Traditional finance has much to learn from new entrant DeFi

Incumbents in traditional capital markets, as well as new entrants looking to capture market share, should heed the innovations within the crypto ecosystem collectively known as decentralized finance, or DeFi. These innovations present a model for the direction that traditional capital markets are likely to take in the coming years as regulation catches up with the capabilities of distributed ledger technology, or DLT, and as the technology itself is refined through “in-the-wild” usage.

Decentralized exchange protocols, also known as automated market makers, or AMMs, are one of these innovations that has been widely adopted in the crypto space.

Real-time settlement is a game changer

Right away, we can see that with AMMs, trades are settled in near real-time. Compare this with the two days (T+2) it takes to settle most liquid securities in today’s advanced capital markets. The near real-time settlement of AMMs brings two key benefits: reduced counterparty risk and improved balance sheet management.

Financial institutions involved in capital markets must reserve cash on their balance sheet to cover their exposure to the risk of non-delivery by their trading counterpart. The reserve requirements are defined by the parties in the trade and, until a transaction is settled, they must tie up cash on their balance sheet to compensate for the risk. With the near real-time clearing and settlement enabled by DLT infrastructure (demonstrated by DeFi protocols), the reserve requirements are a fraction of the amount required to hold in reserve with two-day clearing and settlement. If AMM-like protocols could be adopted in traditional capital markets, the vast majority of capital tied up on the balance sheet today could be put to economic use in the capital markets, turning an opportunity cost into economic gain.

Adopted at a large enough scale, real-time settlement also has the power to reduce systemic risk. Since the 2008 financial crisis, in response to regulations…

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