Will banks embrace decentralised finance?

As decentralised finance (DeFi) evolves, it is attracting the attention of traditional (centralised) banks. Here Rivo Uibo, Co-founder and Chief Business Officer at Tuum explores the rise of cryptocurrencies and DeFi and looks at why and how banks are beginning to get involved and the potential gains to be had by banks’ involvement.

The last couple of years has seen significant growth and a surging interest in
decentralised finance, the overarching term for peer-to-peer financial services based on public blockchain or any other decentralised ledger technologies. A recent report by the University of Cambridge (UK) found that the number of people with crypto assets increased by a staggering 189 percent between 2018 and 2020 alone and as of February 2021, 9.8 million Britons were reported to be owning cryptocurrency.

Decentralised finance was configured to be entirely independent of traditional
financial intermediaries like banks, exchanges, and brokerages. However, in
response to a growing interest of consumers in cryptocurrencies, it has
subsequently begun to attract the attention of the institutions it initially set out to avoid – banks.

What is in it for banks?

With the impact of the pandemic, a need to embrace digital banking has been
inevitable and the public has become less averse to new forms of banking. As
DeFi evolves, it is projected to veer towards the realms of traditional banking.
Likewise, as banks themselves continue their digital transformations they are
more likely to explore new ways of lending and investing money for their
customers. And this includes DeFi.

Bringing DeFi into ‘classical’ banking service portfolios is a tall order because
there is no form of credit rating, or verification of affordability in such a non-
regulated environment where interest rates are entirely driven by the market.
However, we are witnessing increased calls for government regulation and
oversight of cryptocurrencies which would incentivise banks to explore this
sector once more concrete guardrails have been defined. Equally, central banks
are considering digital currencies. The signs are that cryptocurrencies have hit a
crossroads and the future of banking is likely to incorporate both digital and fiat
finance.

Are consumers invested in this new approach?

One argument why banks should embrace DeFi is to respond to the
growing demand from end users for banks to get involved. A recent report,
commissioned by the FCA in the UK on 1,000 people aged between 18 and 40
who had invested in one or more high-risk investment products, found a
significant number of people were unaware of the risks of investing in DeFi. 69%
of people who had purchased cryptocurrency had wrongly assumed these
investments to be regulated by the FCA. The respondents were oblivious of the
lack of investor protection they were afforded and the genuine risk to their
money. A survey by New York cryptocurrency services company NYDIG
conducted in January 2021, also found that 46 million Americans own bitcoin and
of these, 81% said they would store it in their bank if they could.

How are banks getting involved ?

DeFi incorporates a variety of services including trading, trade finance, insurance, peer to peer lending and investment and there are multiple ways for
traditional banks to get involved. We are starting to see banks create DeFi exchange-traded-funds (ETFs), where they offer classic investment products which follow the crypto market. While these ETFs are not a pure crypto-based offering, their arrival indicates the direction of where the market is heading. Recently, we have seen partnerships between banks and fintechs. For instance, crypto exchange Bitstamp and Estonian banking and financial services company LHV partnered, which allowed LHV to roll out cryptocurrency trading by utilising Bitstamp’s capabilities to provide an easy-to-use trading solution to its customer base.

UK fintech startup, Revolut, offers trading services and crypto investment
opportunities and possesses over half a billion pounds worth of cryptocurrency
on behalf of its 15 million clients. The loss-making company made £39 million on
its cryptocurrency investments last year with demand for its crypto services
pushing revenues up by 34%. Despite being hit hard by 2020 lockdowns,
Revolut’s soaring crypto revenue helped to balance a downturn in its core
business of card transactions. Revolut is a prime example of a bank that has reaped the benefits of DeFi whilst maintaining a focus on its core banking and payments business.

Do banks need to implement new technologies to offer DeFi services?

Blockchain platforms such as Ethereum and legacy banking platforms are
incompatible, therefore banks with legacy technology will need to update their tech stack if they are to facilitate DeFi. Banks require modern banking
technology that will allow automatic and real-time transactions as well as fully
digital processes such as digital risk scoring, credit rating and real-time bank
rates. On top of that, they need a platform that has a modular architecture,
allowing them to build services that connect blockchain operations with their
existing core business. This is all necessary so that DeFi banking services inside
blockchain can successfully communicate with “off-chain” regular banking
operations and technology.

Looking to the future of banking and DeFi

For now, it is too soon to forecast the extent to which banks will support
decentralised finance. Like other current trends in the financial services
sector, DeFi may be perceived as a peripheral concern today but could
become a valuable opportunity tomorrow. However, if you consider
the weaknesses of DeFi; the lack of regulation making for a
complicated and daunting landscape, the significant risk of scams, and the
baffling UX of crypto trading platforms, it is the banks that possess the
experience to overcome these challenges. The obstacles for banks lie in bringing a level of control to this non-regulated terrain whilst adopting a fresh
approach that allows them to capitalise on this change in framework within the
industry. Banks have seen unprecedented evolution over the last ten years and have had to adjust their strategies and offerings to keep pace with changing customer needs. With Defi growing in popularity, it is another phenomenon that banks must carefully consider and embrace in order to play a profitable role in supporting a modern way of banking.