Decentralized finance: what future for banks?

Faced with the evolution of decentralized finance (DeFi – Decentralized Finance), the two parallel universes of traditional centralized banks and decentralized banks are beginning to come together. Rivo Uibo, co-founder of Tuum, provides an update on the rise of cryptocurrencies and DeFi, and explores how banks are starting to get involved, and the benefits they can reap.

Interest in decentralized finance, a generic term used to designate peer-to-peer (P2P) financial services based on public blockchain or any other decentralized ledger technology, has been growing strongly over the past two years. According to a study carried out by the firm KPMG on behalf of the Association for the Development of Digital Assets (Adan), in January 2022, 8% of the French adult population invested in cryptoassets (cryptocurrencies and NFTs, tokens not fungible).

This new monetary system was essentially set up to operate independently of traditional financial intermediaries such as banks, stock exchanges and other brokers. However, faced with the growing interest shown by individuals for cryptocurrencies, this new system is beginning to arouse the attention of banking institutions, to the point that more and more establishments are seeking to enter the dance.

Why such interest?

There is little doubt that the digitalization of banking services, accelerated by the pandemic, has encouraged individuals to be more accommodating towards new methods. As it continues to evolve, decentralized finance is expected to move closer to traditional banking. In the same way and while continuing their digital transformation process, banks should be more willing to explore new ways of lending money and investing for their customers, including within the framework of DeFi.

Decentralized finance is an unregulated environment where interest rates are fully determined by the market and there is no form of credit rating or affordability verification, so its integration into service portfolios traditional banking is not without raising certain problems. However, we are seeing an increase in calls for government regulation and oversight of cryptocurrencies, which would encourage banks to explore this area once a more concrete framework has been defined. Moreover, the fact that central banks are planning to use digital currencies shows that cryptocurrencies have reached a plateau and that the future of banks will in all likelihood pass through the coexistence of digital finance and traditional fiat finance.

What do individuals think of this involvement of their bank?

This is one of the reasons banks are adopting DeFi. Indeed, more and more individuals are expecting their institution to get involved in this process. According to a recent study by the Financial Conduct Authority (FCA) in the United Kingdom among a thousand individuals aged 18 to 40 who had invested in one or more high-risk products, many of those interviewed were unaware of the risks involved in investing in DeFi. This study indicates in particular that the majority of these investors (69%) mistakenly believed that this transaction was regulated by the FCA and that they were unaware of the lack of protection and the risk for their money. Similarly, a survey conducted in January 2021 by NYDIG, an American technology platform that offers bitcoin-related services, indicates that 46 million Americans own bitcoins and that 81% of them want to keep them in their bank if they can. In France, again according to the study carried out by KPMG on behalf of Adan60% of French people considering acquiring bitcoins are motivated by the search for yield, while 12% cite the lack of confidence in banks as the main reason.

What aspects of decentralized finance are banks interested in, and why?

Decentralized finance enables the provision of a wide range of services, from trade to international trade finance, from insurance to peer-to-peer (P2P) lending and investments. For traditional banks, there are plenty of ways to get involved.

Some institutions are also starting to create DeFi exchange-traded funds (ETFs) to offer classic investment products that follow the cryptocurrency market. While this offering is not exclusively cryptocurrency-based, the emergence of exchange-traded funds underscores the direction the market is taking. More importantly, partnerships unite banks and start-ups in the financial sector (fintech), for example between the cryptocurrency exchange bit stamp and the Estonian banking and financial services company LHV. This partnership allows LHV to trade cryptocurrency (crypto trading) using the means available to Bitstamp to provide its customers with an easy-to-use trading solution.

For its part, the British fintech startup Revolut has offered cryptocurrency transfer and exchange services to 15 million customers since 2017 and holds nearly €600,000 (£500,000) in cryptocurrencies on behalf of its depositors. Last year, the loss-making company earned more than €46m (£39m) from its cryptocurrency investments as demand for its digital services boosted its revenue by 34%. In addition, the explosion in revenue from cryptocurrencies has allowed Revolut to offset the slowdown in its core target – namely card transactions – which had been hit hard by the 2020 lockdowns. Revolut is the perfect example of a bank that has ventured into the field of DeFi and is reaping the benefits without deviating from its business activities, banking and payments.

What technologies do banks need to offer DeFi services?

Decentralized finance operates on blockchain platforms such as Ethereum which allow transactions to be processed in real time. Traditional banking platforms are incompatible with blockchains. Therefore, institutions that use traditional technology and wish to adopt the DeFi system will have to upgrade their infrastructure. Banks need state-of-the-art banking technology capable of performing transactions automatically and in real time, as well as fully digitized processes such as digital risk scoring, credit scoring or real-time bank rates. They also need a platform based on a modular architecture that gives them the ability to create services that connect blockchain operations to their core business. DeFi banking services deployed within the blockchain can thus communicate with ordinary banking technology and operations that take place outside of the blockchain.

What future for decentralized finance in the banking sector?

It is still too early to know to what extent banks will embrace decentralized finance. Like other trends driving the financial services industry, a concern considered marginal today may turn into a central opportunity tomorrow. However, given the weaknesses of DeFi, the lack of regulations and security mechanisms that make its use both complex and daunting, as well as the high risks of scams and the confusing interface of the On cryptocurrency exchange platforms, it is the banks that ultimately have the credibility and experience to overcome some of these hurdles, but also the potential to fuel the growth of decentralized finance. For the banks, the challenge is twofold: to bring a certain level of control to this still unregulated space, while adopting a new mindset and an innovative approach that will enable them to capitalize on this disruptive structural transformation to play a active (and profitable) in the advent of this new way of doing their job.

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Decentralized finance: what future for banks?

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