Software is eating the world. Marc Andreessen, writing in 2011, describes how software-native companies are swallowing up existing businesses and revolutionizing the industry. Amazon replaced consumer sales, Spotify replaced music, and LinkedIn replaced recruiting – all of which are poised to replace incumbents who have not built Internet-native businesses.
Why? Because software-native companies are faster, cheaper, and more beneficial to users. In Mark’s view, it’s only a matter of time before every industry is swallowed up by software.
But this does not apply to the financial industry. Our financial system is still built on an ancient infrastructure. jim Bianco points this out in the podcast …… Wire transfers haven’t gotten faster or cheaper since the days of the telegraph in 1871!
What about fintech? All fintech has done is give the existing analog system a user experience facelift as well.
But DeFi has really changed everything…
As a money transfer network, compare PayPal and Ethereum.
Source: Dmitriy Berenzon
Or in the case of lending, MakerDAO is already profitable after 6 years of operation, while LendingClub is still losing money after 15 years.
Source: Dmitriy Berenzon
DeFi enables software economics in financial services, making it faster, better and cheaper.
Here’s Dmitriy Berenzon’s explanation of why DeFi is cannibalizing finance. Note, Dmitriy Berenzon is a research partner at 1kx, focusing on cryptocurrency research and investments.
DeFi: Cloud-Native Financial Services
While software has been devouring the world for the past few decades, it has done a relatively mediocre job of disrupting financial services.
Due to entrenched incumbents, high switching costs and regulatory capture, innovation in the industry has largely revolved around channels (e.g. your favorite mobile banking app). This has brought a nice change to the user experience, but the underlying value chain and cost structure is still based on systems developed in the 1970s.
However, DeFi apps are rebuilding financial services from the ground up, replacing humans with machines, paperwork with code, and legal enforcement with cryptographic enforcement. As a result, they are several orders of magnitude cheaper to run than their analog counterparts.
Interestingly, this evolution of financial services is similar to the evolution of the software industry; as software evolves from a single infrastructure and application to microservices in the cloud, cost efficiencies are realized and new business models are invented.
In this article, I will outline the evolution of the software industry as well as financial services and discuss how these changes have led to fundamental improvements in the economics and profitability of the latter.
Traditional Financial Services and Pre-Internet Software
Prior to the advent of the Internet, software vendors had high fixed costs and barriers to entry. In the 1960s, when computers became too expensive to purchase, vertically integrated vendors would invest large amounts of money to develop and distribute software through their private networks.
For example, Computer Sciences Corporation (CSC) spent $100 million (worth about $900 million today) to develop “Infonet,” a network of mainframes that provided (over telephone communication lines!) computer capabilities and software, such as brokerage services and hotel reservations.
Similarly, there is a similar dynamic in traditional finance. Due to high barriers to entry and economies of scale, vertically integrated banks end up providing most of the core banking services, such as taking deposits, lending money, transferring funds, issuing debt, and forming clearing houses, while central banks manage the money supply. These services are costly, involving physical presentation, manual and paper-based processes, and complex and siloed infrastructure.
Fintech and Internet-enabled software
Since the 1990s, the Internet has enabled a new model of software delivery; software no longer exists in standalone instances on people’s computers, but exists in the cloud and is delivered remotely.
This in turn has led to the rise of Software as a Service (SaaS), an innovation in business models where software is licensed on a subscription basis. SaaS offers users a number of advantages over on-premise approaches, such as browser-based accessibility, automatic updates and a lower total cost of ownership.
Fintech and Internet software have similarities in that they both leverage emerging technologies to innovate on products and business models. chime leverages online channels to expand reach and reduce physical overhead for retail banks. robinhood, on the other hand, uses an alternative commission-based business model of “pay for order flow” to provide “free” retail transactions. Transferwise, on the other hand, circumvents the correspondent banking system and creates a two-way marketplace that provides net payment capabilities for people around the world with opposing remittance goals.
All of these companies are valuable, but Chime is still dependent on Visa (started in 1958), Robinhood is still dependent on DTCC (started in 1973), and Transferwise has not replaced ACH (started in 1972) or SWIFT (started in 1973).
