Decentralised finance – a threat for traditional FS firms, or an opportunity?

The decentralised finance (DeFi) ecosystem has grown immensely in the past years, and it is increasingly rewriting the rule book for financial institutions.

A subset within the larger crypto space, the concept and its underlying technology (blockchain) first captivated public discourse also thanks to the allure of alternative investing. Initially, the primary appeal of DeFi was that it meant the flow of money was not controlled by one central authority and did not have to be managed by institutions such as traditional banks, insurance companies, and exchanges. In addition, it is promising 100% uptime and transparency.

Yet we are increasingly seeing the institutionalisation of DeFi markets, with not only hedge funds but also major international banks and financial institutions executing DeFi transactions and leveraging its growing use cases. JP Morgan, for instance, recently completed its first-ever cross-border transaction using DeFi on a public blockchain. This points to an accelerating trend of incumbents experimenting with blockchain technology to improve efficiency and deliver new types of products.

Traditional finance and blockchain technology will no doubt become interwoven over time. But what are the risks, and where does the opportunity lie?

What are the threats?

The statistics tell a story of exponential growth – the global decentralised finance market was valued at  $11.78b in 2021, with this figure expected to expand at a compound annual growth rate of 42.5% from 2022 to 2030 despite the current drop in the market.

For financial services businesses, the threat comes from turning a blind eye to the opportunity that comes with blockchain technology and its associate use cases. While fintechs have already been accelerating the pace of innovation across the sector, DeFi promises to solve some of the lingering and inherent problems of the traditional financial system, both for banks and for consumers.

An umbrella term that refers to financial services and products built on a decentralised blockchain infrastructure, DeFi challenges the status quo and the current centralised banking system. On the surface, these two models appear incompatible, with DeFi making financial intermediaries, like central or commercial banks, obsolete. Yet by assessing the pain points that DeFi is looking to solve, financial institutions can leverage the technology to bolster their own offering, marrying the two models.

Added to this threat, DeFi is becoming mainstream as consumers turn towards solutions like DeFi asset management or investment platforms. Financial services on DeFi protocols are gaining traction with no entry requirements, unlike traditional models. Any customer today can store assets like Ethereum in their digital wallet and everyone can interact with permissionless protocols. One of the most prominent examples  is Uniswap, which enables people to swap tokens that run on Ethereum-compliant networks.

Thanks to smart contracts, computer programs executed on the blockchain which require no human intervention, these assets can be exchanged or sent from one wallet to another without a bank immediately. This offers consumers both convenience and added protection.

In addition, putting funds at work in DeFi-protocols such as Curve – mostly referred to as staking or farming – often provides higher returns to investors than traditional players do for the same risk. And by cutting the intermediary, this makes sense under certain circumstances – raising the question, what are banks doing to respond?

The incentive for financial services institutions

The financial industry must react and accelerate its understanding, positioning itself appropriately in the rapidly evolving market. With any challenge comes great opportunity, giving businesses in this space the opportunity to assess their fundamentals and ensure they are evolving in line with wider market trends and expectations.

Done right, DeFi offers traditional banks and financial services firms the ability to reduce costs, increase speed and attract new customers who are looking for simplified, more attractive, and secure solutions.

When we look at the current payments ecosystem, we’re confronted with a maze of payments services, systems and rules which rely on a cacophony of different players. DeFi offers a solution to this inherent friction, delivering ecosystems than can run autonomously based on rules and verify transactions without human intervention.

The main attractions of this innovation are two-fold. Firstly, it reduces inefficiency while eliminating fees, manual effort (e.g. for corporate actions) and intermediaries. Basic transactions can be executed at any time, from any place, with the only requirement having an internet connection and a compliant wallet. By removing the middleman in asset rights transfers, lowering exchange fees, and giving access to wider global markets, moving securities on blockchain could save between $17B and $24B in global trade processing costs.

Public blockchains also set a new standard for transparency in an industry that has traditionally been opaque. All transactions can be viewed by everyone involved and are verifiable on the blockchain, elevating the ability to record and verify data – in turn making it difficult or impossible to change or cheat the network. On the other hand, whereas the code itself is transparent, it is still very complex and only a minority of people can really understand it.

As a result, many people are vulnerable to scams when interacting with protocols, with fewer consumer safeguards than exist in traditional finance. This creates a huge opportunity for banks to step in and conduct due diligence on these protocols to offer corresponding, but safer, products. In doing so, the industry can break down barriers for investors keen to invest in the space or make use of these protocols, thus making these products more accessible and attractive to the wider population.

How can financial services leverage blockchain?

Many financial services organisations operate under a layer of opaqueness and maintain high levels of manual data processing. In addition, a whopping 90% of European Payments Council members, for instance, believe blockchain will fundamentally change the payments industry by 2025.

Insurance firms, for instance, still often manually make risk calculations, manage contracts, and assess payouts. By leveraging smart contracts and decentralised applications, these processes can be conducted on the blockchain, introducing more automation and tamper-proof audit trails.

The benefits for areas like know-your-customer (KYC) and anti-money laundering (AML) procedures are clear, elevating the ability to safeguard customer data and  internal operations – and potentially saving banks up to $160 million annually in the process.

Through blockchain, financial services can establish a tamper-proof repository of customer data that can be safely shared between organisations. A blockchain-backed system also reduces the risk of human error, and strengthens compliance and regulatory oversight by improving visibility of customer activity.

Blockchain can also reduce the costs often associated with legacy systems and improve price competitiveness. It can automate risk modelling, audits and compliance checks, help businesses create an industry-wide record of claims, and reduce data siloes to improve efficiency.

These use cases can be replicated across the entire financial services ecosystem to elevate standards while reducing costs.

The threat of ignoring innovation

Awareness and understanding of blockchain and DeFi within the financial services industry is growing, yet adoption is still in its nascent stages. Few companies want to be the first movers and are happy for others to lead the way and address the growing pains of implementing new technologies. Yet DeFi is set to reinvent the wheel, and in the long run those who only realise its potential when it’s already fully embedded into the ecosystem will already be too far behind to catch up.

Decentralised finance promises huge cost savings in infrastructure, transaction, and administration, and – if done right – could help improve the level of trust and resilience in the financial ecosystem. Huge strides have already been made towards exploring the use cases within different verticals and across various operations, fuelled by the rise of technology providers that are developing solutions to plug the current gaps across traditional financial services.

Through stronger partnerships between incumbents that are keen to innovate and fintechs or developers that can offer them the tools to do so, the industry can make a success of DeFi’s incredible potential and pave the way for a new generation of strengthened propositions. Collaborating on what may potentially be the biggest change in the history of financial systems will be worth the investment for those who take the opportunity, while those who ignore it face the threat of falling behind.

About the Author

Janis Heibel is the Head of Crypto and Digital Assets Practice, and a banking expert at Synpulse Switzerland. He has more than 10 years of professional experience in the interface between business and IT and was involved in the development of one of the very first cryptocurrency offerings of an international Swiss bank. Janis also led the launch of  the Synpulse Token, an employee compensation program based on a crypto token running front-to-end on Ethereum.

Featured image: ©putilov_denis