• Kaj Burchardi, Managing Director at BCG Platinion


• 07.05.2021 05:45 pm
Cryptocurrencies , DeFi

For some time now, challenger banks and innovative technologies have ignited an explosion of digital transformation in the finance sector. However, the most transformative applications of financial technologies – such as decentralised finance (DeFi) within the crypto and blockchain communities – have been viewed as outliers, rather than something traditional banks should adopt.

Despite this, our most recent research shows that traditional finance interest in DeFi is increasing at a rapid pace. Last year saw the number of crypto wallets increase to 200 million worldwide, while the number of DeFi wallets grew from 100,000 to 1.2 million in 2020 alone.

With Visa now allowing cryptocurrency to complete transactions across its payment network, it’s clear that DeFi is becoming more mainstream as a result of changing customer demands and expectations. Consequently, the need for a newer financial model is growing, providing financial institutions with an opportunity to bridge the gap between the ‘fringe’ technologies, such as crypto and blockchain, and financial services.

However, in spite of its growing popularity, much remains to be done before DeFi adoption becomes the norm, and challenges around security and regulation are proving to be the biggest stumbling blocks. In order to grow the adoption of decentralised finance and traditional financial institutions to recognise its benefits, we must properly address these security concerns as an industry.

Why DeFi?

With an effective centralised finance model already in place, there is of course scepticism in switching to DeFi. Having said that, decentralised finance is rapidly making its way into a variety of simple and complex financial transactions. An increasing number of businesses are either considering, or launching crypto services as a long-term alternative, or at least in addition to the services offered. This is creating growing pressure on traditional financial institutions to adopt the DeFi market.

The financial services sector already invests roughly $1.7 billion in blockchain services per year, but due to regulations and low levels of liquidity, this has had a limited impact. Nonetheless, financial institutes still have an opportunity to enter this field to boost their competitiveness in today’s digital business environment. This includes winning expansive margins that come with a differentiated and profitable offering.

A big advantage of adopting cryptocurrencies is that it overcomes many of the hurdles in accessing financial applications, for both individuals and institutions that could not access them before. In addition, its decentralised nature removes the need for a trusted mediator, resulting in streamlined banking processes.

DeFi also has the potential to address challenges that traditional finance models face. For example bringing considerable benefits to economies in countries that have less established traditional finance services, which in-turn will better support small and medium enterprises (SMEs).

Furthermore, centralised finance services tend to benefit institutions with larger balance sheets, with a focus on helping them pursue partnerships with similar sized businesses to increase shareholder value. However, due to capital this is unattainable for SMEs and therefore cannot benefit in the same way.

Going forward, the next wave of demand for capital and financial services is likely going to come from emerging economies and SMEs, that do not derive the benefits of traditional finance models. DeFi adoption can help to remove these barriers and offer better opportunity for growth.

Tackling security and fraud       

Inescapably, as with any technology that concerns finances, there are worries around security, where arguably the most significant challenge to overcome in DeFi is smart contact risk.

Fraud remains a considerable worry with close to three-quarters (70%) of companies highlighting security and fraud concerns as the obstacles preventing company-wide adoption of DeFi. Many financial institutions have fraud-risk but are reluctant to add further vulnerabilities through DeFi.

The digital nature of DeFi means that the most common method of attack comes in the form of exploitation of bugs in its code and the manipulation of external price feeds for assets within protocol.

This already occurred last year, with $72m worth of assets from smart contacts being stolen from the Decentralised Autonomous Organisation (DOA) and DeFi lending platform bZx being attacked, resulting in the oracle price of collateral changing. Critics of DeFi highlight both incidents as a reason to not consider its adoption.

The financial future

DeFi is now receiving international recognition and wider adoption is growing, with payment providers such as PayPal joining Visa by expanding their bitcoin and other cryptos offering as a payment choice at checkout.

However, in order to achieve wide scale adoption, progress around issues like security need to be made to give businesses full confidence in a DeFi model. Thankfully, the crypto and blockchain communities are well established and have experts who can help finance institutions bring DeFi into their offered services.

Financial institutions should continue their work with the crypto community, to create a new generation of governance that boost accessibility to finance and economic welfare.