Decentralized finance (DeFi) is here to stay and the time to jump on the bandwagon is now. By embracing blockchain and its related technologies, challenger banks are bringing the crypto revolution into traditional finance (TradFi) and preventing obsolescence.
TradFi institutions can survive DeFi by embracing it. Their ace under the sleeve, to garner market share, is the blending of innovation with convenience and security for non-tech-savvy clients.
Recent research from BCG Platinion and Crypto.com found that 23 per cent of insurance, banking and trading companies in the United Kingdom have tested services involving some DeFi application and 55 per cent are assessing it.
DeFi—the use of technology to remove intermediaries between transacting parties—has the potential to address cybersecurity challenges, high costs associated with regulation and poor infrastructures. Moreover, according to DeFi Pulse, the total value locked in DeFi contracts as of May 2021 is $71.1 billion.
Who Are the New Players
The great recession during the late 2000s undermined the credibility of traditional banking and financial institutions, particularly those that received bailouts from the bogus argument that they were too big to fail. A market opportunity emerged for customized, transparent services and new business models.
Taking advantage of new technologies, a proliferating digital ecosystem and the wide adoption of smartphones, new actors introduced innovative products. As a result, fintech companies, challenger banks and neobanks have disrupted the financial system across the world with more agile, cheaper and more inclusive services.
According to the EY Global FinTech Adoption Index, innovative financial services have soared in recent years. In 2015, the first year of the index’s publication, 15 per cent of global consumers used these products. This figure increased to 64 per cent in 2019, given the widespread awareness of digital transfers and payments.
In Canada, fintech adoption nearly tripled from 18 per cent in 2017 to 50 per cent in 2019. Although Canada’s top five banks continue to dominate the market, Canada is already home to approximately 700 fintech firms and VoPay projects the annual growth of account holders between 2020 and 2024 to be at 8.9 per cent.
Blockchains, Not Cryptocurrencies
Another key event was the emergence of bitcoin and its underlying technology, blockchain, in 2009. Bitcoin and the consequent proliferation of cryptocurrencies broke money paradigms.
Legal-tender and government-issued currencies were no longer the only alternatives on the radar. As of 2021, around 200 million people use cryptocurrencies and more than 22,000 businesses are already accepting crypto payments.
Blockchain, however, was the main innovation. While plenty of forward-thinking banks have remained reluctant to accept or use cryptocurrencies, they have been testing private distributed ledgers for years.
A 2018 study from New Greenwich Associates estimated that the financial-services sector invested $1.7 billion on average globally per year in blockchain services. As of the date of the report’s release, one in 10 banks, and other companies reporting blockchain budgets allocated more than $10 million annually.
As more countries have issued regulations to the blockchain ecosystem and the technology has started to mature, with more real-world applications and improvements, financial services discovered another wide array of possibilities around DeFi.
Leveraging DeFi for TradFi Goals
Although DeFi services are publicly available and cater to individual users rather than institutions, challenger banks are taking advantage of these apps to service their own customers.
For instance, they can offer saving accounts with higher interest rates and faster cross-border money transfers. Blockchain-powered smart contracts can also reduce operational costs with swift methods for know-your-customer and anti-money-laundering compliance.
As it removes barriers and lowers operational costs, DeFi can also help TradFi serve the unbanked and underbanked populations and small firms.
DeFi, however, is still at the cutting-edge stage and needs to overcome critical challenges. Its infrastructure is vulnerable to mishaps and hacks and the lack of consumer knowledge makes it a breeding ground for fraud.
Nearly three-quarters of companies operating in the financial sector fear security risks regarding DeFi services and almost all of them worry about fraud risk. For instance, last year, attackers drained around $1 million from bZx, the eighth-largest DeFi project according to DeFi Pulse.
For William Foxley, a tech reporter at CoinDesk, the amount of money stolen was relatively small compared to the cryptocurrency ecosystem. However, “the attacks demonstrate DeFi’s move into the big leagues and the attention it will now receive from manipulators and thieves.”
Another roadblock is regulation. Existing legal frameworks do not contemplate financial products and services that run without middlemen or monitoring and occur across borders seamlessly. In this context, which laws to enforce and who has jurisdiction over criminal prosecution are unclear.
If TradFi does not want to be left behind, it needs to find shortcuts through partnerships with leading fintech firms. Mainstream banking and investment firms can bring to the table their expertise on navigating regulation while transforming blockchain, artificial intelligence and other technologies into easy services.
Fergus Hodgson is a research associate at the Frontier Centre for Public Policy.
Photo by Jeremy Zero on Unsplash.