Could Decentralised Finance be the banks of the future?
DeFi has been exploding over mainstream media lately and people flood into the market. It appears to offer very similar services to banks and maybe even more. Posing the question, could it actually replace banks?
To determine this lets first look at the roles of banks currently and then we will take a deep dive into DeFi, it’s pros and cons and whether it could actually replace banks.
There are two types of banks, a commercial bank and a central bank. A commercial bank put simply, acts as a functional intermediary between classes of savers and borrowers collecting cash deposits and creating lines of credit where they lend out borrowers’ money at interest which lenders then repay with interest. A central bank is one that manages a country’s currency, their money supply, interest rates and oversees the integrity of the commercial banking sector as a whole.
Since 2019, Decentralised Finance or better known as “DeFi”, has been trying to do all of that and more, completely online. Blockchain based DeFi lending projects such as MakerDao, Aave and Compound have been acting as direct competition to the traditional banking system.
CoinMarketCap estimates the market cap of DeFi tokens has grown to US$142 billion as of May 2021. The chart below shows the exponential growth of DeFi tokens in the past 9 months.
The market capitalisation and exponential growth is something not to be ignored and shows that consumers have trust in DeFi. Are they looking to it as alternative? So, what is DeFi? And could it really replace banks?
DeFi
Decentralised Finance, more commonly known as DeFi, is a blockchain based form of finance that is can be accessed by anyone with an internet connection. The markets are global and operate 24/7 without a centralised authority and have automated services using cryptocurrencies and smart contracts that previously were subject to human error. Most DeFi projects are built on the Ethereum platform and consists of Lending platforms, cryptocurrency exchanges, stablecoins and prediction markets. Lending platforms such as Aave, Compound and MakerDAO, work similarly to a bank in the sense that lenders will put their cryptocurrency into a liquidity pool locking it up in return for an interest rate. The platform will then take a borrower’s cryptocurrency as collateral, and provide a loan generally issued in a stablecoin with little interest to repay. The Platform incentivises lenders by rewarding them for locking up their crypto with the platforms native cryptocurrency which increases in value the more it is used. So, as the platform becomes more popular, lenders become wealthier, these tokens can then be sold on the secondary market. Decentralised exchanges, such as UniSwap or PancakeSwap, work much like a forex market and allow users to trade cryptocurrencies. However, the currencies are usually pegged to a stablecoin such as USDT or USDC, not a fiat currency. Prediction markets allow users to bet on the future of the market. It can be seen that DeFi operates very similarly to traditional finance and shows that the cryptoeconomy is on the rise using blockchain technology to help pave the way.
Benefits of DeFi
DeFi creates open financial platforms that enables greater levels of innovation and competition. It allows for seamless transactions and uninterrupted interoperability, meaning anyone can transfer capital across almost any platform in a matter of minutes generally costing very little. Something unheard of in the traditional banking sector. Other benefits are that smart contracts can be programmed to include any terms the parties want, instilling complete trust, and can be executed autonomously without the need for intermediaries. The ability to cut out intermediaries allows for higher yields for savers and lower costs for borrowers. Additionally, these transactions are non-custodial and are completely transparent, with the data being stored on the blockchain.
However, arguably the biggest benefit of DeFi is its permissionless nature that promotes financial inclusion, banking the unbanked. In 2017, the World Bank Group stated that 1.7 billion people globally did not have access to a bank, making an obvious use case for DeFi. It allows anyone with an internet connection to access the functions of a traditional bank completely online with minimal barriers to entry. These platforms do not require identification or a credit score yet provide collateralised cryptocurrency loans at particularly low interest rates.
