial Times called trade finance one of the most archaic corners of the financial world. It’s currently heavily reliant on paper documents. DLT can revolutionize this process. Especially the decentralized finance (DeFi) branch. DeFi could be defined as a movement that wants to leverage decentralized networks to transform traditional financial products.

An example of how DLT can make a difference is by lowering paper documents consumption and with it the manual labor that is needed to process the documents. Without the usage of paper documents, and the automatizing filing procedures the chances of human error can be reduced. Another front where DLT could improve upon is the transparency between different parties during a transaction.

Not all sunshine

While using decentralized networks to power financial products has advantages, it also brings challenges. Key challenges that have to be overcome are possible conflicting laws in different jurisdictions, rights and obligations of the participants, and the clarity and enforceability of the legal basis for any payment and its settlement finality.

Conflicting laws in different jurisdictions

The main challenge to overcome is that because the nature of a decentralized network is, as the name conveys, decentralized, there isn’t a central authority figure like with traditional infrastructures. Traditional institutions, like banks and payment service providers, currently have to enforce certain laws, BSA, KYC, AML, and much more. They are also accountable for illegal transactions. With decentralized networks, there isn’t such control which could make it accessible for criminals to use it for illegal purposes.

Another point is the difference in regulatory and supervisory oversight in different jurisdictions. The laws differ from country to country. FATF, FinCEN, and Finra, to name a few, have different requirements for oversight than the FSA in Seychelles, for example. Companies based in the Seychelles can be compliant in the Seychelles but not in the US due to different rules. This is even more difficult for DLT’s since they aren’t located in any geographical jurisdiction.

Rights and Obligations

Before DeFi can be adopted, rights and obligations for the participants should be clear. Questions like what the rights and obligations are aren’t at all clear at the moment. Most DLTs are still lacking basic dispute mechanisms. When a transaction goes wrong, there is no central point where users can go to resolve their problems. General liability is also lacking with most, if not all, DLTs. If something goes wrong on the network and economics losses are incurred, no central party is liable or accountable. Another point of concern is the uncertainty around transfer of ownership. If there is no legal basis for transactions, can someone claim that transfers are legally enforceable?

Enforceability

The core element of a payment, settlement, and clearing system is that it has a well-founded, transparent, and enforceable legal basis. DLT’s often lack such an element. Risks are increased when there is ambiguity or lack of certainty about a legal basis. DLT’s are mostly developed by developers and coders without assistance from a plethora of lawyers in the sector of finance law. Then again, this risk can be reduced if the system is built with a bottom-up approach by automating certain terms and conditions of legally binding agreements, the same way it would work with contractual agreements.

DeFi in the future

Overall, DeFi is looking promising. We at Icoinic definitely like the way it is going and will keep a close eye on its progress. The promise of faster transaction speeds, lower costs and higher transparency is beneficial for all the parties involved. However, before DLT can change the current financial paradigm, it will need to overcome crucial challenges in regulation and possible conflicting laws. It needs to be clear and concise what the rights and obligations are of the participants, what they can expect when a transaction goes wrong or who is liable in such a scenario. Most importantly, it needs to be legally enforceable. Transactions or transfers made via any of the DLTs need to be legally binding or it needs to be clear what is and what is not.

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