Web3: the future of finance?

Finance has evolved to become extremely centralized, a trend that has benefitted banks and other financial services institutions. Decentralization may well be a guiding principle of future versions of the internet, and finance will be impacted by this too.

Web3 is the next potential iteration of the internet. It will be based on decentralization, and ideally will be interoperable and hand users control of their data. Decentralized finance (DeFi) aims to transform traditional finance by using blockchain-powered smart contracts and by eliminating the need for intermediaries.

Decentralized finance and regulation can coexist

DeFi will not be widely adopted until it is sufficiently regulated. The permissionless nature of some DeFi projects means that they could be used for money laundering, tax evasion, and fraud. This is one of the reasons why China has banned all cryptocurrency transactions, as well as the fact that the lack of an intermediary makes it a difficult system to monitor. China is trying to limit capital flight, which cryptocurrencies can often facilitate. The irreversibility of deals and trades made on the blockchain compounds this difficulty.

DeFi can be regulated and decentralized, but these require regulators to collaborate with platform creators and for both to understand the potential challenges and pitfalls of the specific DeFi project. Dangers may have been built into the system, either accidentally or on purpose, highlighting why collaboration between providers and regulators is crucial. Creators can be anonymous entities, making this harder to facilitate. Closed-source DeFi projects may seem to be counterintuitive, as one of the advantages of decentralized platforms is transparency. However, closed-source systems can be harder to exploit as details of the system are not accessible to all.

Smart contracts play a vital role in DeFi, as they automatically facilitate transactions that run a program on a blockchain when preorganized conditions are met. Controls will need to be embedded within these contracts to provide a defense against financial crime. These could be AML/CFT (anti-money laundering/combatting the finance of terrorism) checks, which are typically not found today in DeFi applications but are commonplace in centralized markets. However, the decentralized nature of DeFi makes finding appropriate entry points for regulation difficult, posing challenges for law enforcement.

Crashing crypto undermines the Web3 vision

In keeping with its core philosophy, Web3 and the Web3-based metaverse will need a decentralized payment mechanism. Cryptocurrency is the ideal candidate for this, but it is clear that the crypto industry is facing growing pains.

Decentralized applications may find it harder to attract venture capital following recent cryptocurrency crashes. However, it is recognized that the system is in its infancy, so investors are still putting money into the underlying technology. Cryptocurrency would be the cornerstone of a decentralized financial system, with blockchain technology proving ownership of assets through distributed ledgers. Using cryptocurrency can lower the cost of transactions by removing intermediaries.

Recent market volatility raises the question as to which, if any, cryptocurrencies are stable enough to be the foundation of a new digital economy. For example, the so-called ‘Stablecoin’ TerraUSD recently collapsed. This is because it lost its peg to the dollar as the company did not hold US dollars in reserve to back it up. Bitcoin, touted as the industry’s gold standard, has fallen by 68% in value in the last year. These are examples of the structural immaturity that is impeding the development of decentralized finance.

Meta attempted to enter the cryptocurrency scene with little success, eventually shutting down its crypto payments wallet, Novi, and sweeping the failure of its payment system, Libra, under the rug. Web3 platforms have benefited from the additional features offered by cryptocurrencies, like MANA, the native cryptocurrency on Decentraland, which has been used to purchase virtual land. This is an example of a more democratic form of finance, where customers are given voting rights.

Decentralized finance is not a black-and-white topic. Totally decentralized finance could be exploited by financial criminals, but traditional finance creates barriers to access for banking. A fine balance is needed to secure DeFi’s spot in a Web3 world.