Bank on change: DeFi’s challenge to traditional finance and fintech

The world of decentralized finance has already surpassed the milestone of US$100 billion in total value locked, and a critical question is on the lips of finance industry observers: Will traditional finance and fintech companies adapt to the growing public appetite for DeFi products, or will they somehow thwart it?

 For Jun Li, founder of Shanghai-based Ontology, an open-source blockchain focused on digital identity and data, there’s an encouraging answer. 

“For fintechs and neobanks, the huge expansion of the DeFi market is great news because it bridges their usability to blockchain,” Li told Forkast.News.  

“Fintech and DeFi have a lot of overlapping features, and as DeFi grows, so too will the fintech industry,” Li said. “The bridge between them will bring many more users to DeFi, as fintech will probably be engulfed into the whole DeFi space soon.” 

Part of DeFi’s appeal is that it is much more accessible than traditional finance. 

Blockchain company ConsenSys recently announced that more than 5 million people were using its MetaMask cryptocurrency wallet, which allows users to interact with the Ethereum network and decentralized applications, known as DApps. The apps power such functions as crypto lending, borrowing, swapping and pooling, using a variety of smart contracts and protocols that make up the bulk of the DeFi ecosystem. 

The peer-to-peer nature of DeFi has a number of advantages over centralized finance, such as transparency, immutability, automation and programmability via smart contracts. 

Smart contracts are the primary tools that allow DeFi users to use services in the ecosystem without the need for intermediaries, because they are essentially computer code that carries out tasks such as automatic crypto transfers if certain predefined conditions are met. 

Companies such as San Francisco-based Ripple aim to leverage some of those advantages in the financial world, particularly as they apply to cross-border transactions, in which cryptocurrencies are faster, cheaper and more accessible than incumbent money-transfer systems such as SWIFT. 

Banks on board

Banks and fintechs are increasingly making headlines for using or investing in blockchain and distributed ledger technology. 

Last month, ConsenSys closed a US$65 million funding round involving J.P. Morgan, Mastercard, UBS and other investors, highlighting a growing appetite among traditional finance sector players for exposure to DeFi. 

ConsenSys also turned heads last year when it acquired J.P. Morgan’s Quorum product, an enterprise-grade Ethereum-variant platform that aims to be an open-source blockchain platform for businesses. 

Ethereum co-founder and ConsenSys founder Joseph Lubin last month laid out his vision for the future of finance and decentralization, drawing parallels between DeFi and the early days of the World Wide Web’s journey to becoming an essential part of the global economy. 

“ConsenSys’ software stack represents access to a new automated objective trust foundation enabled by decentralized protocols like Ethereum,” Lubin said in a statement. “We are proud to partner with pre-eminent financial firms alongside leading crypto companies to further converge the centralized and decentralized financial domains.” 

Banks around the world are taking note. Last month, the European Investment Bank issued about US$121 million worth of digital bonds on the Ethereum network. The lender said the two-year bond “represents the market’s first multi‑dealer led, primary issuance of digitally native tokens using public blockchain technology.” 

The increasing number of banks and fintechs making forays into the crypto sector reflects the growth of funds tapped by the DeFi ecosystem. DeFi reached a US$96 billion market cap in the first quarter of 2021, and the combined TVL on Ethereum and the Binance Smart Chain hit US$72 billion in the same period, according to a report by CoinGecko. 

“The recent growth in DeFi brings with it an increase in liquidity of decentralized assets and increased adoption, too, which in turn leads to the maturing of the underlying technologies,” said Matthijs de Vries, CTO and co-founder of AllianceBlock, a decentralized capital market. 

“Fintechs and neobanks in particular stand to benefit from the maturation of underlying technologies nowadays, [as] DeFi’s new innovative financial products allow them to offer new opportunities to their existing customers.”  

Playing by the rules

As cryptocurrency and DeFi applications gain acceptance among large players such as Visa  and Mastercard, pressure is mounting on traditional finance sector businesses to explore new finance models.

