The CeFi-DeFi Battle Has Already Begun

Right now, much of the attention in the world of financial services is focused on the explosive growth of the DeFi (decentralized finance) ecosystem on Ethereum. When I last checked DeFiPulse.com, I counted 30 lending services, 32 trading, 20 derivative tools, 22 wallets and another 22 asset management entities, not to mention more than 20 types of algorithmic and asset-backed stablecoins. That number has surely gone up between the editing and publishing cycle alone.

Paul Brody is EY’s global blockchain leader and a CoinDesk columnist.

Collectively, these 200-plus services amount to a re-creation of major portions of the existing banking activities. Basic functions like collecting deposits and making loans are already represented as well as many major types of trading activity. Right now, this is a business for risk-tolerant early adopters, offering big returns and commensurate levels of risk. It won’t always be like that. Ambitious DeFi companies are targeting big chunks of the traditional centralized finance (CeFi) business and their more risk-averse clients.

DeFi companies and protocols have some big advantages, starting with ruthless efficiency. Startups like Uniswap, SushiSwap, Poly, Celsius and more are building high-volume operations with a fraction of the staffing levels and cost structures that are necessary in the existing banking industry. The permissionless, interoperable and open nature of the Ethereum ecosystem means that building a better lending algorithm doesn’t require that you build an entire banking infrastructure first. DeFi companies can also iterate their solutions much faster than API-based systems, which are typically permissioned and far less standardized than most ERC-20 and -721 tokens.

Despite these advantages, the existing financial services ecosystem is not going to give up their customer base without a fight and has some significant advantages of its own, starting with regulatory compliance skills. The U.S. Securities and Exchange Commission (SEC) has made it clear that “decentralization theater” won’t protect investor-owned companies from scrutiny and that governance tokens, which are all too often marketed and sold as investible assets, do not pass any Howey Test exempting them from regulation. Traditional finance companies know this game well and have mature processes for everything from securities registration to Know-Your-Customer compliance.

Read more: Gary Gensler Isn’t Buying Your Decentralization Theater

Beyond regulatory compliance, the existing financial services industry has some big advantages it will need to deploy against blockchain-native upstarts. The first is the ability to act as a one-stop shop. Credit cards, mortgages, business loans and, yes, even checks are not going away anytime soon. The ability to seamlessly integrate multiple dimensions of the financial ecosystem will be a powerful advantage. Having one view of your financial assets – on-chain and off-chain – is powerful. Most consumers and business users won’t want to know or care on which back-end system the transaction is occurring.

Legacy players assume they have time when early market penetration is so low. They don’t.

Traditional financial services companies will also bring a much wider view of the customer to this fight. Most on-chain lending systems, for example, rely upon collateral to make loans, and today that collateral is entirely on-chain. Banks, with credit histories and mortgages, will have a much wider range of assets and data to consider and will be able to offer a great deal more credit at much lower rates.

As with all intense competitive battles, this one will result in both parties coming to look a lot like their competition. Blockchain startups are acquiring banking licenses as fast as they can and expect oracles to bring off-chain assets and credit ratings into the mix. They are also hiring regulatory compliance teams, bringing in auditors and security experts and starting to mature internal processes to manage risk.

For some, this will feel like the end of an era. And it is. The speed with which new products come to market will slow down, as they encounter layers of regulatory and security checks. But the size of the prize is going up. Blockchains and crypto assets are currently a $2 trillion market. Global stock markets alone contain more than $71 trillion in assets. It’s not unreasonable to imagine a future in which much of those assets migrate on-chain and get put to work in DeFi ecosystems.

Read more: Money Reimagined: Can DeFi Stay Decentralized?

Right now it’s too early to forecast the winners, but the last two decades of technology-driven transformation should stand as a warning to the legacy financial institutions. In my personal experience working with some companies that are struggling to change, I think there are two important mistakes that some legacy players have made as the internet transformed their markets. The first was the assumption that, in taking on the regulatory and operational complexities of the real world, new players will find themselves equally burdened. I believe they won’t. Legacy players, whether they are banks or retailers, usually have decades of process complexity layered together. Adding new technology is much easier than stripping away layers of complexity.

The second big mistake some legacy players make is the assumption they have time because early market penetration is so low. They don’t. Market leaders, once established, are remarkably hard to dislodge. Customers who have dipped their toes into the market with new suppliers are unlikely to return. In this battle, new market entrants probably have the edge, but it is by no means a guarantee of victory.