Why banks will have to integrate decentralized finance
Banks have been extremely hesitant to look into DeFi. Recently, the picture is changing. It should.
Decentralized finance (DeFi) is today’s biggest buzz in fintech. At first cryptocurrencies like Bitcoin enabled value transfers without intermediaries. But as new blockchain capabilities were added, an entire legion of unconventional financial applications rose. They are providing cheap and fast alternatives to everything from credit to insurance. While the impressive growth explosion in market volume is largely overblown as JPMorgan explains, DeFi will be a key component in banks’ long term efforts to stay prime financial hubs in a digital age.
Two features make DeFi so appealing: First, money becomes completely programmable. DeFi is powered by smart contracts. Those are not contracts in the legal sense but if-then scenarios coded onto a blockchain. Financial transactions are then executed automatically. Sometimes applications are even managed by decentralized autonomous organizations (DAOs), which means they are run solely by computer code with no human management or legal entity.
Second, DeFi modules can easily be combined, which earned it the nickname lego of money. The big question is: Can they also be integrated with traditional banking services, or will DeFi continue to exist as an independent system?
Banks are taking notice
Banks have been extremely hesitant to look into DeFi. They have – rightly so – put their major focus on centralized blockchains. Now the realization is dawning that DeFi can’t be ignored on the long run. Yes, centralized applications will remain the backbone of the economy, but DeFi is here to stay. It is not an alternative to classic banking, but an addition.
According to the Bank for International Settlement, at the end of 2021 big financial players have each held between 150m and 380m USD in crypto-equity. And research by BCG Platinion shows that 55% of banks and insurances are assessing DeFi applications, while 23% have already tested them. The study works with a broad definition of DeFi, but it demonstrates that crypto is gaining acceptance across financial companies.
But providing access to crypto-investments is barely scratching the surface of the DeFi potential. So some banks are already taking a deeper look into advanced DeFi applications. ING performed an in-depth analysis of Aave, a secured lending protocol based on crypto-assets. The study concludes that DeFi is not a challenge to banks but rather a powerful complement. Aave, like many other DeFi competitors, heavily relies on over-collateralization. Customers deposit 100 USD worth of crypto and can take a loan worth 75 USD. This is a fundamental difference to traditional banks, who are not simply taking funds from one customer and giving them to another. When banks issue credit it involves the creation of new money. The money loaned by far exceeds the money deposited. It is what experts call leverage.
Investments are only the first step. Banks’ target must be to become a platform or a hub that connects all financial services. The perfectly suited place for that is the gateway layer. Ergo, banks must work towards developing potent wallets that can handle crypto assets, physical assets, and all kinds of other financial services. Those few banks that succeed will stay the primary financial manager of their customers, get complete transaction data, and can extract rents from providers that connect their apps to their platform.
There is a second pressing reason for banks to actively start getting hold of the DeFi space: The liability side. DeFi heavily uses stablecoins, which are digital currencies pegged to a stable asset. Since stablecoins do not necessarily have to be pegged to fiat, but can also hold certificates of deposits or commercial paper, DeFi could end up pumping funding into banks’ balance sheets. If this happens and DeFi continues to grow at the rates it did in 2020 and 2021, a run on stablecoins could end in a funding shock for banks.
A promising target vision
Much of this is still theoretical, but some are venturing into that direction. Silvergate Bank accepts crypto collateral for loans. Moreover, it intended to be the exclusive issuer of the Diem USD stablecoin, a trimmed-down version of Facebook’s digital currency formerly known as Libra that eventually will never be issued. Another early example of what such a link between DeFi and traditional finance could look like is EQUIFI, a DeFi platform that is linked to a regulated and fully-licensed bank called EQIBank. EQIBank is a digital-first neobank and certainly built with global, crypto-affluent customers in mind, but its product portfolio shows possible routes of integration.
One the one hand EQUIFI offers classic banking services like a Mastercard debit card, but on the other customers can securitize their loan with crypto collateral. EQUIFI also offers a DeFi yield aggregator platform. Simply put, this is a machine that enables EQUIFI to automatically decide into which crypto assets to invest customers’ deposits.
The most interesting feature, however, is a card NFT offered jointly with Polka City. Polka City is a blockchain-based gaming platform. An NFT is a non-fungible token that represent a digital original, something like a unique piece of digital art - more about it here. In EQUIFI’s case only 2,000 digital pieces (NFTs) of the card were minted. Purchasers of the card NFT get the proof of ownership for this digital original, but have other benefits too. Those benefits cleverly combine the on-chain as well as the off-chain world. Holders of the card NFT are eligible for a free bank account, a debit and credit card, and they get weekly crytpo-rewards as long as they don’t sell the NFT.
On- and off-chain marketing is interwoven too. EQIBank will be placed as a virtual bank in Polkadot’s upcoming 3D NFT game. You can imagine it like a traditional Playstation or Nintendo game, only built on a blockchain. Instead of walking through the land of Super Mario or Grand Theft Auto, you walk through Polka City, a similar virtual space with one significant difference: It functions as its own economy in which you can spend and make money that also has value outside of the game universe. Hence, a benefit of the partnership for EQUIFI and EQIBank is that they get prominently featured in this game’s economy. Their brands and services will be advertised on in-game billboards. And holders of the card NFT will be able to unlock some game features and discounts.
Without banks, DeFi can’t grow either
But as much as banking will need DeFi, DeFi will also need traditional banking. DeFi can never reach the necessary liquidity by only handling crypto assets. It will have to tokenize assets from the physical world like houses, commercial property, or commodities.
The bridge between a physical item and the digital token is legally tricky. Today, in many jurisdictions there needs to be a recognized (and centralized) agent such as a notary to verify that link. It is a role not foreseen in the original DeFi ecosystem.
Another issue is usability. It has improved massively in the DeFi space, but the products are far from understandable for mass-market customers. Comprehending them requires much time and effort that most people are unwilling to invest. 69% of Americans are struggling with basic financial concepts such as compound interest. Now imagine teaching them about staking and yield farming. It will require banks to “translate” those new possibilities and ideally relegate blockchain and crypto speak to the backend, while passing on the benefits.