DeFi is Much More Than Autonomous Protocols, Part 1: Driving Efficiency in Lending Markets!

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By Guest Author Sefton Kincaid (Cicada Partners)

“The institutions are coming” is a crypto meme that never fails to go away. And while institutions are adopting over a longer time horizon than the popular narrative would like, they are coming — slowly, methodically. A key barrier to institutional adoption is the institutions themselves, their processes and business models that make them good at their existing business do not prepare them well for DeFi protocols.1

Separately, the ardent idealism of promoting only fully autonomous protocols is unrealistic in the complex world of bridging off-chain recourse with on-chain operations. DeFi builders and protocols will have to embrace asset managers, structurers, and servicers of off-chain processes as customers, to drive the next era of on-chain use cases. To date, protocol builders have thoughtfully focused efforts on autonomous use cases like P2P borrowing/lending and exchange, but businesses need economic incentives to drive future infrastructure adoption and the pool of crypto-native high net worth individuals is quite small. Further, few consumers have the time to learn and analyze risk as we painfully witnessed by the dramatic collapses of Terra, the crypto-banks, and countless ponzi-nomic scams.

It’s no wonder crypto critics view much of DeFi as a problem in search of a solution. Apart from automated market makers (AMMs) providing real-time liquidity for tail assets and lending protocols matching borrowers with lenders, there have been few real-world use cases that have grown out of DeFi Capital Markets. Still, having extensively used the underlying technology, proving out a 100% on-chain business model, and taking time to reflect, we at Cicada are more convinced than ever in the radical improvements in efficiency, transparency, and access that on-chain tools can provide both consumers and users of lending products.

In part one of this series, we dig into the efficiency gains passed on to end lenders that are driving us to build a 100% on-chain Risk-as-a-Service business promoting the use of smart contracts and self-custodial solutions. In later parts, we will cover the nuanced improvements of greater transparency in lending and the benefits of greater accessibility.

Efficiency Drives Cost Savings to End Investors

In stark contrast to the 100% trust-based financial markets, DeFi replaces most trust assumptions with smart contracts. Code and smart contracts can assume the role of custodian, escrow agent, clearinghouse, fund administrator, auditor, and fund compliance. If two parties want to exchange assets, decentralized exchanges leverage smart contracts and remove the need for a central clearinghouse. This significantly decreases counterparty risk and makes financial transactions more efficient. No more T+30 to settle an institutional loan trade. Lower trust requirements should have the eventual benefit of reducing regulatory pressures and the need for third-party services like fund administration and audits. Unfortunately, given the actions of various bad actors and limited risk management across crypto lending, trust requirements are certain to increase in the near term (see our recent post for more insights into the needed changes). Still, radical efficiency gains are possible for nearly every area of the middle- and back-office within buy- and sell-side firms.

As depicted in the chart below on the asset management value chain, it’s easier to bucket financial firm cost structures into front-, middle-, and back-office functions. Capital markets on public blockchains remove most back- and a large part of middle-office functions. We estimate these efficiency gains have saved well over 50% of the costs to manage a traditional loan book. In fact, recent cost-to-income ratios for large-scale asset managers are now north of 60%2. With fee pressure exerting multi-decade top-line pressure, asset manager consolidation has been a big focus over the past decade.

But let’s be honest, a 50–70% cost reduction underlying an extremely sticky recurring-fee business is no catalyst for immediate change, particularly when many back- and middle-office functions are shared, and fixed costs spread across a larger legacy business. This is where better tooling for the front-office, as well as added transparency for lenders, drives down the long-term cost of capital, brings more borrowers on-chain, and the flywheel to scale real world non-crypto native lending begins to turn. Operating cost reductions are evolutionary, front-office tools to reduce risk and drive down the cost of capital are revolutionary.

In fact, we’ve seen this evolution play out in crypto-native markets already. The below chart benchmarks investor fees on a platform like Maple Finance vs. other traditional financial products. While the asset classes are unique, you can see the massive disconnect between credit funds, particularly on the private side, and private lending on chain. Unfortunately, investors won’t benefit from these savings until DeFi participants can build a flywheel to attract borrowers and asset managers alike.

Building a Risk-as-a-Service Business

Our long-term vision at Cicada is to build a leading credit risk service that operates at a fraction of the cost/income ratios of traditional asset managers by leveraging scalable self-custodial infrastructure. Over time, as DeFi rates harmonize with traditional interest rate markets, and stablecoin usage grows, our ability to launch new products at lower costs to lenders should support non-crypto native adoption of crypto lending tools and payment rails.

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