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Why Banks Should Be Paying Attention to the Rise of Decentralized Finance

13 January 2022

Decentralized finance (abbreviated as “DeFi”) has evolved from a blockchain-based FinTech sandbox into a complex network of platforms that allow borrowers, lenders, and investors to conduct bank-like transactions without having to deal with banks.

The Covid-19 epidemic has lately worsened these disparities. Most white-collar, high-income employees have had the option of working remotely, while blue-collar people have not. The epidemic has had a detrimental effect on a huge number of low-paid employees in important sectors such as police, education, cleaning, retail, and hospitality. And the divide between affluent nations, which can offer a safety net for employees, and impoverished ones, which lack the resources to assist individuals, has increased substantially. The poor have been disproportionately impacted by the pandemic’s economic effect, notably in underdeveloped nations and even industrialized economies where healthcare is not assured.

Decentralized finance (“DeFi”) has gained popularity in the last two years “) has evolved from a blockchain-based FinTech sandbox into a sophisticated array of Ethereum-based platforms that allow borrowers, lenders, and investors to conduct bank-like transactions without the use of banks.

Importantly, Defi is run on accounts that are open to everyone with an internet connection anywhere in the world. They can store and transfer value, as well as develop and use any financial product imaginable, on the same terms as everyone else. There are no banks. There are no middlemen involved. There will be no politics. You only need an open-source digital wallet, which you can get for free from your preferred app store.

The billions of dollars invested in DeFi now pale in comparison to the trillions of dollars invested in traditional, centralized finance. However, the allure of quick development and the prospect of significant investment returns in a low-interest-rate environment is luring some real money away from traditional investments. Furthermore, the relatively unregulated environment encourages innovation and appeals to those who believe banks should be less stodgy in light of the taxpayer-funded rescue during the Great Recession. Banks do not need to be concerned, but it would be unwise to ignore the situation.

The governance token, not surprisingly, has traded at seven times its issue price, and its method of issuance likely offers the token instant utility in a decentralized platform. The utility is a sought-after appellation, among other things, because the utility is one of the features that indicate a token is not subject to securities law in the United States and elsewhere.

There are so many fresh and interesting developments in DeFi right now that it feels like a turning point.

  • Cryptocurrencies in general are known for their volatility, and previous watershed moments have proven to be illusory, as the ICO boom of 2017-2018 has shown.
  • Bitcoin (BTC) (31%) and Ethereum (85%) have outperformed most traditional stocks and bonds in terms of year-to-date gains.
  • More importantly, DeFi has evolved into a legitimate financial system, although one that is mostly utilized by crypto insiders to create more crypto to speculate on even more crypto.
  • The global financial services market is one of the most valuable business prospects everywhere, and DeFi has produced some intriguing toys if it is truly a FinTech sandbox.
  • To avoid volatile value changes, most Defi transactions are priced in stablecoins, which are tokens whose value is pegged to a specific asset or currency, such as the US dollar.
  • Profits are produced by lending stablecoins at market demand rates or borrowing stablecoins through overcollateralized loans, with the proceeds usually reinvested.
  • DeFi can support almost any form of centralized financial instrument that traditional finance can, and it frequently delivers better returns for lower fees.
  • Depositors (lenders) can earn interest of up to ten percent depending on the crypto asset they deposit, and sophisticated users can leverage their positions by borrowing and lending.
  • All of this new growth will almost certainly result in even more new growth.

Aside from the predicted influx of governance tokens like Comp, another asset class undergoing rapid expansion in the category of tokens clamoring to transfer Bitcoin to Ethereum (and thus into DeFi). BTC is by far the most valuable store of value among digital assets, yet its primary function, like gold, is to store value. Until now, that is. Several tokens have begun to use smart contracts in recent months to allow the value of BTC to be reflected in ERC20 tokens that can be exchanged on DeFi platforms. Instead of just owning BTC, these tokens allow serious BTC holders to lend or borrow against their holdings with what are BTC-backed stable coins. The sky is the limit when it comes to the inclusion of new investment plays and their derivatives as Defi continues to grow exponentially.

DeFi is being pushed into the mainstream via new protocols and yield farmed tokens. Many feel that institutional investors seeking high-risk yields are driving a large portion of the new funds into DeFi.

The taint of cryptocurrency investing is normally avoided by institutional money, but in an era where centralized interest rates are headed into negative territory, there aren’t many possibilities to generate guaranteed double-digit returns or greater, even for those willing to take on more risk. Daily APRs of 50% to 100% aren’t going to stay hidden for long, and they’re not going to last indefinitely. Any institutional or non-institutional investment fund with a high-risk tolerance that isn’t actively considering DeFi markets isn’t doing its job.

