Demystifying decentralized finance: An opportunity or threat for financial services?

Decentralized finance (DeFi) is a relatively new term that has been volleyed around the financial circles, picking up traction with the media and financial community since last year. But what exactly is DeFi, and - more importantly - why does it matter in financial services (FS)?

Put simply, DeFi’s the umbrella concept that encompasses financial protocols, applications or services for the distribution of FS without relying on centralized financial intermediaries such as banks or traditional exchanges. Its high-level intent is to create an open-source, permissionless, decentralized global financial ecosystem of web applications that leverage smart contracts stored on public blockchains to facilitate FS that is accessible to everyone.

 Key characteristics of DeFi

While many decentralized applications (DApps) have yet to find their ideal product-market fit, the rising total value locked (or the sum of all digital assets that are staked, loaned, deposited or used in DeFi protocols’ smart contracts) makes it clear how much attention, activity and value the DeFi protocol now has. And as adoption becomes increasingly pervasive, this tech could impact the underpinnings of the broader financial system and materially disrupt the distribution channels for FS. 

DeFi offers transformation potential for banks…

DeFi solutions present a series of growth opportunities and operational efficiencies to incumbents that have the foresight to embrace these changes. APAC banks shouldn't view these with suspicion but leverage the protocols to facilitate cross-broader payments, lending, trade finance, and investment services linked to digital assets. Here, I see two primary ways banks can participate in DeFi, by:

1)    Providing consumers with trusted access to DeFi products: DeFi platforms lack the historical precedence to create a foundation of trust – with trust even harder to come by recently as various crypto players run into operational and financial difficulties. This is where participation of traditional banks in DeFi’s governance model could provide additional industry knowledge, experience and expertise to enhance transparency and reliability of these protocols.

After all, banks have built up their ‘trust currency’ over centuries, and that is a major asset that they can transpose into DeFi services. As part of the embedded finance infrastructure, they can collaborate with DeFi platforms to embed crypto solutions in everyday digital banking apps we are already familiar with. This would ingrain the cumbersome payments process into customers’ purchasing experience to provide seamless access to FS, and help incumbents to compete more effectively with new disruptors within the decentralized economy.

 2)    Executing financial transactions for corporates using smart contracts: Beyond retail banking applications, DeFi also has the potential to disrupt banks’ role in corporate banking. DApps use smart contracts to facilitate trade financing, margin trading, and in managing the legal and financial lifecycle of derivatives. By potentially reducing cost, DApps could further extend trade finance to smaller players that may not normally have access to banking relationships to support traditional trade financing arrangements.

And with DeFi platforms operating as fully permissionless, efficient self-executing systems, corporate banks might eventually face the very real risk of being sidelined (or eliminated) as the trusted intermediaries for international trade activities between importers and exporters. To avert that, traditional players must step up to explore where and how they can similarly leverage DeFi to minimize its disruption and potentially transform their own roles as financial intermediaries. 

 ...but mind the associated risks

As with any nascent technology with a slew of issues to address, DeFi is no different. While some literature appears to be biased toward these incredibly exciting new financial protocols, the DeFi universe is also a perilous place. Among others, I’ve concerns around anti-money laundering (AML) compliance, contagion risk, fraud and cybersecurity, and regulatory uncertainty. 

For instance, AML rules and associated Know Your Customer (KYC) procedures were traditionally designed on the premise that centralized financial intermediaries act as gatekeeper institutions. By removing the banks, DeFi potentially side-steps the enforcement of AML measures. An instance would be retail consumer loans – individuals traditionally needed proper financial records to illustrate their eligibility, but with DeFi, lenders are connected directly with the borrowers, eliminating the opportunity for AML checks.

Another risk of DeFi for AML compliance originates from the anonymity that comes from transacting automatically on a direct peer-to-peer basis. Cryptocurrencies used in DeFi projects don’t require identification of participants, and such lack of traceability coupled with DeFi’s borderless nature mean it’s extremely challenging to enforce global AML compliance. Instead, anonymized, cross-border execution of financial activities on such networks makes it easier for criminals to launder money.

As market participants continue to work out such kinks within this nascent financial protocol, perhaps these new platforms could learn from the wealth of knowledge, experience and expertise of traditional institutions. Herein also lies the opportunity for consultants to provide third-party reviews, smart contract security audits, and other forms of assurance that can enhance the reliability of the smart contracts and protocols.

Opportunity or threat, and ready or not - DeFi is coming

There’s no denying that DeFi is still highly speculative and there are challenges to participating. But like the transformational growth brought about by the advent of internet in the 1980s followed by the rise of digital banking in the decades to follow (and many of us being skeptical back then) - I believe that DeFi is here to stay.

APAC banks that ignore DeFi’s growing opportunities do so at their own peril. Instead of resisting its disruption, they should educate themselves on this new model of financial intermediation, then strategize to participate in a world of DeFi to better engage customers already exploring this space.

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With thanks to @Li-May Chew

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.