In only few years have Cryptocurrencies become a relevant asset class with a fast-evolving global ecosystem of financial services. They are already comprising a volume of around USD 100 bn and further tech development leads to swiftly integration of new solutions in parallel to service offerings of traditional banks, and beyond. On top of that are non-fungible tokens (NFTs) and smart contracts gaining business relevance. Which are the puzzle parts of the new paradigm and how do they constitute the future of our global financial world?
In recent years, the world is experiencing the digital assets growth and evolvement. Talking about cryptocurrencies, many institutions begun offering services like purchase and sale of digital assets, custody services, and now expanding their presence and deepen involvement in Decentralized Finance (DeFi) arena. Mentioning DeFi in a conversation, the majority would directly link it to the crypto world and discuss the most popular coins like Bitcoin and Etherium. This fact is not coming as a surprise, as looking at the global market we can see the business giants like PayPal enabling purchases and sales of cryptocurrencies, Tesla gaining momentum and adding cryptocurrencies to their financial reports, and VISA allowing providing payments by USD coin (USDC).
The rising polpularity of digital currency
Central banks are working on central bank digital currencies (CBDCs), i.e. digital liability of a central bank that is widely available to the general public, or in simple terms digital money instead of physical paper bills and coins. And the European Investment Bank (EIB) issued their first Blockchain-based bonds in April 2021 together with three major banks.
The shift is also taking place in corporate finance; soon it would be no longer necessary to book issuing a bond or set any kind of provisions with the central custodian, but with a decentralized (crypto) one if it would be blockchain based.
The DeFi movement is accelerating its use-cases and supporting the innovation growth. Starting with the first published Bitcoin white paper on P2P Electronic cash with guaranteed cap on supply topic in 2008, followed by the Etherium launch in 2013, Oasis DEX in 2016, and Maker Protocol in 2017, specifically DeFi ecosystem expansion started only in 2018. The rise of DeFi has overwhelming implications for the world financial system and how investors, institutions, regulators, and anybody concerned with financial decisions will practice finance in the future.
What does DeFi stand for?
It is challenging to define one common description for the DeFi term; however, we prepared a short overview of the puzzle parts of current DeFi ecosystems to emphasize the aspects which are the most relevant for the CFO of any company.
Starting point for DeFi is the Blockchain approach, also called the Distributed Ledger Technology (DLT), saving all financial transactions which occur bundled together to blocks on a linked-up chain. By targeting it we can indicate the most important aspects for business users:
- Each block of transactions becomes evident by the deduction of a digital fingerprint of that block which then gets in parallel encrypted and stored on the same chain. Since those fingerprints are forever distinct and encrypted nobody can change the stored transactional information they represent. Any block contains the fingerprint of the preceding block to guarantee that it becomes impossible to change the order of those blocks of transactions.
- Blockchains get also called distributed ledgers (DLT) since they are originally created as open-source ledgers which anyone could download, read, and use. If the local copy operates under the same logic and with the identical preceding transaction data of former operations, it may take part in the global network in parallel to many others. We could think of this approach as a global bank with an open books policy which allows anybody to download and read the transactional data of all bank deposits, transferals, or withdrawals anytime. Talking about businesses, corporates may prefer less publicity which they could realize by creating their own Blockchain / DLT within a private network, for instance, only including partner companies (we would call them Club DLTs).
- Many crypto currencies, which got created as coins, kept in a such blockchain. Some of them are pegged to the US Dollar, called stable coins like the USD Coin or Tether, some are algorithmically limited to prevent value inflation, like the Bitcoin, although most coins get generated by the community holding stakes in the so far created value, called minting, like Ethereum.
There are many different blockchains with different approaches to exactly how and why new coins get minted. The important point for businesses is to understand the fundamental psychology that any blockchain entails it´s own incentive system regulating behavior. Additionally, blockchain is having a great potential beyond it and is actively used in many industries such as logistics, transport, e-commerce etc.
- But further not only value coins get stored and exchanged through DLTs but also non-fungible tokens (NFTs) which represent non-exchangeable assets. Such NFTs may securitize the ownership of some related digital art, e.g. the famous Bored Ape Yacht Club NFTs. But what seems a flippancy and quite playful at first is showcasing a serious blueprint to digital securitization of any property right, called the token economy.