Moreover, there are numerous developing countries whose financial systems are failing, and citizens are subject to hyperinflation. These residents are looking for an alternative to their traditional systems to retain value in their money and to transact day to day. Turkey’s uptake in DeFi, for example, has been so great that the government has had to ban the use of cryptocurrencies to pay for goods and services to force citizens to use the Turkish Lira. However, DeFi does not only undermine the financial infrastructure of developing countries. Bank of America thinks that DeFi is the most fundamental challenge for modern finance. MakerDAO is a great example of this, last week they bridged real world assets and crypto assets, collateralising residential property to issue a loan in their native stablecoin Dai. This has never been done before and banks are incredibly concerned about projects like MakerDAO. It can now be seen that DeFi is a force to be reckoned with and is here to stay. However, this does not mean that it is all smooth sailing, there are some serious risks and issues that DeFi faces.
Risks of DeFi
There is obvious risk to DeFi such as human error, paying too much in fees, losing or giving away your private keys. The immutability of smart contracts also poses risks as people do not realise their finality, once executed it is close to impossible to undo. Moreover, due to its autonomous nature DeFi platforms does not have much in the way of customer support and it is largely user beware platform.
Additionally, fraud is a serious risk and a recent example of this is SafeMoon, a get rich quick pyramid selling scheme promising high rewards that penalises those that sell the cryptocurrency. So much so that when buyers went to withdraw, they were lucky get back their initial investment. Due to the cryptocurrency market being an extremely volatile place there are market and liquidity risks. During massive price swings users in liquidity pools may not be able to access funds due to lockups or be penalised substantially if they wish to withdraw. Moreover, the Decentralised Apps (DApps) that DeFi platforms run on have not been tested rigorously and it’s unsure what will happen for some of them during unpredictable market conditions. Take MakerDAO’s black swan event for example, due to high market volatility causing congestion on the platform errors arose causing users to lose US$8.32 million.
However, probably the most looming risk of DeFi is its ability to completely undermine any regulatory approach to cryptocurrency or blockchain space. Pseudonymous usage means that important laws like Anti-Money Laundering (AML) or Counter Terrorism Financing (CTF) cannot be enacted. The Financial Action Task Force (FATF) is an intergovernmental watchdog and known for countering global money laundering and terrorism financing. It recently mandated all DeFi projects implement some form of Know-Your-Customer (KYC) verification to aid them. The issue with this is that FATF’s jurisdictional reach is limited, and it is extremely easy for DeFi projects to operate outside this. The major issues here are that there is no one to hold accountable for wrong doings.
Does DeFi pose a significant risk to banks?
Clearly there are some great benefits to DeFi and can offer some new and improved financial services. However, it is a hard to navigate space and the average person is a serious risk of losing money. This shows that DeFi on its own is probably not ready for Mainstream yet. It is important to note that traditional banks have one major advantage over DeFi. Banks have spent decades understanding markets and how to react under pressure, they have built reputations around trust and reliability. DeFi projects on the other hand are extremely nascent in nature and are at risk of unforeseen technical issues along with unforeseen market developments and do not have a reputation as a safe space. So, maybe a better way of look at whether DeFi can place banks is rather a statement that suggests that DeFi and Banks could benefit each other handsomely. If banks were to interoperate with DeFi creating a more collaborative space this could being the added support and knowledge that banks have to the incredibly advanced technology that DeFi has. Creating interoperability between banks and DeFi would require compliance with regulators which would be a major challenge to this space but would ultimately result in the best experience for the users. This is farfetched and could potentially never happen as DeFi was created as a way to operate without the need for traditional financial institutions.
Conclusion
In conclusion, it can be seen that DeFi is expanding at an exponential rate and is something that banks can hardly keep up with posing some serious threats to the industry as a whole. People/teams are taking it upon themselves to cut them out completely and craziest part is no one can stop them due to their decentralised nature. Additionally, due to the level of anonymity online it would be hard to even find who created the platform and near impossible to tie them to a jurisdiction. The level of disruption and the increasing adoption mean that banks cannot ignore this and will be required to address this issue or be left behind. There will either be a level of interoperability between the two or DeFi may become the new norm for a large part of the world. Nevertheless, DeFi is going to be a very interesting place to watch in the coming years.