DeFi is eating finance: what does decentralized finance mean for financial services providers?

Use cases of Decentralized Finance

DeFi has attracted the media’s attention, especially in 2021. Nevertheless, many people are still unfamiliar with this term. Could you briefly explain what exactly DeFi is?

DeFi or decentralized finance stands for decentralized financial markets or financial services. The applications’ infrastructure is built on a blockchain. DeFi has the potential to cover a large part of the different services offered by banks.

At present, the following use cases are already in operation:

• Crypto interest products as an alternative to traditional current and fixed-term accounts
• P2P lending
• Decentralized exchanges for cryptoassets
• Derivatives and trading
• Cost-efficient payment transactions

In the financial sector, DeFi offers the entire spectrum of benefits provided by blockchain technology. All transactions can be processed globally via the internet. Another advantage is that target groups who were previously excluded from the traditional financial system can now also participate.

Which use cases are attractive for private customers?

There are several: in our opinion, crypto interest and lending products can generate significant added value. Especially lending is still too dependent on the bank’s costs and margins in traditional banking. It would be much fairer to let supply and demand drive interest rates.

DeFi can also shorten the process of granting credits to just a few minutes. Personnel and administrative costs are reduced through the use of smart contracts – this in turn would have a positive impact on the banks’ profitability.

At this point, however, I would like to point out certain risks: loans are always linked to collateral. In the case of DeFi, the collateral is often in the form of a cryptocurrency. The high volatility of this specific collateral may result in the liquidation of the position should the cryptocurrency drop in value. Currently, the regulatory framework is still insufficient in defining liability and responsibility issues in a standardized way. Probably several years will pass before the legislative “gray areas” are eliminated, even though Germany is heading in the right direction with its Electronic Securities Act (Gesetz zur Einführung elektronischer Wertpapiere – eWpG).

Aside from lending, decentralized marketplaces (exchanges) or

It is crucial that financial services providers work on educational content or enter into cooperative ventures with educational partners in order to help their private customers understand these sometimes complex issues.

Many participants in the crypto market still do not know how the technology actually works and base their decisions merely on hope without being aware of the risks. We hold the opinion that product providers clearly are also responsible for ensuring that their customers only use products that fit their needs.

DeFi democratizes the financial market

Today, banks are still struggling with huge legacy IT systems. Is this the decisive advantage of DeFi?

It’s definitely one of the major advantages. So far, innovation in the financial sector mostly took place on a superficial level. While new banking apps have radically changed the user experience, the infrastructure in the background of financial services has remained the same – owing to high regulatory requirements and switching costs. This is reflected, for instance, in high administrative costs at established financial institutions. They consider their profit margins to be “good” when they are in the low double digits. By comparison, the company MakerDAO, for example, boasted a profit margin of 99 percent in May 2021.^[1] 

Decentralized finance revolutionizes the financial system. The use of smart contracts renders expensive IT systems and high administrative and personnel costs obsolete: contracts are stored as code and executed automatically without any manual effort in between. Even complex lending processes can be implemented in this way without a third party controlling the processes.

Financial services are becoming much more affordable for customers. They no longer have to pay commissions, administrative fees or other hidden costs. DeFi is not free of charge, but it is much cheaper.

And, let us not forget that although we have already witnessed a lot of innovation in the 21st century, not all people are equally involved. Especially in developing countries, many people do not yet have access to the financial system. The journey to the nearest bank often takes several hours, and even the most basic loans are only available to a small number of people. DeFi solves this difficulty and democratizes the financial market.

How exactly should banks deal with the DeFi market? A complete restructuring of their systems is unlikely.

A look at history shows that innovation usually prevails. Our needs change almost every day. We used to buy books in bookstores, but now most Germans do so via Amazon. CDs, records and DVDs have been replaced by Spotify and Netflix. The financial world is not excluded from this development. Here, too, financial services providers must ask themselves whether they want to follow the trend. From our perspective, it would be naive to think that DeFi has no future. DeFi will not replace the banking sector within the next few years. However, banks can increase their value-added services and retain customers by using DeFi protocols or interfaces to DeFi applications.

Some European banks have started to launch DeFi projects. One of the first banks to do so is the ING Group, which is working on a P2P lending project. The aim is for smart contracts to coordinate loans. In addition, ING Group is working on a crypto custody offering.

We recommend that traditional financial services providers follow the ING model. Nobody needs to reinvent the wheel. Cooperations are an interesting lever – also for DeFi companies who gain access to a broad customer basis through partnerships.

Where is Decentralized Finance heading?

What developments do you expect in the DeFi market in 2022?

The overall cryptocurrency market has established itself as an asset class – that’s a fact. It is, therefore, subject to the usual macroeconomic factors. Current uncertainties in the market due to inflation, the question of the turnaround in interest rates and geopolitical tensions influence the crypto market and consequently the DeFi market.

However, if we take an isolated view of the decentralized finance market, a clear picture emerges: 2022 is a year of development and implementation. In addition to the leading platform for decentralized finance, Ethereum, there are more and more decentralized ecosystems around Cardano, Polkadot or Solana, which are realizing a growing number of applications and projects.

From this perspective of growth and competition, I personally see opportunities especially in projects that manage to offer decentralized applications in the financial sector in a scalable and affordable way. This step creates the necessary bridge to adaptation.