Recently, the finance sector has been driven forward by the explosive growth of digital transformation spurred on by challenger banks and innovative technologies. Despite this, many of these transformative applications of financial technologies – such as decentralised finance (DeFi) within the crypto and blockchain communities – have been viewed as outliers, rather than banks.
However, recent research indicates that traditional finance interest in DeFi is increasing rapidly. Last year alone, the quantity of DeFi wallets grew from 100,000 to 1.2 million, while the number of crypto wallets increased to 200 million worldwide.
It’s clear to see that cryptocurrencies are working their way into the mainstream, driven by changing customer demands and expectations. With the likes of Visa moving to allow cryptocurrency to complete transactions across its payment network, the argument for a newer financial model is growing. In turn, this could provide traditional financial institutions with an opportunity to bridge the gap between ‘fringe’ technologies and financial services.
Despite the growing popularity, much remains to be done before the adoption of DeFi becomes the norm in finance, with challenges around security and regulation highlighted as the biggest stumbling blocks. We must properly address these security concerns as an industry, in order to grow the adoption of decentralised finance, and for traditional financial institutions to recognise its benefits.
The opportunity DeFi presents
Naturally, there is some amount of scepticism in switching to DeFi, given that the current centralised business model already in place is effective. Having said that, decentralised finance is making its way into a variety of simple and complex financial transactions at a rapid rate. Financial institutions are under growing pressure to adopt the DeFi, with a number of businesses either considering, or launching crypto services as a long-term alternative, or at least in addition to the services offered.
Annually, the financial services already invest roughly $1.7 billion in blockchain services, but the impact is restricted by regulations and low levels of liquidity.
Nevertheless, financial institutes have an opportunity to boost their competitiveness in today’s digital business environment, by entering this field and creating a differentiated and profitable offering that results in winning expansive margins.
An advantage to the adoption of decentralised finance is overcoming the many hurdles in accessing financial applications, for individuals and organisations that could not access them before. Additionally, its decentralised nature removes the need for a trusted mediator, resulting in streamlined banking processes.
DeFi also has the potential to tackle challenges that traditional finance models face. As an example, bringing substantial benefits to those economies that possess less established traditional finance services, subsequently better supporting small and medium enterprises (SME).
Centralised financial models tend to favour institutions with larger balance sheets, with the focus on helping them pursue partnerships with business of a similar size to ultimately increase shareholder value. However, this is unattainable for SMEs due to capital and therefore cannot benefit in the same manner.
The next wave of demand for capital and financial services is most likely going to come from those that do not derive the benefits of traditional finance models, in emerging economies and SMEs. Going forward, DeFi adoption can offer better opportunity for growth and remove such barriers.
Challenges: Security and Fraud
Inevitably, as with any new technology in the financial industry, there are concerns around its security. However, for DeFi the most significant challenge barring its widespread adoption is smart contact risk.
Fraud remains a considerable concern with close to three-quarters (70%) of organisations claiming that security and fraud are preventing company-wide DeFi adoption. While many financial institutions have fraud risk, there is a reluctancy to add further exposures through DeFi.
DeFi’s digital nature means that often an attack will come in the form of exploiting bugs in its code and the manipulation of external feeds for assets within protocols.
Unfortunately, events of this manner already occurred last year; most notably, $72m worth of assets from smart contracts being stolen from the Decentralised Autonomous Organisation (DAO) and DeFi lending platform bZx being attacked. This resulted in the oracle price of collateral being altered. Critics of cryptocurrencies highlight both incidents as a reason to not consider its adoption.
Having said that, both attacks have been extremely valuable in helping to prevent future incidents by better addressing and understanding the challenges facing DeFi, having exposed new vulnerabilities in the system.
In fact, the ongoing threats DeFi will face sparks a proactive approach amongst developers and security professionals to improve security, to identify and prevent flaws before cyberattackers can strike. And as with all digital technologies, as DeFi matures, security will improve and in due course will match – or even succeed – the security of centralised models.
The future of financial technology
Wider adoption is growing and DeFi is now receiving international recognition, with payment providers such as PayPal joining the likes of Visa by expanding their cryptos offering as a payment option at checkout.
At the same time, for DeFi to be adopted on a larger scale, businesses must have full confidence in the financial model, which will only be achieved when progress has been made around issues like security. Thankfully, there are well established experts within the crypto and blockchain community that can assist financial institutions in bringing DeFi into their offered services.
Both financial institutions, and the crypto community should continue working together to create a new generation of governance, to make finance and economic welfare more accessible.