DeFi is not a Stock Market Replacement

One of the suggestions made by some public figures 1 2 3 on Twitter following the GME aftermath was to use DeFi as a replacement for the stock market given its ability to not close after hours and to be censorship resistant against pressures from high profile market players like the trade restrictions to retail investors on stocks like Gamestop (GME), AMC and Nokia (NOK) on Robinhood that happened shortly after the parabolic rise in GME on January 27th 2021. The reality is that DeFi is still a financial sandbox that has limited participation in the stock market or market in general.
These are some of the reasons why:

Records need to be kept of the transactions of stocks involving ownership, for the most part.

A common idea shared on social media is that securities could be “wrapped” as a token (tokenized security) to be shared freely, after hours and even potentially transacted freely on automated market makers like Uniswap.
Truth is, securities markets are highly regulated so securities offered there need to be registered so owner records are kept as well as the transactions involving ownership. Therefore, the identity of the owner needs to be registered on some ledger of transactions. At the same time, identity needs to be kept confidential so prying eyes can’t know about ownership but also be open for audits and reporting to certain parties as well as providing compliance with regulators on the markets that these securities are issued and transacted on.

So a version of a security directly tokenized on a public blockchain doesn’t fulfill any of these requirements. Let’s imagine for a moment that shares of a company get tokenized as a NFT. Most public blockchains will allow trading this simple NFT without any identity requirements involved, only a pseudonymous address required which would violate most markets rules about keeping records of ownership. In addition, these NFTs could be moved to known wallets which will diminish confidentiality of ownership. This hypothetical security NFT could also be moved freely to sanctioned parties that will cause break of compliance or break of cross-border transactions of that security in addition to not being able to be freely audited at any point in time unless the owner of the share wants it to. This is the main obstacle blocking the issuance of shares on a public blockchain directly by any reputable company as cryptocurrency native assets are high risk regulatory risk similar bearer bonds.

Unfortunately, most regulated markets don’t like this type of behavior in a security as it would resemble the once popular bearer bond. Regulators have curtailed the issuance of bearer bonds in the US since 1982 and all US bearer bonds have already matured by May 2016. They still exist though, but most high profile companies from regulated markets will shy away from such instruments because of the regulatory risk and possible criminal implications that its issuance could entail. Put simply, Apple issuing a bearer bond on a public blockchain is not compatible with the modern reality of the markets and there are no indications that it will change any time soon.

Synthetic Markets On Public Blockchains, Lack Volume and Real Participation in the Market

Another common suggestion is the use of synthetic markets that would simulate the state of the market and being able to bet on market movements. Synthetic tokens are representative of securities or assets that commonly trade on the stock market, users on DeFi could able to gain exposure to the prices of the regulated stock market. In a nutshell, liquidity is provided or lent by third parties so that others are able to bet on stock markets outcomes. It’s usually advertised as unlimited liquidity but realistically, liquidity is capped at the maximum amount of third party collateral. As with any derivative, removal of collateral or steep changes in collateral ratios can bring a lot of trouble so it has all the risks related to regular derivatives, limited liquidity risks plus DeFi risks. The consequence to this is volume gets reduced and impact in the real market is null. So large players wanting to trade on certain asset above a certain threshold won’t have an accurate simulation of the real market. Moreover, a large impact on the prices inside the synthetic asset sandbox (think about what happens to the percentage impact on a large sum on an AMM with low liquidity) in addition to not owning the real underlying asset. Synthetic assets are a brilliant idea for people inside the DeFi sandbox to experiment with the real conditions of the stock market at a small scale but lacking in real volume or real assets the stock market represents. Even the creation of “utility tokens” on public blockchains won’t represent realistically the company on the DeFi market as shares have their own behavior and liquidity.

Oracles are still a Problem for Synthetic Assets on Public Blockchains

Oracles have not being solved yet on any public blockchain and they still need to rely on centralized data feeds so synthetic assets will most likely depend on them for now. Prediction markets and sometimes governance are still not a reliable source of information for securities on blockchains due to its low liquidity in the case of prediction markets and proneness to feed and price manipulation Depending on a centralized source render trading synthetic assets similar to betting on financials on centralized betting houses being the centralized data source a single point of failure in the case of decentralized applications and the lack of participation in the market. Other federated applications can make use of several data sources to provide a robust data feeds, however.

Learning from Blockchain Solutions Already Live

However, there has been research and development to tackle these issues and others effectively. What most people don’t realize is that most of the stock market on a blockchain solutions will require some kind of regulatory compliance and there are solutions that address it.
An example is Polymath its team developed one of the earliest solutions available on Ethereum with the ERC-1400 which helps with the creation of compliant security tokens as well as other solutions like the Polymesh blockchain which will be used as securities-compliant blockchain in addition to the use of relay-chains that will be helpful for transmitting data across blockchains and even other centralized points of trade like stock exchanges.

Despite impressive fees, DeFi in its current state remains highly secluded and not compliant to the stock market which makes it difficult to use in its raw form for securities but specialized blockchains or specialized standards will be of the most use for issuance, mediation and investing in the stock market. Additionally, relay chains will be the most useful to connect secluded parts of finance like DeFi to the stock market without the need of trusted third parties.
With time, the stock market could make use of certain parts of blockchains and possibly to an even more mature, more scalable and liquid DeFi, in the meantime, DeFi cannot replace the stock market in its value, scale, content or even simulate its volume or price fees completely. It is too early to call DeFi a stock market replacement and people who push the idea of DeFi replacing stocks are simply not well educated on the intricacies of securities compliance as well as the specific compliance risks companies or sovereign states would face if they chose to issue shares, bonds or debt on a public blockchain in its raw form. Parallel development of DeFi, or a blockchain economy of blockchain assets is a good thing but for now it simply cannot absorb real shares, stocks or debt without a specialized compliant-security approach.

Published by: Saxemberg on Feb. 1, 2021