Decentralized finance (DeFi) emerged as a movement with the promise of revolutionizing the global financial system based on a simple yet powerful premise — offering access to better solutions with its peer-to-peer asset transfer and smart contract-powered autonomy.
Since 2015, multiple sub-sectors like lending, trading, and automatic market-making quickly emerged, amassing US$175 billion in Total Value Locked (TVL) in just a few years. Like the rest of Web3, innovation and adoption in DeFi grew very fast.
Very fast, but very limited.
Putting aside its recent even faster descent, DeFi protocols’ reach outside its native early adopters remained limited due to its frequent security hacks, lack of risk disclosure, poor user experience and limited regulatory compliance.
Today, we are witnessing regulators stepping up their enforcement on DeFi almost daily, further contracting its reach, while established traditional finance (TradFi) players leverage decentralized technology, further diminishing its unique value.
Needless to say, DeFi protocols today are standing at an existential fork in the road.
With its bumpy ride to date, does DeFi still have a chance at fulfilling its promise of building a more inclusive financial system? Studying the dynamics of change on systems, Systems Theory gives us a framework and potentially a roadmap of how to think about the two diverging roads that DeFi is facing.
Two Diverging Roads
In a nutshell, systems theory stipulates that, to change a system, we need to first understand its component variables and how they relate to each other and to those of other systems. With that, we can then modify the right variables in relation to each other or add new ones to create a series of new relationships and outcomes, and over time a new system.
However, systems are not linear but rather dynamic neural organisms. For every change in the relationship between two variables creates a domino effect with other variables.
Coming back to DeFi and the question above, systems theory provides us with a roadmap of two likely outcomes.
Road 1: TradFi Wins
Choosing to go down the first road, DeFi does not adopt the minimum rules or variables required by the macro-system TradFi, such as Know Your Customer (KYC), Anti-Money Laundering (AML), disclosures of required information, security controls and data protection. Instead, DeFi operates as a parallel and independent micro-system, but with each of its variables having a direct impact on the interest of the broader macro-system.
This impact is seen as relatively benign initially, but increasing in size overtime. TradFi regulators and the established players with considerable power over the macro-system start to see DeFi as a potential long-term threat.
They heavily impose its rules, adopt DeFi’s key features that benefit their interests, such as liquidity and smart contract settlement, and make any variables that do not fit their interest illegal and, therefore criminal to engage with.
The outcome is that TradFi incorporates elements of decentralized features but remains a TradFi system. DeFi’s reach is limited to a fringe community engaging outside the marco-system with considerable legal and financial risk. If this road sounds familiar, it’s because it’s a continuation of the same road that DeFi has been on.
Road 2: The Consumer Wins
Going down the second road, DeFi emerges as a legitimate alternative to the old-guard TradFi players by adopting the minimum required rules or variables to protect the consumer and operates within the broader macro-system, solving real problems with better solutions than the established players.
Here, DeFi incorporates elements of centralized features but remains largely a decentralized offering providing on-chain transparency, access to solutions traditionally reserved for institutions and UHNW, liquidity to illiquid asset, speed of transactions bypassing multiple intermediaries, and self-custody and ownership over one’s own financial assets.
Playing alongside TradFi players invariably leads to tension and, at times, direct conflict, with each outmaneuvering the other with the next innovation or crying foul, whether warranted or not. Within this arena of competition, some DeFi players fail while others succeed. And the same goes for TradFi. But the real winner here is the consumer.
With these two diverging roads before us, and to finally answer the question, if by its promise we mean DeFi replacing TradFi, the answer is NO.
If, on the other hand, we mean DeFi flourishing within the broader macro-system by adopting some of its variables while remaining decentralized in its core offering — and ultimately fulfilling its promise of providing broader access with better value to the consumer — then the answer is a resounding YES.
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