Reflecting the political tensions that run through society, traditional finance is divided into two protesting currents: on the left, sustainable finance, on the right, libertarian finance.
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Sustainable finance, particularly supported by large institutional investors, fights against climate change and promotes the common good, two objectives considered compatible with the long-term return of the investor.
Libertarian finance, pushed by the “crypto bros”, offers a decentralized version of finance where the State and the big institutions do not stick their big noses and where risk and quick enrichment are valued, under the guise of the noble goal of democratization.
Jostled by these two radical currents, in the center, traditional finance appears conservative and risks becoming obsolete if it does not adapt.
Of course, these labels are reductive and the reality is much more nuanced. However, they provide a better understanding of the trends that are transforming finance, bringing with them values, challenges, risks and renewal.
Libertarian finance, known as “DeFi” (for decentralized finance), connects individuals by bypassing banks and insurers, the regulated institutions of traditional finance.
DeFi is technically very complex. It looks like a Lego game whose components can be assembled in multiple ways. However, there are four layers.
At its core, to execute payments and record transactions, decentralized ledgers called blockchains, assembled by “miners”, compete to solve energy-intensive calculations. Fortunately, some chains are evolving towards a method that consumes less electricity.
The winners are paid in Bitcoins or other tokens, cryptoassets that constitute the currencies and values of decentralized finance, of which there are 13,000 species.
On some chains, such as Ethereum, “smart contracts” are codified, i.e. protocols that automatically execute operations when certain conditions are met. These contracts generate tokens and allow deposits, loans, derivatives as well as the management of cryptoasset portfolios.
The last layer includes applications or interfaces that facilitate access to users in this fully digital universe. It is accessed through various automated trading platforms. All of this technology is meant to be accessible and transparent – if you know how to read codes.
Cut out middlemen
DeFi embraces an ideal where financial services are faster, more personalized, and accessible to people overlooked by the traditional system. Cheaper, above all, by dispensing with costly and inefficient intermediaries such as regulated institutions, argue Campbell Harvey and his co-authors, in the book DeFi and the Future of Finance.
“Although DeFi may rely on libertarian ideals, such as its own rules, created and enforced by the community in the general interest of the parties, in reality emerging blockchain systems run the risk of being infiltrated. by a small group that can bend the rules in its favor,” warns Eswar Prasad, a professor at Cornell University and author of the book The Future of Money.
This danger is also in the long list of risks posed by DeFi according to competent bodies such as the International Monetary Fund, the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board.
This list includes among others money laundering, terrorist financing and market manipulation by crooks, problems that also affect traditional finance, but where criminals are often caught by the authorities.
According to IOSCO, last year the total value of money stolen by hacking smart contracts, software and cryptocurrency wallets exceeded US$10 billion, including US$2 billion for DeFi alone, an increase 1300% in one year!
DeFi remains connected to TradFi, the nickname it gives to traditional finance. For many transactions, it uses “stablecoins”, whose fixed value, most often in US dollars, is backed by a reserve of traditional money market instruments.
However, this sometimes obscure reserve could cause liquidity crises likely to spread, threatening the stability of the entire financial system.
The main problem with DeFi is its main characteristic: the absence of regulated financial institutions to ensure its solidity, the integrity of the markets and the protection of individual investors. Not certain that the self-regulatory mechanisms put in place will prevent crises.
But how to regulate virtual networks without a postal address? Despite ill-adapted legal frameworks, regulators have stateless trading platforms in their sights. Some regularize their status, others slip away, having things to hide.
What’s the point ?
DeFi wants to be democratic, but at this stage of its evolution, it remains turned on itself, reserved for insiders. In practice, its innovations essentially serve to speculate on pure abstractions, of which we do not see the economic or social utility. It does not channel savings into mortgages to buy a house or into investments to build a factory. It is still far too risky to ensure a retirement.
In contrast, sustainable finance aims not only to provide these services of traditional finance, but also to provide the immense capital required for the transition to a decarbonized economy.
It also cares about the well-being of the workers and the communities where the companies in which it invests operate. But it also has challenges to overcome, such as greenwashing.
These two currents are still young and in the minority, but will gain in maturity by integrating and transforming traditional finance, which retains a tremendous capacity for adaptation in the face of social movements and technological change.
Caisse de depot, a globally recognized leader in sustainable finance initiatives, has dipped a big toe into DeFi by taking a stake in Celsius Network, a crypto trading platform. The technological innovations that are germinating in DeFi are too important to ignore and several institutional investors are taking an interest in them, cautiously.