Why should banks be concerned about this? 

Because non-banks are offering all of this investing and all of the fascinating new fintech products. Traditional banks and investment firms must join the bandwagon or risk being left behind. I’m not suggesting that investment firms develop their blockchain protocols, but they should be aware of a new asset class with the potential for great returns and minimal bureaucracy. JPMC’s Jamie Dimon, one of the most outspoken early detractors of bitcoin, was one among the first to harness the power of blockchain with his JPM Coin, which allows for rapid financial transfers between institutional clients.

Because many protocols are permissionless (decentralized), there is no kill switch to shut down a platform if it malfunctions or is attacked. Smart contract hacking continues to be a problem, but some insurance companies are stepping in to help lessen the risk. The yield one obtains is primarily determined by the amount of risk one is willing to take, just as it is in traditional finance.

The inefficiency of early protocols is undoubtedly responsible for some rapid advancements. However, some investors consider DeFi investments to be safer than ICOs because ICO values are sometimes based on ether (pun intended), but DeFi returns, particularly yielding farming profits, are based on the value gained by establishing and employing a new financial instrument. Rather than obtaining value by owning one or more tokens, DeFi investors generate and receive value by assisting in the fueling and operation of the underlying DeFi protocol. In the current ecosystem, they can also obtain governance tokens for doing so, further incentivizing them to protect the platform’s long-term viability.

Decentralized finance (DeFi) recreates the conventional financial system without the need of intermediaries by operating without a central exchange. As a result, it has a significant democratizing effect on the financial industry. DeFi is allowing a vast group of people who were previously unable to participate in financial markets to do so. Financial literacy, regulation, and cybersecurity are all becoming more important as more individuals get access to these markets.

In a centralized system like today’s, intermediaries, strong organizations that manufacture financial products and ensure that money flows from savers to spenders, have been used to connect the supply and demand for finance. DeFi alters middlemen’s initial job and forces them to take on additional responsibilities.

Historically, intermediaries have acted as a link between savers and spenders in the financial markets, charging fees to cover transaction expenses. Because transactions are normally more efficient in well-developed financial markets, these costs have tended to be lower than in emerging markets. As a result, there is more disparity between established and developing markets.

Furthermore, intermediaries have evolved into direct players as a result of capital movements. The number of financial intermediaries has lately expanded as the degree of liquidity has increased and the amount of money in financial markets has increased. As a result of this tendency, mechanisms that favor certain actors more than others have emerged.

Capital investments have played a crucial part in enhancing the wealth of the richest in the twentieth and twenty-first centuries, consequently expanding disparities. Large wealth holders have had easy access to investment products (such as hedge funds) with much greater financial returns than the mainstream products available to ordinary investors (e.g. bank deposits and government bonds).

DeFi is on the verge of reversing this disparity. By eliminating intermediaries, it will result in more direct transfers between savers and spenders. DeFi avoids pricey conventional financial institutions by allowing peer-to-peer financial transactions utilizing cryptocurrency blockchains such as Ethereum. Furthermore, members may access a wider range of financial services, including borrowing and lending, via these decentralized exchanges. A bigger populace might profit from financial rewards comparable to those enjoyed by affluent people in the future years. Overall, DeFi will usher in a new, more inclusive financial reality for a large number of people.

DeFi also improves the transparency of financial transactions. Many transactions will be done via a decentralized, open-source network, eliminating the need for intermediaries. Today, Ethereum is the most popular platform, but other systems that support smart contracts might also function.

DeFi transactions now total roughly $8 billion in assets, a minuscule fraction of the $25 trillion and $11 trillion market capitalizations of the NYSE and NASDAQ, respectively. Experts, on the other hand, expect that the DeFi sector will rise rapidly. Such expansion would open up the market for bigger DeFi players, perhaps triggering a virtuous cycle that would provide the disruption that DeFi advocates have promised. As more individuals engage in financial decentralization, banks and financial enterprises that move toward DeFi systems will gain.

Conclusion

DeFi has the potential to lessen economic inequality by increasing access to the finest financial assets. DeFi equalizes the opportunity structure and access to investments by breaking down social barriers in finance. Almost anybody who has a smartphone will be able to invest. Private cryptocurrencies, on the other hand, considerably raise the danger of financial crimes (e.g. money laundering, bribery, and tax evasion).

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