Faced with the evolution of decentralized finance (DeFi – Decentralized Finance), the two parallel universes of traditional centralized banks and decentralized banks are beginning to converge. Rivo Uibo, co-founder of Tuum, provides an update on the rise of cryptocurrencies and DeFi, examining how banks get involved and what benefits they can reap.
Interest in decentralized finance, a general term used to denote peer-to-peer (P2P) financial services based on public blockchain or other decentralized ledger technology, has grown significantly over the past two years. According to a study conducted 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 that are not replaceable).
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 of individuals in cryptocurrencies, this new system is starting to attract the attention of banking institutions, to the point that more and more institutions want to get into the dance.
Why such an interest?
There is little doubt that the digitization of banking services, accelerated by the pandemic, has encouraged individuals to be more compliant with new methods. As it evolves, decentralized financing is expected to move closer to traditional banking. Similarly, as they continue their digital transformation process, banks should be more willing to explore new ways to lend and invest for their customers, including in the context of DeFi.
Decentralized finance is an unregulated environment where interest rates are completely determined by the market and there is no form of credit assessment or affordability verification, so its integration into traditional banking services portfolios is not without its 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 is 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 most likely be via 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 why banks use DeFi. In fact, more and more individuals expect their institution to be involved in this process. According to a recent survey by the Financial Conduct Authority (FCA) in the United Kingdom of a thousand people between the ages of 18 and 40 who had invested in one or more risky products, a large number of those surveyed were not aware of the risks of investing in DeFi. In particular, this study indicates that the majority of these investors (69%) falsely believed that this transaction was regulated by the FCA and that they were unaware of the lack of protection and risk to their money. Similarly, a survey conducted in January 2021 by NYDIG, a US technology platform that offers bitcoin-related services, found that 46 million Americans own bitcoins and 81% of them want to keep them in their bank. In France, according to the study carried out by KPMG on behalf of Adan, 60% of French people who want to buy bitcoins are still motivated by the search for yield, while 12% cite the lack of trust in banks as the main reason.
What aspects of decentralized financing are banks interested in, and why?
Decentralized finance makes it possible to offer 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 track the cryptocurrency market. While this offering is not based solely on cryptocurrency, the rise of exchange-traded funds underscores the direction the market is taking. More importantly, partnerships bring together banks and start-ups in the financial sector (fintech), for example between the cryptocurrency exchange Bitstamp and the Estonian banking and financial services provider LHV. This partnership will allow LHV to trade cryptocurrencies (crypto trading) using the resources Bitstamp has at its disposal to provide its customers with an easy-to-use trading solution.
For its part, British fintech startup Revolut has provided cryptocurrency transfer and exchange services to 15 million customers since 2017 and has nearly €600,000 (£500,000) worth of cryptocurrencies on behalf of its depositors. Last year, the loss-making company made more than €46 million (£39 million) from its cryptocurrency investments as demand for its digital services boosted its revenue by 34%. In addition, the explosion in revenue from cryptocurrencies has enabled Revolut to offset the slowdown in its core business – which is card transactions – that was hit hard by the 2020 lockdowns. Revolut is the perfect example of a bank moving into DeFi and reaps the benefits without deviating from its business activities, banking and payments.
What technologies do banks need to provide DeFi services?
Decentralized finance works on blockchain platforms such as Ethereum that allow transactions to be processed in real time. Traditional banking platforms are not compatible with blockchains. Institutions that use traditional technology and want to use the DeFi system will therefore have to upgrade their infrastructure. Banks need advanced banking technology that can execute transactions automatically and in real time, as well as fully digitized processes such as digital risk scores, credit scores or real-time bank rates. They also need a platform based on a modular architecture that allows them to create services that connect blockchain operations to their core businesses. Thus, DeFi banking services deployed within the blockchain can interact with common banking technology and operations that take place outside the blockchain.
What future for decentralized financing in the banking sector?
It is still too early to know to what extent banks will embrace decentralized financing. Like other trends in financial services, a concern seen as marginal today can become a central opportunity tomorrow. Given the weaknesses of DeFi, the lack of regulation 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 lose 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 innovative approach that will allow them to take advantage of this disruptive structural transformation to create an active ( and profitable) in the advent of this new way of working.