How Will DeFi Integrate With The Real-World Economy?

Rajeev Bamra, SVP – Head of DeFI & Digital Assets, Moody’s Investors Service will be speaking at the upcoming Benzinga Future Of Digital Assets. Mark Nov. 14 on your calendar for the must-attend gathering in the industry!

Decentralized finance, or DeFi, is a bold experiment, built on technologies that have potential to rewire finance, such as blockchain and smart contracts. However, DeFi in its current state relies heavily on unsustainable business models and unbacked cryptocurrencies. The overall total value locked in DeFi has fallen from its peak of around $175 billion in late 2021 to roughly $41 billion in the third quarter of 2023. To broaden its appeal and usability, DeFi will likely need, in Moody’s view, to find more reliable ways to integrate with the real-world economy and traditional finance, and to address investor concerns over data privacy and security, as well as regulatory ambiguity.

One way in which DeFi could better integrate with traditional finance is through stable digital currencies. These do exist – stablecoins, primarily backed by reserve assets such as fiat currencies, offer potential value stability – but they have nonetheless encountered bouts of volatility. Recent depeg events, where significant investors caused prominent stablecoins to fall below their intended value, raise questions about their liquidity and long-term sustainability. There are other innovative forms of stable digital cash, such as tokenized bank deposits and even central bank digital currencies (CBDCs), that could provide another path forward for DeFi. What form the preferred digital currency of the future will take is unclear, but investors’ desire for stability and security is evident.

Tokenization is another clear path to integration between DeFi and real-world assets. Tokenization is a means to convert shares in certain illiquid traditional finance investments, such as private equity funds or real estate, into tradable digital securities, or tokens, representing the assets as fractional interests on a blockchain. Tokenization would allow a wider base of investors to access asset classes previously only available to institutional investors, increasing the liquidity of those assets, and can do so in a way that boosts operational efficiencies. However, it is still early days for the technology, and issues around the ability of blockchain systems to work together, known as interoperability, could limit tokenization’s scalability. There are also risks relating to cybersecurity and compliance with regulations in regions with strict data privacy laws.

To address problems of the safety and security of individuals’ data in the digital realm, we believe that one potential solution may be decentralized digital identity (DID), an emerging system of digital identity management that enables individuals – rather than a centralized entity – to own and control their digital credentials. DID offers other potential benefits, too, including shorter sign-up times for permissioned databases or applications and enhanced data security through encryption on decentralized ledgers. However, the development of DID will take time. DID also presents hurdles, including technical complexity, cyber risks, and interoperability. To build trust in the technology, DID service providers will need to formulate consistent standards for its fundamental elements.

Finally, all DeFi technologies – including stablecoins, digital tokens, and DID – will need consistent, cross-regional regulation in order to widen DeFi’s appeal and help it to integrate with the real-world economy. Although some regions of the world, like the EU, have begun to introduce regulatory frameworks for digital assets, there is wide regional variation around both the approach to and degree of development of DeFi rules. For now, regulatory ambiguity remains a significant hurdle to investor confidence.

As the Head of DeFi & Digital Assets Strategy at Moody’s, Rajeev leverages over 15 years of experience in strategy, operations and financial analysis. He possesses deep insights into both the dynamic digital ecosystem and traditional finance infrastructure. Through visionary leadership, extensive research, and the strategic utilization of enabling and emerging technologies, he shapes innovative strategies that adeptly tackle the unique challenges and opportunities that arise from this convergence.