Sep 11 2020

A Guide to Decentralized Finance: What Banks Need to Know

As financial institutions are pushed to embrace digital transformation, preparing for this new trend is critical.

Banks and financial institutions are deeply embedded in everyday life. Paychecks are deposited directly into accounts. Tenants write checks for rent payments. Customers get their morning coffee or replace their tattered running shoes with the swipe of a piece of plastic, all powered by a financial system that relies on institutions to act as intermediaries between customers and the goods and services they’re purchasing.

Financial organizations are also critical for customers’ long-term plans and goals. Mortgages for homes, loans for businesses and management of retirement funds are all tools for customers to build a life and plan for the future. 

This reality makes it difficult to move through much of the modern world without interacting with banks. But some are starting to envision a different kind of financial system that allows people to directly access services such as loans and market trading. It’s a system where lenders and borrowers can perform transactions on their own, bypassing intermediaries that have long played a vital role in both the economy and personal finances. That system is decentralized finance.

Decentralized finance (DeFi) uses blockchain technology to conduct transactions securely outside of a traditional bank structure. Although not yet considered mainstream, the number of decentralized applications (DApps) has steadily increased since 2017, according to State of the DApps.

This movement is rising at a critical time for banks, many of which have been slower to adopt digital transformation initiatives amid concerns about compliance and security. The COVID-19 global health crisis has pushed them to accelerate those digital transformation plans, and it’s a great opportunity to prepare for the potential effects of decentralized finance.

What Is Decentralized Finance?

Decentralized finance is a blanket term for a number of financial services that are conducted directly between parties, without a traditional intermediary. 

“In short, DeFi refers to an ecosystem of financial applications that are built on top of a blockchain,” reads a whitepaper from Bitkom. “Its common goal is to develop and operate in a decentralized way — without intermediaries such as banks, payment service providers or investment funds — all types of financial services on top of a transparent and trustless blockchain network.”

The goals of DeFi aren’t limited to simplified processes or lower fees for customers. There is also a social justice element to the movement, as supporters think the system can make services such as stock trading and loans accessible to the masses, regardless of a person’s economic circumstance. 

“The spread of crypto-based financial services would shape a new world of decentralized finance,” according to Forbes. “This world would be characterized by wider global accessibility to financial services, safer transactions, and lower transaction costs.”

The Technology Behind Decentralized Finance: Blockchain and Smart Contracts

DeFi is foundationally built on blockchain technology, which is a chain of online transactions saved as a shared ledger across numerous computers on a peer-to-peer network. This means they are not all stored in any one place, keeping these transactions protected from a central attack. The rise of Bitcoin in recent years has made blockchain a relatively mainstream idea. 

Within blockchain, the other tool that plays a crucial role in DeFi is the smart contract. Smart contracts are essentially what solves for the kind of guarantee that working with a bank can provide, ensuring the transaction. Smart contracts are programs that execute transactions automatically once certain terms and conditions are met. These are executed on the blockchain, meaning they’re distributed and transparent. The terms and conditions are predetermined between the parties.

WATCH: Learn how to build resilient security without hindering the user experience.

“They are relatively inefficient (in terms of latency and throughput) compared to centralized computing, because, like simple blockchain transactions, smart contracts are executed in a decentralized manner,” the Bitkom whitepaper says. “That said, their strength stems from a high level of security and transparency. Anyone can potentially verify the results.”

This is different from the traditional banking experience, in which customers are often unaware of the exact process of a transaction once they’ve instructed the bank to execute it. Ethereum is the leading platform in the DeFi market.

Why Does Decentralized Finance Matter to Banks?

DeFi has the potential to fundamentally change the way people manage their finances, and it is critical for banks to understand the movement. While the value of assets that are “locked” in DeFi fluctuates (the website DeFi Pulse had it over $6 billion at the time of this posting), it is clear that the value is growing rapidly. Bitkom says the amount of money in DeFi doubled in late June, while Banking Exchange reports that the second most popular DeFi platform, Compound, increased its assets under control by 900 percent from June to July.

Three main areas of finance stand to be most affected, according to a report from the Financial Stability Board: payments and settlements, trade finance, and capital markets.

“Decentralised technologies might be less likely to be adopted where financial services are reliant on intermediaries to provide large-scale maturity or liquidity transformation or make use of private information to overcome information asymmetries,” the report says. “Conversely, their adoption may be more likely when existing methods for delivering financial services incorporate a lower degree of intermediation or are more costly.”

Much like retailers have adopted cryptocurrency to meet customer demands, banks may find themselves needing to develop services that incorporate DeFi. They’ll also need to increase the ease and comfort of their customer experience and maintain trusting relationships with them.

How Can Banks Prepare for Decentralized Finance?

Despite the benefits of transparency and low fees, most financial customers are happy with their banks. A recent survey conducted by Morning Consult on behalf of the American Bankers Association found that 88 percent are either “satisfied” or “very satisfied” with their bank. It also found that 93 percent would rate their access to financial services as “excellent” or “good,” which implies that many would be inclined to stay with their traditional bank.

But banks can’t afford to remain stagnant. As DeFi offerings expand and grow, banks must give customers extra incentives to keep doing business with them. Using data analytics tools, banks can power machine learning and develop better experiences for their customers. Services such as video banking make it convenient for customers to get the personalized advice they’re looking for.

In addition to customer service enhancements, more mainstream technology companies are committing to helping banks navigate these changing waters. Nitin Gaur, director of IBM financial sciences and digital assets, said in an interview with Cointelegraph that the company wants to help banks build innovative products and connect them “into the dynamicity of the global marketplace that the DeFi space has to offer.”

Gaur also said it’s critically important for banks to properly understand the DeFi space.

“I think that the financial institutions should understand it because it has the potential to eventually sort of take over and subside the business elements of existing business models.”

DISCOVER: Learn more about how banks can use technology to get future-ready.

Illustration by Traci Daberko