Digital Currencies open doors to traditional banking services
The global digital community quickly created a new market for digital currencies and non-fungible tokens. Transferring DLT coins to exchange value is much easier, faster, and cheaper than any comparable service Global Banks could ever offer, questioning the future value proposition of such intermediaries. Businesses and CFO`s of MNC`s may consider DeFi alternatives to hold at least a small percentage of their treasury capacity in digital currencies to pool liquidity and being capable to fund any project within any subsidiary around the world.
Ethereum became one major blockchain containing Ether as first layer token but furthermore allowing to codify smart contracts, i.e. “if-then-else” clauses, allowing to condition the transfer of stored value and further link it to other business events. One simple use case could be a borrower who has lent money and after back-payment the collateral securing this transaction becomes automatically freed up again. Due to the mechanisms of the Ethereum blockchain the lender and the borrower do not need to trust or even know each other; all relevant rules of the transaction may get immutably fixed as a smart contract and will play out according to the realized conditions.
On this level, blockchain could already substitute one primary function of traditional banks, i.e. the credit market, by a decentralized algorithm. Aave, as an example, offers such services and currently comprises a total value locked (TVL) of almost USD 10 Bn by a daily trading volume of some hundred million Dollar. The global market has a TVL of around USD 100 bn strongly indicating the relevance of this sector. Startup companies could offer investment chances in early-stage financing to the public which usually remains reserved to VCs nowadays.
The token economy innovates beyond simple digitization of financial services
But Blockchains help not only digitizing current financial services but offer disruptive solutions which go way beyond.
One huge disruption will become enormously relevant for businesses and financial services within the subsequent decade: The integration of almost two billion potential customers which until today remain unbanked. “Bank the unbanked” is one important step on the way to fulfill the demands of the UN Development Goals under a social point of view. People who are excluded from the banking world so far may now simply register by opening a digital currency wallet on their mobile phone within minutes. It is the chance to enter a previously underserved market with great offerings.
Furthermore, a production company now could fully tokenize their machinery and fund them through the decentral capital markets. Afterwards it would be possible to digitize the production of that machinery and steer them each as distinct P&L units, with their own usage, settlement, accounting, invoicing, and even autonomously paying the interest for the loan. Implementation of current approach would beneficially impact the CFO`s agenda and allow usage of new controlling instruments to shape and overlook the value creation of the company as a whole.
The next innovation level on top of smart contracts is the decentralized autonomous organizations, in short DAO. DAOs allow the programming of whole governance structures on top of a blockchain, for example earlier mentioned Ethereum. On top of that, they are steering it as a decentral organization, allowing the stakeholder to take decisions over their funds in a predefined manner.
One DAO pioneer is the shareholder company Amazing Blocks AG which was established solely with Ether as paid-in capital stock. They gained momentum and made use of the Liechtenstein Blockchain Act, which is the first comprehensive regulation framework for innovative blockchain applications. Amazing Blocks´ offerings are a new level of doing the business. The speed founding of legal entities on shares as a service (SaaS) promising to get the new company up and fully registered within ten working days.
Impact on the CFO’s agenda
Summarizing above said, a great deal of examples of additional business applications emerges from the value storage as blockchain coins and the securitization of rights as digital token. There is more than simple digitization of financial services on the way, smart contracts, decentralized autonomous organizations and the token economy are pointing to new ways of value management which open many doors for the CFO of the future.
- PayPal Launches New Service Enabling Users to Buy, Hold and Sell Cryptocurrency, PayPal Newsroom website, October 21, 2020 (updated November 2020), https://newsroom.paypal-corp.com/2020-10-21-PayPal-Launches-New-Service- Enabling-Users-to-Buy-Hold-and-Sell-Cryptocurrency
- Visa Becomes First Major Payments Network to Settle Transactions in USD Coin (USDC), Visa USA website, March 29, 2021, https://usa.visa.com/ about-visa/newsroom/press-releases.releaseId.17821.html
- Infrastructure and Design of Central Bank Digital Currencies (report), Bison Trails website, https://bisontrails.co/cbdc/
- How will decentralized finance shake up your industry?, EY report, How will decentralized finance shake up your industry? | EY - Global
- Amazing Blocks Sales Deck