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- Fintech 🧠 Food - 28th Aug 2022 - DeFi as new global capital markets, FTX vs FDIC and how NFT lending works
Fintech 🧠 Food - 28th Aug 2022 - DeFi as new global capital markets, FTX vs FDIC and how NFT lending works
Hey everyone 👋, thanks for coming back to Brainfood, where I take the week's biggest events and try to get under the skin of what's happening in Fintech. If you're reading this and haven't signed up, join the 20,090 others by clicking below, and to the regular readers, thank you. 🙏
Hey Fintech Nerds 👋
OMG, we passed 20k subscribers 🤯. I genuinely never expected it to take off as it has. It started accidentally during the original COVID lockdowns in the UK as a way to think out loud. But it became so much more than that because of you.
In the two years since I've met many of you and learned much about the industry through it. So grateful for all of you 🙏.
I loved being at Fintech Devcon this week. It fills me with so much hope and optimism around this industry's brilliant and lovely people. Nothing gives me energy like being around builders, optimists, and industry folks. If you want to meet the smartest operators in Fintech, they're at Devcon.
The team at Moov put on an incredible show. Highly recommend attending next year if you get the chance 👏
Based on feedback, I've tried to go a bit shorter this week and let some of the sections shine, so you might just get through all of this one, Dan 😅
Weekly Rant 📣
A short rant on DeFi as new capital markets.
DeFi is building a new global capital market infrastructure that's lower cost, more transparent, and potentially much more efficient than the existing one. But I worry regulators might kill it before it can live up to that potential, with well-intentioned but short-sighted enforcement of current rules.
Capital markets run the world.
A capital market is how businesses and entrepreneurs find the finance for growth, create jobs, and manage risk (like trading internationally). For example, if an airline wants to lease 100 aircraft and secure its fuel at a consistent price, that involves complex financial transactions.
Perhaps a bank helps the airline issue a bond (debt) that other 3rd party investors will buy. In addition, the bank acts as a broker assisting the airline in securing their fuel for a consistent price today (oil futures). Companies with access to capital markets can find the finance they need to grow or manage shocks like global pandemics and bounce back.
Countries with large, diverse, and trusted capital markets grow faster than those that don't have strong capital markets. In 2020 (the pandemic), the US securities industry raised $2.7 trillion for businesses through debt and equity. Fixed income (like mortgage-backed securities) totaled $12.2 trillion. The US represents nearly 40% of all business equity value globally.
Developed capital markets like the US continue to provide finance for the economy and grow because investors trust those markets. They trust the markets because there is a rule of law and regulatory framework, the availability of investors (like pension funds), and an efficient "market structure."
The term "market structure" is jargon used by capital markets folks to explain all of the participants, technology, people, and process that makes up the capital markets. "Financial market infrastructure" (or FMI) refers to actors like exchanges (NYSE, NASDAQ), clearing houses (DTCC), custodians (BNY, State Street), and a spiders-web of other providers.
We need capital markets.
We need efficient, fair, and transparent capital markets.
But capital markets are becoming slow and expensive.
Like everything in financial services, most transaction types and contracts existed on paper before they became digital. Most of the infrastructure has evolved over decades to evolve those paper contracts and make marginal efficiency gains gradually. Each additional tech provider and market structure development adds value and makes sense in isolation.
But when you stand back and look at capital markets today, they're a maze, like an overcrowded city with tall skyscrapers and no city planners or architects.
To be fair to capital markets, you see some of the most incredible technology in the world when it comes to trade execution. High-frequency trading, cutting-edge computer science, math, and advanced machine learning are all used to help investors find an edge and deliver returns for their shareholders.
But most of the cost comes from the complex nature of the contracts (making them hard to get agreed), and everything that happens after a trade is agreed upon (post-trade). The trade itself is lightning; it's the before and after that's hard.
Capital markets are also opaque.
Some of the complexity comes from the nature of the transactions and contracts. Leasing 100 aircraft is a non-trivial transaction compared to a car loan. Some of it comes from the fact that every single institution processes that loan in their own systems, in their own way, and then reports that to the regulator using a standard that is often PDF based.
We have no single way to manage a contract and no view of where they all are in the process. What happens after a contract is agreed upon is a black hole to most participants.
