Get ready for decentralised finance

Interest is growing in decentralised finance (DeFi) and the potential it presents in areas such as lending, cross-border payments and trade finance. Banks which ignore the growing opportunities for fear of the disruption it will cause, do so at their peril.

Although the average consumer is not yet actively engaging with blockchain technology and digital assets, uptake will likely increase as more attractive propositions come on stream. Over the long term, we can expect the global banking ecosystem to be disrupted in significant and lasting ways. Not unlike the transformation driven by the introduction of online and mobile banking, decentralised finance and digital assets will enable people to bank differently—and financial institutions will need to adapt their offerings to remain competitive.

DeFi is all about enabling financial activities – from lending to investing – to occur on a blockchain. Transactions are based entirely on code, within a smart contract and executed within milliseconds. This means the need for human intervention is eliminated. This can be a frightening prospect for financial institutions which have relied on personal service to build relationships and customer loyalty.

On the surface, DeFi offers individuals the ability to access, exchange, and grow capital outside of a traditional banking relationship or environment. Rather than resist this disruption for fear of obsolescence, banks need to educate themselves on new trends and find ways to better engage and serve customers exploring this space.

Evolution of peer-to-peer lending

The difference between traditional peer-to-peer lending platforms and DeFi is that blockchain eliminates the middleman. Anyone who has a digital wallet can lend money or take out a loan and make interest payments. Borrowers and lenders can connect their digital wallets to one of the dozens of DeFi lending apps, select their preferred interest rate, currency or asset, and liquidity, and the app executes the smart contract for their loan. Neither the borrower nor the lender needs to trust (or even know) the party on the other end of the loan. The DeFi app (dApp) tracks the loan and extracts payments automatically via the blockchain, which prevents default.

As with traditional peer-to-peer lending, DeFi peer-to-peer lending circumvents traditional banks. Although still in its infancy, the market for this service is growing quickly. To remain part of the value chain banks need to be able to provide customers with access to digital wallets and cryptocurrency exchanges that link to their existing bank accounts.

International payments and foreign exchange 

Blockchain technology and digital assets could also disintermediate banks from the process of foreign exchange and cross-border payments. Traditionally, bank customers needing to exchange currency to travel overseas would do this at a bank or other currency exchange and be tied into the exchange rate at the time of the transaction. But a traveller with a digital wallet and access to a cryptocurrency exchange app can exchange their Bitcoin or Ethereum for DAI, a stablecoin linked to the value of the US dollar and use this to buy foreign currency. This can be done completely online, and avoids the high fees associated with traditional foreign exchange.

Banks still have a role in this use case, because CBDC can be used to facilitate currency exchange. Again, the process is in its infancy, but banks which make cryptoasset wallets and exchange apps available to their customers stand a better chance of keeping those customers engaged, even if they bypass the bank’s foreign exchange services, using digital currency instead.

Bringing smart contracts to trade finance

DeFi also has the potential to disrupt banks’ role in trade finance and the service they offer corporates. Where banks currently serve as third parties between importers and exporters, reducing risk and facilitating global trade through lending, lines of credit, letters of credit, and other financial instruments, smart contracts on the blockchain could eliminate the need for banks to perform these functions.

Rather than arranging financing and managing risk through their banks, importers and exporters can use decentralised apps to establish smart contracts which issue payment automatically upon delivery of the goods. The dApps use APIs to validate workflows. While not actively in use yet, DeFi applications for trade finance will reduce costs and extend access to smaller players who may not have the banking relationships to support traditional trade financing arrangements. Wallets, and later, super-apps will be the engagement interface. Banks which enable customers to explore DeFi solutions in this area can engage with customers who might otherwise bypass their services.

Decentralised finance and digital assets belong to an emerging and rapidly evolving area of the financial services landscape. Rather than view DeFi with suspicion or steer away from its potential for disruption, traditional banks and financial institutions should start exploring how to engage in ways that support customers’ needs and preferences, now and in the future.

Peer-to-peer lending, cross-border payments, and trade financing are three examples of areas where banks would benefit from understanding digital currencies and DeFi use cases and expand their offerings accordingly.

Hack to the Future: supporting DeFi innovation

To help drive innovation and explore new ideas in the world of DeFi, Finastra is inviting participants to sign up to our hackathon: #HackToTheFuture 2022 which opens on 8^th March. Building on the success of our previous hackathons – to redefine finance for good and build an unbiased fintech future – the event is open to all.

You do not need to be a technical expert to take part. We believe everyone has a role to play in defining the future of finance and this year we will be focusing on the three key themes of ESG, DeFi and embedded finance. Register interest here: https://www.finastra.com/hack-to-the-future.

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