By Kaj Burchardi, Managing Director, BCG Platinion
Traditionally, decentralised finance (DeFi) has been viewed as belonging exclusively to the crypto and blockchain communities. Financial services companies once distanced themselves from the model, which created a DeFi community separate to traditional centralised institutions.
Yet, organisations are starting to take DeFi more seriously. Our latest research found that 23% of insurance, banking and trading companies have introduced services built on DeFi, while 55% are currently assessing it.
But why is this? As more ‘traditional’ organisations move towards newer models of financing, there is a significant opportunity for collaboration between the crypto community and financial service organisations.
However, there are still steps that need to be made until we have mass DeFi adoption; and addressing issues around regulation and security, in particular, will be crucial for an accelerated uptake.
Only once those concerns have been addressed, financial services companies will begin to reap the benefits of a DeFi model.
With a centralised finance model already being quite effective, there has been a caution in switching to DeFi. But as DeFi has grown, businesses are beginning to consider whether it could become a genuinely sustainable alternative to the services offered by centralised finance.
Supporters of DeFi argue that it extends access to financial applications to individuals and institutions that perhaps couldn’t before. That would be without the need for a trusted mediator, streamlining the process.
The financial services sector already invests around $1.7 billion in blockchain services per year but that has had little impact to date. This is largely because regulations and low levels of liquidity mean that the more established businesses are not taking full advantage of the opportunities it creates.
But there are also some challenges posed by traditional finance models that DeFi can help address; for example the benefit it brings to emerging economies and the small and medium enterprises (SMEs) that are growing in those countries.
Currently, incumbents tend to benefit institutions that have larger balance sheets, helping them pursue coalitions with similarly sized businesses and increase shareholder value through rent-seeking behaviour.
SMEs, who simply don’t have the capital to run that type of a model, cannot benefit from traditional finance models in the same way.
The next wave of demand for capital and financial services will come from the emerging economies and SMEs that do not reap the rewards of traditional finance models. DeFi could help to narrow those gaps and offer them better opportunities for growth.
Addressing security concerns
There will always be security concerns when venturing into the relatively unknown, especially when they’re fairly untested by contemporaries. And arguably the most significant drawback in DeFi is smart contract risk.
Indeed, 70% of companies believe that security concerns over fraud is a challenge preventing company-wide adoption of DeFi. This indicates that there are genuine concerns about DeFi opening up vulnerabilities into an organisation that did not previously exist.
The most common method of attack involves the exploitation of bugs in code and the manipulation of external price feeds for assets within protocols.
This happened twice in February 2020 alone, when DeFi lending platform bZx was attacked, allowing the oracle price of collateral to be changed. Even more recognised was the attack on the Decentralised Autonomous Organisation (DAO) – where an attacker stole $72m worth of assets from smart contracts. Critics of DeFi point to these two incidents as a reason to not consider its adoption.
Yet these incidents have provided learning curves in DeFi adoption. It is still a relatively new model and we are still beginning to understand how to use it effectively.
Each attack exposes a new vulnerability in the system which can then be addressed to prevent them from happening in future. Moreover, the attacks encourage developers to take a proactive approach to security, looking to identify and prevent flaws before cyberattackers strike. As the model matures, DeFi will likely become more secure and will eventually match that of centralised models.
The future of finance
While DeFi models are relatively young and we are still far from seeing it adopted at scale, it is promising to see they are being taken more seriously.
And while there is still progress that needs to be made, particularly around security, to give businesses confidence in adopting it more widely, the benefits that a decentralised model has on small businesses and emerging economies outweighs the drawbacks of ignoring it.
Financial institutions should continue to work with the crypto community, to help build a new generation of governance and solutions that makes financial services more accessible.