Decentralized finance (DeFi) exploded into the public consciousness in 2020, as an ambitious offshoot of the cryptocurrency space that promised to revolutionize the world of financial services. That hasn’t quite happened, though a great many users have accessed DeFi to trade, borrow, lend, and invest, activities formerly reserved to the traditional banking system.
Although the sector hasn’t achieved its lofty aims, financial protocols leveraging blockchain technology have opened up a world of possibility for savvy investors, startups craving capital, day traders, VCs, and others. At its peak, the total value locked in DeFi protocols exceeded $245 billion (December, 21) – and that’s without DeFi maximizing its worth by competing with certain sections of the traditional financial market. One of which being foreign exchange (forex) trading.
But that may be about to change.
Forex: A $6 Trillion Market with Major Inefficiencies
The forex market is one of the oldest most liquid capital markets in the world, and it operates on an entirely different scale to DeFi – particularly now the latter has fallen from its bull-market peak (today’s TVL: $46.5bn). With daily trading volume of over $6 trillion, forex is 10 times larger than the bond market and eclipses even the stock market.
Although forex has traditionally been dominated by central and commercial banks, as well as other institutional investors (hedge funds, asset managers), the growth of online trading platforms has made it possible for retail traders to participate, just as the rise of DeFi has opened up avenues to everyday investors. Despite this, forex is still viewed as something of a closed shop by many, perhaps due to the inordinate influence wielded by major financial institutions.
Despite the endless ocean of liquidity floating in the forex market, it suffers from serious inefficiencies – leading some to speculate whether DeFi could represent a solution. As it stands, the forex market is highly centralized, with a small handful of powerful players controlling the lion’s share of trade activity. This oligopoly-like structure, made up of banks, multinational corporations, governments, hedge fund managers and the like, means that prices can be easily manipulated, with modest changes in supply and demand having a major impact on price movements.
Unlike DeFi, the forex market relies on many intermediaries to function (counterparties, dealers, brokers), all of whom require a certain level of trust from end users. These same end users also have to contend with unpredictable fees according to the vagaries of the market.
Moreover, the FX market is hampered by a serious lack of transparency, since there is no central exchange where trades are conducted and reported. This highly fragmented market runs 24 hours a day, 5 days a week, across multiple time zones, yet there is no central domain for price discovery. Although regulations have recently been introduced to elevate transparency in forex, they are mainly geared towards ensuring brokers have sufficient capital to cover their losses, as well as strengthening reporting requirements.
In some ways forex still operates as Tradfi’s West Wild, an arena where anything goes, where participants perpetually exchange national currencies against one another, hedge against interest rate risk, and speculate on geopolitical events.
Could DeFi Help Forex and Vice Versa?
Although DeFi has somewhat stagnated since the heady days of 2022, it retains hope that the mainstream will eventually catch on. And recent events haven’t exactly hurt its case. After all, the collapse of FTX and the subsequent chaos that engulfed centralized exchanges in Q4 of 2022 barely left DeFi with a scratch, highlighting its resilience and decentralized credentials.
Representing a seismic shift from centralized financial systems to peer-to-peer (P2P) finance enabled by smart contracts, DeFi has grown into an expansive network of integrated protocols and financial instruments, and the most active sector in the blockchain space. Like forex, the industry has been dubbed a Wild West in its own right, a consequence of its largely unregulated status and the numerous hacks and exploits that have been perpetrated in the space.
But is DeFi capable of tackling forex’s inefficiencies in a meaningful way? After all, DeFi protocols are designed to facilitate real-time exchanges without intermediaries – which is exactly what many argue forex trading needs.
What’s more, many DeFi protocols offer features that could potentially be useful for FX traders, such as automated market making and flash loan issuance. And with blockchain providing a public record of all transactions, it could allow for more accurate pricing and reduced opportunities for corruption and fraud in foreign exchange trading.
Recent research by Circle and Uniswap, meanwhile, suggests DeFi protocols could slash the cost of cross-border remittances by as much as 80%, due to the fact that blockchain transactions are “near-instantaneous, low-cost, and borderless.”
Some projects are already making the case for bringing forex to DeFi and vice versa. One of them, Pendulum, aims to bring about a “forex-optimized app ecosystem” by creating an interoperable blockchain that offers composable fiat services. Forex is one of several tradfi services supported by the Berlin-based venture, which integrates the market with familiar DeFi touchstones such as lending protocols and automated market makers.
Having already secured the fastest parachain crowdloan in the history of the Polkadot network, Pendulum has ambitions to become “the missing link between fiat and DeFi,” bringing industrial-grade FX trading on-chain and unlocking opportunities for traders and liquidity providers.
And Pendulum isn’t alone. The aforementioned Uniswap protocol already facilitates on-chain FX in the trading of Circle’s dollar and euro-denominated stablecoins, USD Coin (USDC) and Euro Coin (EUROC). In fact, the EUROC/USDC pair has already surpassed $124 million dollars cumulatively as of January 12, 2023. Daily volume, meanwhile, has hit $8.6 million exchanged on a 24-7 basis. To be sure, this is a drop in the ocean compared to tradfi FX values – but it shows potential.
Handle.fi is another DeFi FX protocol currently in the wild, enabling users to trade with leverage across EUR, JPY, GBP and more, speculate on FX movements, and borrow multi-currency stablecoins. Launched in 2021, Handle.fi is built on Arbitrum, a Layer-2 scaling solution for smart contract powerhouse Ethereum, the undisputed home of DeFi.
Overall, it’s perhaps still too early to say that DeFi will provide a viable alternative to traditional forex trading. But with several projects building effective protocols to do just that, it’s not out of the question that DeFi protocols could eventually become an important part of the global financial system – including within the world of forex trading.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
