Blockchain is back in the spotlight. After the introduction of bitcoin a decade ago, banks are now being challenged by the emergence of a new decentralized financial ecosystem.
In the early 2010s, the media started talking about cryptocurrencies, and the term “bitcoin” first found its way into the mainstream. These digital assets, secured by cryptographic algorithms, bypass traditional banks and move outside the financial system.
Faced with a boom in digital assets, central banks have begun experimenting with central bank digital currencies (CBDCs), cryptocurrencies backed by fiat. This shift reflects a level of maturity that explains, in part, the simultaneous emergence of an ecosystem built around decentralized finance, also know as DeFi.
As the term suggests, DeFi draws on the principle of decentralization inherent in cryptocurrencies and applies it to the entire finance ecosystem. Currently, banks serve as the custodian of funds and organize various exchanges on behalf of their customers. Banking services, such as credit, loans, or insurance, are therefore centralized. Partners and intermediaries have to be paid and have access to these services, and one has to meet the required criteria and have time to invest.
Decentralized finance eliminates the need for intermediaries and, depending on the product, provides access to highly competitive returns. The idea behind DeFi is to offer everyone direct access to the financial system. No account is required, access is fast, and everything is permissionless.
By its nature, a public blockchain offers transparency and gives users more agency over their data. This makes it likely that certain consumers will move away from the current system, where they have less control. DeFi provides an enticing alternative to banks by offering both classic and more innovative services and extending access.
Decentralized finance is relatively new, and it has limitations that must be understood. This approach to offering financial products and services is based on a technology that represents a yet-to-be-regulated sector, one that lacks oversight and offers no recourse in the event of a problem. Hence, there are challenges posed by this new system:
- User protection. When banks act as the intermediary, they offer their clients security guarantees. Since DeFi has no central body, it presents security and fraud risks. According to CipherTrace, between January and April 2021, $156 million was stolen in DeFi-related hacks, not to mention numerous scams and unfixable user errors.
- Stability. DeFi runs on cryptocurrencies, and this represents a breaking away from central banks, which in turn raises the question of stability in the monetary value of the currencies in use. As we have seen recently with bitcoin, these cryptocurrencies are often subject to extreme volatility.
- Regulation. The current financial system is heavily regulated in terms of data protection and transaction security. DeFi currently falls outside of these regulations for various reasons because, despite the ever-increasing growth, this sector is still relatively unknown to the general public. Although it’s tempting to cut out intermediaries, they do offer important guarantees.
DeFi and the future of banking
If you consider the speed at which central bank digital currency projects are running, the era of cryptocurrencies could arrive faster than many people imagined. For banks, it is not a question of rejecting decentralized finance or spending a lot of time focusing on it. But in the short term, one possibility could be to simply get exposure to it as you would any other emerging market.
The popularity of DeFi, whose total locked value (TVL) has increased an eye-popping 88-fold in one year, already indicates that many customers are looking for a more flexible, beneficial, and less controlled system. DeFi faces an educational gap, challenges with implementation, and a poor user experience. But it does signal an important change in the financial services industry, and it’s a change worth paying attention to.