As I write this, the crypto market is going through a period of very strong turbulence. While volatility may spark some concerns, an interesting aspect has emerged from the crypto world, which is starting to be acknowledged by financial institutions – decentralized finance (DeFi). Banks and financial services institutions have noticed the benefits DeFi has to offer for good reasons.
If the main goal of cryptocurrency is to be the store of value, making smart contracts and payments accessible to all people, DeFi takes this to another level entirely. If you’re new to the world of DeFi, picture a banking alternative that takes all the financial services—loans, savings, trading, and more—and makes them available to everyone while eliminating the time-consuming paperwork surrounding it all. That’s DeFi and it’s the antithesis of the banks we all grew up with. A full-service bank without any KYC/AML.
What makes DeFi work?
One of the underlying elements enabling DeFi is blockchain, which not only records the history of transactions but establishes trust, accountability, and transparency throughout the process. Blockchain builds trust because it is completely public, and anyone can see and inspect it if they choose to. This trust is vital because it’s a quality that many financial companies are desperately lacking as of late. According to Edelman’s 2021 Trust Barometer, only 53 percent of people trust the U.S. financial companies. That represents a decline of five percent from 2020.
A second key ingredient of DeFi is the smart contract, which is a self-executing contract that includes the terms of the agreement between the two parties. However, unlike the contracts most of us are familiar with, the terms of a smart contract get written into lines of code. After the borrower agrees to the terms, the code is placed on the blockchain where the borrower’s cryptocurrency is locked away until the transaction gets paid back in full. It’s that easy, and execution takes mere minutes without ever having to exchange personal information or review credit scores.
DeFi: Appealing to small and medium-sized businesses
Ease and speed are two words not often associated with banks and financial services companies, which traditionally small and medium-sized businesses (SMBs) turned to for loans, savings, trading, and similar services. However, with banks and financial services companies becoming increasingly more risk-averse, SMBs have been quick to look into new options like decentralized lending platforms such as Dharma, which is built on Ethereum.
Using Dharma, a business has the freedom to choose the terms of the loan. This includes the type of asset, collateral, and the duration. The asset could be cryptocurrency or something else thanks to services such as TrustToken, which can be used to create asset-backed tokens. Now the asset could be real-estate, a piece of art, or company shares. The lender then submits their preferred terms, and if the sides agree, the transaction happens immediately. Until the loan is re-paid, the principal becomes a smart contract.
Volatility concerns
The benefits cryptocurrency created are clear, but one must acknowledge the volatility the crypto market is facing. According to Forbes, the crypto market was down about 27% this week. Every market fluctuates, and while it's important to be aware of the risks, it's worth looking into the rewards and assessing the value on an institutional level. In a recap of this week's market drop, Business Insider echoes the sentiment of why the historic drop should not cause too much concern.
Is DeFi the future of finance?
While trust dwindles for these traditional entities, momentum around DeFi is skyrocketing.
According to articles in Cointelegraph and CoinJournal respectively, users put nearly $40M billion into DeFi apps as of February 2021, which was up from $14.3 billion at the end of 2020. As of May 14, analytics and rankings hub DeFi Pulse reports the number has surpassed $86 billion.
It’s numbers like these that have vaulted DeFi onto banks and financial services companies’ radar. In fact, we see this at Virtusa. Many of our traditional banking and financial services customers have taken notice of DeFi. Naturally, there is some hesitation to expand beyond the tried and true practices, but we have helped them recognize the benefits that are too big to ignore.
By integrating DeFi into their model, banks can become more impactful by serving the needs of small and medium enterprises (SMEs). Many SMEs lack the capital to leverage a bank or are based in regions where the financial sector does not have the resources to truly be of assistance; some face both of these challenges.
We are finding through our conversations that banks and financial services companies recognize this struggle and how, through DeFi, they can access powerful new resources. Tapping into these resources will allow them to better serve the companies that need it most and win back the trust that’s so vital. By doing this, they will also usher their own business into what many are calling the era of Web 3.0, a turbulent future characterized by an abundance of learning and opportunities.