DeFi and Cloud-Native Software
The “modern cloud” began with the launch of Amazon Web Services (AWS) in 2006, and many applications began to migrate in the following decade.
Nonetheless, most of them are still “cloud-enabled” rather than “cloud-native” applications, which means they likely still have monolithic and dependent modules that cannot be upgraded individually without changing the entire application.
Cloud-native applications, on the other hand, are designed from the ground up to run in a public cloud like AWS. They take advantage of resource pooling, rapid elasticity and on-demand services. They are also built on a microservices architecture and are designed as standalone modules that serve a specific purpose. Today, many applications also run on serverless architectures, allowing developers to purchase back-end services on a “pay-as-you-go” basis. These design patterns can also be used in tandem, resulting in so-called serverless microservices.
Similarly, cryptographic networks implement serverless financial microservices. This is possible because crypto networks are themselves a business model innovation; instead of vendors contractually providing infrastructure and services for dollar-based compensation; a distributed network of “nodes” (i.e., computers) provides these functions to earn protocol tokens and, in effect, become part owners of that network.
Note that this is not to be confused with the “blockchain is not bitcoin” logic, as protocol tokens are necessary to incentivize “third-party providers”.
Because of this, DeFi realizes many advantages from the software and SaaS economy that are not available to financial services. Specifically, siloed transaction processing and banking systems are replaced by a global blockchain and its associated smart contract and node infrastructure, allowing for significant cost savings. Applications can also benefit from instant interoperability and single sign-on (public/private key pairs for users) upon deployment.
Moreover, this reduces the need for multiple market infrastructure providers to build effective identical systems (e.g., about 100 ACH systems around the world), and for applications to build and maintain their own back-end infrastructure.
In addition, the proposition is even more attractive to application developers because instead of them paying for the use of the “financial cloud”, users pay “gas” to the miner/verifier on a per interaction basis. In other words, the transaction, service and infrastructure costs are all bundled into a single gas fee.
In addition, external service providers often perform the core functions of the application, such as Compound’s clearer and Uniswap’s liquidity provider. In addition, once a smart contract is deployed, the service has no additional maintenance costs, so the marginal cost for the application to acquire an additional user is ~$0.
This cost structure allows the DeFi protocol to cash flow even with high churn and low recurring revenue.
Comparison of companies and protocols
Nothing is exactly equivalent, but let’s do our best to compare using a set of examples from the three most closely related revenue statements: Deutsche Bank, Lending Club, and MakerDAO.
In 2020, Deutsche Bank has $8 billion worth of costs associated with infrastructure, real estate and operations, representing 64% of its overall operating expenses. This cost structure is to be expected for such a large organization with decades of technical debt and structural importance, but we can actually do better.
In 2020, more than 50% of Lending Club’s operating expenses are likely to be personnel, hardware software and maintenance costs. If the company had a leaner cost structure, it would likely be able to turn a profit.
While the majority of MakerDAO’s operating expenses come from headcount, this is a small portion of overall net profit, resulting in a 99% margin compared to Lending Club’s -60%. It is important to note that these are not the “full” costs of MakerDAO and will increase as additional costs of the foundation (e.g., prophecy machine operations, token-based compensation) are transferred to DAO.
Over the next decade, the DeFi protocol will be used as a “financial microservice” for traditional financial institutions and traditional fintech companies. These institutions will use DeFi as their back-end infrastructure and will effectively serve as a conduit for a variety of customer personas, demographics and geographies.
While the DeFi protocol may add additional costs to enable them to further integrate with the fiat economy, it will still be more efficient than the current market structure and business model.
I am excited to see a burgeoning array of DeFi applications that will serve as the new infrastructure for a variety of financial applications for people around the world.
Finally, thanks to Jason Choi, Christopher Heymann, Chris McCann and Peter Pan for their feedback on this article.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/in-the-shadow-of-the-software-devouring-the-world-find-the-way-to-defi-devouring-finance/
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