The promise of DeFi in the real world

The concept of removing intermediaries to enhance market efficiency and reduce concentration has been a fixture in theoretical economics for decades. The objective is for finance to become more affordable, transparent, and readily accessible.

DeFi holds the potential to bring about this transformation.

Today, technology is making it possible

As the necessary technologies arose to actually make it happen, DeFi has kept at least some of these promises. Today, smart contracts automate various financial transactions, allowing users to interact without relying on third parties. DeFi platforms enable users to lend cryptocurrency assets to others and earn interest, or to borrow assets by providing collateral. The network itself manages interest rates, collateral requirements, and repayment terms, all without a central authority. Users trade directly through decentralised exchanges. Yield farmers earn additional tokens and provide liquidity to the system.

All this is fertile ground for innovation and delivers broad access. And yet, DeFi has not been universally or even widely adopted, especially in business-to-business scenarios. This has much to do with the risks of participation in DeFi protocols, such as smart contract vulnerabilities, market volatility, and regulatory uncertainty. Existing regulation of financial markets often demands the involvement of licensed intermediaries to secure the system. This traditional approach is now challenged in certain fields when modern technology, like offered by blockchains and smart contracts, can offer better security guarantees than human-led institutions.

Incumbents need to adopt a point of view

Established players ask: is this threat or opportunity? The threat bit is easy to understand. After all, it is in the nature of this beast to cut out intermediaries – i.e. established financial institutions. But this is a reductive view and runs the risk of missing the opportunities inherent in DeFi, which others are sure to seize – FinTechs, challengers, or nimbler competitors.

Rather, banks would do well to use DeFi's potential on their own terms. Use cases cover all the layers of the financial value chain (see chart) and range from rethinking financial marketplaces to new forms of digital money and tokenising all kinds of assets, be it financial instruments or real-world assets. The core strengths of DeFi protocols lie in their extreme focus on automation, openness, extensibility and transparency. These allow sources of liquidity and returns to be tapped that would be too complicated or expensive to access using old-school methods, while providing flexible and individual solutions to clients.

Folding DeFi into traditional structures requires a delicate balance

But what happens when the highly regulated environment and somewhat hide-bound culture of conventional finance encounters the free-wheeling world of DeFi? What about KYC and AML? How do they affect a system that was conceptualised in a permissionless manner? Will DeFi meld with the traditional financial system, combining the best of both worlds? Or will institutionalisation destroys its advantages and confine it forever to a niche?

Banks and insurers who manage this balancing act best will create new opportunities for themselves that neither a stubborn old incumbent nor a nimble, but small FinTech can match.