 According to research in Europe by the Boston Consulting Group and Crypto.com, 86% of finance sector companies surveyed are analyzing or implementing products and services using decentralized systems. Visa and Mastercard’s activities in the decentralized sector reflect their attempts to stay ahead of the curve and maintain their dominance. 

A statement released alongside the Boston Consulting Group report says: “Larger financial institutions are more likely to adopt DeFi and realize first-mover advantages because they can afford more risk.”

 De Vries said: “At this point, it’s fair to say DeFi has established itself. The high level of value locked and the effect it has on transaction volumes and the volume of assets flowing through different DeFi protocols underlines the importance of the need of decentralized financial processes.” 

 The surge in financial activity involving cryptocurrencies and decentralized technologies has piqued the interest of finance sector regulators such as the intergovernmental Financial Action Task Force and the European Commission’s 5th anti-money laundering directive.

 FATF last year published guidelines for virtual asset service providers such as crypto exchanges on compliance with know-your-customer requirements for transactions involving sums worth more than US$1,000. As reported by Forkast.News, regulators’ activities in the sector have stirred concerns over the potential chilling effect they may have on business.

 “As more traditional financial players find themselves interested in DeFi, it’s clear the industry is lacking in a compliant channel for both worlds to safely interact,” said de Vries. “Compliance with regulations must begin with a solid KYC/AML process, [and] to increase the flow of institutional assets into DeFi, we must do just that.” 

 Some say more regulation offers an opportunity to develop DeFi and cryptocurrencies as a more mature ecosystem and help prevent abuses, and to reduce risk and volatility.

 Li said: “Given DeFi’s decentralized nature, it is much more attractive than centralized services in fintech. It will give regulators an opportunity for a fresh start, since many of them didn’t fully invest in setting proper guidelines for fintech. Overall, this is a very bullish time for the entire DeFi ecosystem, and regulators will play a big part in the continuing progress.”

 Integration where it works

Although the world of DeFi is awash with news of investment, regulation and financial activity, some “cypherpunks” may not agree that the trend toward greater collaboration between centralized finance and DeFi is compatible with the ideals of trustless, permissionless finance pioneered by cryptocurrencies such as Bitcoin in the wake of the 2008 financial crisis. 

Proponents of the sector’s development say there is sufficient room for such ideals to persist despite DeFi being increasingly the domain of traditional finance sector businesses and increasingly subject to regulation. 

“For some protocols in DeFi, it’s only natural to interact heavily with centralized finance in order to maximize opportunities,” de Vries said. “However, in other cases, these interactions do not make sense, and that is fine — decentralized technologies cannot be forced to all follow the same rules set out by centralized entities, but where they are needed by both the investors and service providers, they can be implemented and they will be used, because they add value and protection to the investors.”

In order to create a true bridge between DeFi and traditional finance, some say a “cross-border” compliance layer with integrated KYC verification is required.

 “At first glance, that might seem to go against decentralization, but with trustless KYC/AML, we don’t just make a step towards regulation, we can at the same time guarantee users control of their own data and the power to give or revoke access to third parties,” De Vries said. “This is a first start that will help bring money from CeFi [centralized finance] to DeFi, thus allowing increased adoption leading to all kinds of innovations that are also beneficial for CeFi.”

 Ontology is one DeFi-oriented company aiming to provide risk-mitigating systems such as credit scoring and identification through its OScore system and ONT ID, a decentralized identity framework that aims to facilitate the identification of different entities in both decentralized and centralized networks.

 “Currently, DeFi is the Wild West — and providing a credit scoring system adds much more value than it detracts,” said Li. “More importantly, credit will bring real-world assets into crypto because you can collateralize something like your limited-edition baseball card as part of your credit on-chain, allowing you to borrow against it.”

 Ultimately, DeFi services are striving to replicate well-known financial products used in the traditional finance sector and in fintech, and, as the market matures, the lines between sectors could blur. 

“Fintech is merely the adoption of technology in finance, so whether it merges with [centralized exchanges and decentralized exchanges], we will see,” Li said. “I think it is better to view CeFi and DeFi as alternative roads leading to the same destination.”

Contributed by Forkast.