Introduction

The genesis block of Bitcoin bears the inscription, "Chancellor on Brink of Second Bailout for Banks." This encoded message, imparted by Satoshi Nakamoto, signaled the advent of a paradigm shift in finance: distributed ledger technology. The distributed ledger transformation is not limited to crypto speculators; it is finally reaching the echelons of central banks and commercial banks.

Cryptocurrencies bear significant risk. The collapse of entities like FTX and Terra, coupled with extreme volatility and the largely unregulated nature of the crypto realm, suggest that it might not be an ideal investment avenue for the average consumer.

Despite these risks, the innovative technology behind cryptocurrency is undeniably powerful. It empowers anyone with internet access to transact and store their own crypto-assets, opening up promising possibilities for financial inclusion. It represents the precursor of an open, global financial system without intermediaries, operating 24/7 and challenging traditional financial structures, thus paving the way for a more accessible and inclusive financial landscape.

As we will explore, blockchain technology - more broadly referred to as distributed ledger technology (DLT) - is spearheading dramatic changes and advancements in finance. DLT enables for an efficient, secure, and interoperable financial ecosystem, enabling faster and more inexpensive experiences for consumers and businesses. Its potential to transform payments and capital markets is enormous, extending even to implications for geopolitical dynamics.

Decentralized Finance (DeFi) is finance operating on DLT. More accurately, I would define DeFi as DLT-based finance that replaces centralized databases and / or disintermediates centralized entities. In crypto-native DeFi, this definition may include self-custody, uncensorability, and community-based governance. In the regulated world of central banks and commercial banks, DLT is also playing a role in Central Bank Digital Currencies (CBDCs), tokenized assets, tokenized bank deposits, and institutional DeFi.

This book aims to unravel the complex world of DeFi and explore its transformative impact on finance, preparing finance and investment professionals for the future ahead.

I.1 Who Am I?

Allow me to introduce myself and how I came about writing this book.

My career began at Goldman Sachs in London, where I worked as an exchange-traded fund (ETF) trader on the Program Trading desk. My role involved using algorithms to hedge the firm's exposure to Eurozone ETFs in futures and equities markets, as well as executing orders for clients. Coincidentally, I bore witness to the unfolding of the global financial crisis in 2008 right from the trading floor. This first-hand experience with the global financial system's flaws sparked in me a conviction that substantial improvements can be made in the realm of finance.

My journey into the world of digital assets commenced in 2014, when I began researching Bitcoin and bought it for the first time. This exploration fortunately led me to invest in the Ethereum crowdsale, and also into investing my Ether into other Layer 1 platforms such as Cosmos and Tezos. Additionally, I organized a conference called De/Centralize in Singapore in 2018, bringing many world-class innovators in the industry to my home country.

Subsequently, I served as Head of Growth and Strategy at Zilliqa, a Singapore-based Layer 1 blockchain platform. During my time there, I led ecosystem and business development, supporting developers and startups looking to build on Zilliqa. I also spearheaded FinTech and DeFi strategy, fostering collaborations with FinTechs such as Xfers, which launched Singapore's first stablecoin, and HG Exchange, a regulated security token exchange.

I currently run my own boutique DeFi / FinTech advisory company Blocks.sg. I'm also an active trader and angel investor in the crypto and DeFi space. Since 2014, I've executed various strategies such as arbitrage, yield farming, and relative value in the DeFi space. On the long-only side, I've participated in numerous crowdsales, angel investments, and other kinds of advisory engagements. I'm also a pro bono mentor with R3, a leading financial DLT. Please reach out if you're building something interesting in the DeFi / FinTech space via my website: kennethbok.com

I.2 How This Book Is Organized

This book is organized into two main parts: Crypto-native DeFi and DLT in Traditional Finance.

Part I, Crypto-native DeFi, explores DeFi in its native setting: public blockchains on the internet. It operates in an unregulated environment, characterized by high risk, yet fosters remarkable innovation, global accessibility, and operates at a rapid pace.