There have been efforts to standardize and make digital all of the contracts in capital markets (see ISDA's common domain model as one excellent example). Studies by banks looking to move towards smart contracts in derivatives identified between 50 to 80% cost savings available. That cost impacts the market's ability to lend and help the economy grow.
While regulatory reporting is required, it's often hard to get a single source of truth. The infrastructure wasn't designed from first principles as a protocol or network that sits between organizations. Most of it was designed to solve one specific problem decades ago and then added to gradually.
DeFi is lower cost and creates space for innovation
Regular readers will be bored of me citing work by the IMF that showed DeFi lending has almost zero marginal, labor, or operational cost. But if that cost reduction remains true at scale (even if it becomes more costly to comply with regulation), that could be massive for our economy.
DeFi achieves these cost reductions by reducing transactions to basic primitives and letting developers build more complexity as code in smart contracts.
Let's unpack that sentence. DeFi might have one service that lets you trade (Uniswap) and another that enables you to borrow (Aave), and a third that allows you to create IP (NFTs). Developers can put these together to create a lending service for NFTs that connects buyers and sellers.
The modular, permissionless nature of DeFi reduces the cost of running capital markets and creates space for innovation.
DeFi is transparent
While capital markets have public data that must be reported, the granularity of that data is often limited. It's also old. There are market data feeds that are real-time, but they represent a fraction of market activity.
For a thought experiment, can you tell me precisely how many US dollars have been transacted in the last 7 days on capital markets? There are no doubt estimates, approximations, and reports, but the reality is its guesswork + data.
I can confidently tell you that US dollar stablecoins had a transfer value of $186.67B in the last 7 days. Or that $1.24bn has been traded on decentralized exchanges in the previous 24 hours, 67.7% of which happened on Uniswap.
But DeFi is also super risky.
DeFi is early, experimental, and subject to hacks. It has no clear regulatory framework, no clear jurisdiction, and perhaps can only succeed if we rethink how we make regulations. Investors trust capital markets because there is a clear regulatory framework and rules about what happens if something goes wrong. DeFi is still the wild west, but enough smart people are working to fix that; I sense it won't take long.
DeFi's real home will be with institutions.
While many have discussed the financial inclusion potential for getting retail investors to access to more complex financial assets (and, therefore, higher returns), I don't think that's where DeFi will impact us.
Complex transactions require focus. Yes, they can be broken up into financial primitives and built back into smart contracts, but consider the number of people who have used Metamask vs. the number of people who are managing complex DeFi strategies. We'll automate much of that and package it better, but creating those complex financial products will likely always be a specialism.
I hope we don't recreate the existing maze to make DeFi "safe."
The best and worst thing about DeFi is its wild and unruly nature. This parallel capital market is lower cost, transparent and modular.
But all of the money and rules are in the existing capital market, and that thing is a maze.
DeFi is global, but all of the rules that allow investors to trust capital markets are made by regulators who get their power from a single country.
We can't copy + paste how it works today onto DeFi.
What comes next?
Capital markets are the hardest financial services to disrupt because they require so much specialist knowledge. But in the last 3 years, so many operators and leaders from capital markets have sat up and started to pay attention to DeFi.
The "institutions" in DeFi today are hot money, hedge funds looking to make a quick trade, but if the professionals move in, we might see "real money" like pension funds and sovereign wealth funds start to allocate meaningful capital to DeFi.
DeFi can go mainstream if we're pragmatic but also lean into what the tech is capable of.
ST.
4 Fintech Companies 💸
1. Deposits - Plug and play Fintech experiences for banks and CUs
Deposits aim to solve the complexity of launching digital products, especially for smaller banks and credit unions who are often willing but unable. Deposits provide program management for cards and will help integrate all underlying partners (like KYC, KYB, and core processing).
🤔 It's hard not to see this as another BaaS play, but the investors say the low-code focus and early traction is why they got excited. Selling to credit unions is an art form and a path many have trodden. My question is if long term, this is a venture-scale business when the market is already crowded. Deposits the name is also confusing, deposits don't do deposits as a product 🤷♂️.
2. Mural - DAO Treasury management "for brands."
Over the past year, plenty of projects rushed to create NFT collections and build community, but now as they transition to community-led lack the financial tools to implement decisions. Mural aims to solve this by offering a simple interface to manage payouts, provide audit trails and accept new project funds.