Chapter 1, What Is DeFi?, provides an introduction to what DeFi is, offering a broad, top-down perspective and its unique characteristics, together with an examination of its size, key participants, and an exercise for you to try it yourself.

Chapter 2, Infrastructure and Instruments, examines the infrastructure of DeFi, with a focus on Ethereum. Basics of blockchains, cryptography, the difference between Bitcoin and Ethereum, L1s and L2s, how transactions work in DeFi, smart contracts, and types of crypto-assets.

Chapter 3, Activities and Applications, explores actual DeFi applications that run on L1s and L2s. Understanding how payments, trading, investing, lending, and borrowing work in DeFi. Delving into aggregation, governance/DAOs, real-world assets, and examining relevant case studies.

Chapter 4, Risks and Mitigation, discusses cybersecurity, software, operational and financial risks associated with DeFi and how they can be mitigated. It includes case studies. It considers the risks endemic to DeFi and the risks that DeFi poses to the broader financial system, from a global regulatory perspective.

Chapter 5, Regulation, considers the vital role that regulation plays in shaping DeFi's evolution. Considering DeFi's global nature, our focus lies on key standard-setting bodies like the BIS, FSB, IOSCO, and significant jurisdictions such as the US and EU. Additionally, we delve into DeFi-specific regulations related to stablecoins and decentralized exchanges.

Part II, DLT in Traditional Finance, delves into how DLT is being implemented by commercial banks, central banks, and other financial institutions in the highly regulated and supervised financial world, which transacts in volumes significantly larger than that of crypto-native DeFi. While innovation may move at a slower pace, this environment offers much greater integrity, stability, and consumer and business protection.

Chapter 6, Central Bank Digital Currencies (CBDCs), views how CBDCs represent a highly significant development that holds the potential to transform the base layer of digital money, consequently reshaping the landscape of finance as we currently know it. The chapter includes historical context, central bank motivations for CBDCs, comparisons between retail and wholesale CBDCs, analysis of their benefits and risks, central bank preferences for permissioned DLT, and highlights developments in Nigeria, the United States, and China regarding CBDC adoption.

Chapter 7, Asset Tokenization, notes how nearly any kind of financial asset can be tokenized on a DLT. We explore the what, why, and how of asset tokenization, understanding its significance and implications. We also look at the impact of DLT on capital markets, across five different segments: primary markets, secondary trading, clearing and settlement, custody, and asset servicing.

Chapter 8 considers Deposit Tokens, which refer to commercial bank deposits represented on a DLT. In this discussion, we distinguish between CBDCs, stablecoins, e-money, and deposit tokens, understanding their unique characteristics and roles. Additionally, we explore the advantages of deposit tokens and explore case studies on deposit token projects, including the Regulated Liability Network (RLN) and initiatives from Onyx by JP Morgan.

Chapter 9, Institutional DeFi, investigates the ongoing efforts of central banks and commercial banks in piloting DeFi innovations within a regulated environment. We delve into how they are integrating automated market makers (AMMs), smart contracts, CBDCs, tokenized deposits, and tokenized assets. Our exploration includes considerations for institutions seeking to participate in DeFi, along with examples of pilots. Additionally, we explore FX as a key asset class for AMMs and examine the BIS's concept of a Unified Ledger.

Chapter 10, Conclusion, provides an overview of the current DeFi situation and looks ahead to what the future of DeFi might be.

I.3 Scope of This Book

A brief note on the scope of this book, taking into account the wide-ranging topics of finance, technology, law, and regulation we are going to cover.

I.3.1 In Scope

1. All types of DLT: This includes both public blockchains and permissioned DLT.
2. All types of finance: This encompasses traditional finance and crypto finance, both regulated and unregulated.
3. Infrastructure, applications and technology: While it is impossible to encompass every aspect within this domain, I...