🤔 There was a wave of "DAO tooling" start-ups in ~ Q4 of last year, just as the Crypto boom hit its peak. It's a client segment making far less revenue than a year ago, so I wonder if DAO native tooling is a feature of Fintech companies or its own category. A fantastic Dune dashboard shows that Nike made more than $185m in NFT revenue in the year's first half (almost 50 / 50 between primary and secondary sales). Big brands need to manage this stuff, and perhaps there's something in being a little more "Web 2.5" for those clients.
3. Rocketplace - "Fidelity for Crypto"
Rocketplace allows users to buy, sell, trade and hold Crypto and charges no fees to the user. Over time it wants to make fund management and distribution its focus as an explosion of new products hits Crypto (e.g., an Index of the top 10 Crypto assets or NFTs).
🤔 There is a big need for "Crypto for normies" since the heavy trading focus isn't for everyone. But today, Rocketplace looks more like Robinhood for Crypto with its zero-fee offering. From their website and background, this solid team really gets what they're doing. It could be too late and the wrong time to enter this market, or it could be that Rocketplace is one to watch. Many VCs have arguably competitive plays already.
4. Highbeam - Business banking for e-commerce businesses
Highbeam has built a dashboard for revenue and spend, insights into data like returns and the impact on profit, and offers merchants instant payouts. Highbeam provides revenue-based credit (where the credit line increases with revenue).
🤔 Highbeam is a financing company that can offer a full bank-like experience through its dashboard. Under the hood, Currencycloud and Blue Ridge provide payments and cards which makes me wonder if this is a model we'll see repeated. Highbeam is competing against big expense cards, payments automation platforms, revenue-based finance platforms, and monsters like Square and Paypal but might just have its own niche.
Things to know 👀
The FDIC said a July tweet by FTX US CEO Brett Harrison had misleading claims that funds at and stocks purchased through FTX were FDIC insured. The FDIC ordered the company to remove any misleading language from its social media and websites. The FTX CEO and FTX US CEO have taken to Twitter to correct any comments and misleading statements.
🤔 FTX is getting the headlines, but their miss step is small compared to some Crypto Companies. There was one company literally called "FDICcrypto.com" that was included in this statement by the FDIC. But there's a bigger issue, "FDIC insured" has become an almost "intel inside" short-hand way for people to say "your money is safe with us," sometimes without even knowing what it means. And as Fintech and Crypto have boomed, the lack of nuance about how this works can be confusing.
🤔 The broader issue with "FDIC insured" will continue to run because the "FBO account" is a complicated beast without clear regulatory standing in a modern context. FBO stands for "for the benefit of," allowing a company to manage funds on behalf of one or more users. Start-ups often use the FBO account to avoid becoming money transmitters (MTLs) in their early days, and in some cases, each virtual "FBO account." will benefit from the $250k FDIC protection. But this framework wasn't designed for Neobanks getting to potentially millions of accounts.
🤔 Regulators are looking for wins in their jurisdiction. The big problem regulators have with Crypto is how global it is. FTX is headquartered in Bermuda, Binance has no formal headquarters, and many major DeFi platforms operate outside the arms of national regulators like the SEC or FDIC. I think this is why Coinbase gets so much attention, because they've set themselves up in the US, and that draws the sting of the national regulators.
🤔 It's also true some of the crap that happens in Crypto is blatant and needs a regulatory response. The problem with Crypto being global is that international bodies like IOSCO (the network of securities regulators) don't have local powers. Powers exist in a country or jurisdiction. Those international bodies can coordinate but do so best with industry. We need Crypto and DeFi to partner internationally as much if not more so than nationally. The conversation to date has been very Europe or US-centric, but the reality is we need an international equivalent. (Disclosure: That's why I helped found Global Digital Finance, which does exactly that)
Huntington Valley Bank (HVB), a Pennsylvania Chartered US-based commercial bank, is seeking a 100 million DAI debt ceiling participation facility to support the growth of existing and new businesses. HVB will get access to DAI liquidity. HVB originates mortgages and commercial loans. Maker is partnering with a trust which provides fiat liquidity and works for the benefit of Maker.
🤔 A chartered bank is funding its balance sheet in partnership with a DeFi protocol. This feels significant. As with all "firsts," there are a ton of caveats and complexities under the hood, but this is a watershed moment no matter how you cut it.
🤔 DeFi is finding its home as a more efficient capital markets platform. Real World Asset (RWA) lending has gained popularity in DeFi in the past 6 months and makes up a sizeable portion of the MakerDAO balance sheet. Much of this RWA lending has been facilitated by teams like GoldFinch, Maple, and Credix, who help provide capital to emerging markets Fintech lenders.
🤔 You could argue that the quality of loans originated via DeFi capital markets is "high risk" so far. Emerging market lending businesses are "high risk" historically because it was hard to get a feel for their long-term performance. The DeFi platforms rely on sophisticated institutions to underwrite this risk and then allow anyone to participate in providing additional capital (following the lead of the institution). High risk might mean high returns, and these emerging market lenders could be misunderstood. But in the long run, credit quality matters, and not knowing = risk.
🤔 But a chartered bank has a different risk profile. I'm curious to see if, over time, DeFi has more demand providing capital to lenders more internationally, domestically, or both.
🤔 Historically, buying loans as an asset was manual and reserved for the largest institutions because it was high cost (so it was only worth the cost if you could deploy enough capital to profit). Disrupting that cost profile potentially creates much more efficient capital markets. The fact that it runs on DeFi arguably makes it more transparent in the long term. I hope regulators don't break DeFi before it delivers on its potential.
🤔 MakerDAO has a real shot at being a "central bank for the internet" at the core of a new, digital, global capital market. DAI and Maker consistently sit in the middle of the "Real World" lending projects. Maker needs to survive being decentralized (and all of the messy governance that comes with it), regulated, and potentially a significant push by central banks to enforce the use of CDBCs. There's a long way to go between now and a new global financial market structure. But change is often slow then sudden.
🥊 Quick hit: The DTCC and R3 have moved into "parallel production" with project Ion. The "DLT-based" platform provides bi-lateral equity settlement for some of the US's largest banks and financial institutions.
🤔 This is quietly massive for several reasons. 1. The DTCC doesn't do things by accident; they've implemented this because they and the FIs are getting major cost and risk management benefits, meaning the business case is real. 2. R3 has quietly built a business that consistently wins the big projects in CBDC and the financial market structure. 3. R3 also has some super thoughtful architecture in Corda that is "forwardly compatible" with Crypto assets and digitally native tokens. If we move to a world where equities become tokens, R3 and the DTCC will be a big part of making that happen.
Good Reads 📚
How do you lend against NFTs? NFTs are illiquid (not easy to sell) and hard to price, so interest rates are higher than for DeFi lending. NFTs are "whitelisted" to be lent against; therefore, most NFT lending occurs against known blue chips like Punks, Apes, etc. There are three primary types of lenders, protocol, peer-to-peer, and pool-to-peer.
There are three types of NFT lending today 👇
In protocol-based lending, the borrowers "lock" their collateral in a CFP "collateralized debt position" and receive a stablecoin in return. JPEG'd is the primary protocol-based NFT lender and only accepts "whitelisted. To get the NFT back, borrowers must repay the principal and interest.
Peer-to-peer borrowers submit a "request." which, if accepted, moves the NFT into Escrow until the expiry of the loan. Peer-to-peer lenders may accept a wider range of capital than protocol or pool-based lenders.
Pool-to-peer borrowers deposit their NFT to a smart contract, but the price here is determined by Oracles (like Chainlink). Lenders can choose pools (like Yuga Labs only) to manage their exposure to certain NFT types.
🤔 In most consumers' lives, escrow only happens during a home buying experience, but making this possible with any digital asset and automated could have a ton of use cases we haven't discovered. Why couldn't my rare video game items be collateral to start a business? Or does my ultra rare music collection form part of the deposit on a house?
Tweets of the week 🕊
Retrofitting compliance after launching the fintech product
— Sar Haribhakti (@sarthakgh)
2:21 PM • Aug 21, 2022
Today is a defining moment to envision the potential of connecting decentralized finance and real-world finance.
Huntingdon Valley Bank and Maker pioneer the first commercial loan participation between a U.S. Regulated Financial Institution and a decentralized digital currency.
— Maker (@MakerDAO)
11:52 AM • Aug 23, 2022
That's all, folks. 👋
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