DeFi as a key development in the cryptocurrency sector
DeFi may prove to be the most important trend in the cryptocurrency market in 2022. In just over a year, the sector’s capitalization has grown from $3 billion in mid-2020 to over $200 billion in the fall of 2021. Already, blockchain technology is widely used in this market, but predictions are for decentralization on a much larger scale. So the forecasts for DeFi are very optimistic, and it’s not just about the numbers. Analysts emphasize the huge growth dynamics, innovation of solutions, but also the growing interest of financial institutions. But what exactly do we mean by DeFi?
DeFi – how does it work?
The term DeFi comes from Decentralized Finance. At the core of DeFi is the key idea of bitcoin, which is to create an e-money system based on a decentralized peer-to-peer network. Financial tools and applications that make up DeFi run on a blockchain network (usually Ethereum) equipped with smart contracts. Thus, all contracts are defined and executed automatically using the code written on the blockchain, so that a service can be provided without intermediaries.
This means that users can exchange, for example, cryptocurrencies and make other transactions without the intermediation or control of third parties. The process is fully automated and decentralized, and the blockchain provides it with a high degree of security and reliability from the technical side. DeFi is also a solution that meets the need for anonymity – to participate in transactions, you do not need to verify personal information.
Tokenization and DeFi
In the context of DeFi, the topic of tokenization should be mentioned, which is giving a digital form to objects of a certain value. Tokens can be assigned to projects, companies, real estate, etc., but also to different types of assets. Tokenized financial instruments operating under DeFi are of course created using smart contracts, so they are quite safe. The use of tokens eliminates a lot of formalities, facilitates the transaction and ensures its full transparency. Another issue, of course, is the lack of guarantees for such instruments, unless they operate within the current legal framework.
DeFi as an ecosystem of financial services
DeFi is a technology that can be used to build a whole ecosystem of financial services with invaluable advantages such as openness, wide and equal accessibility, transparency and full control of users over their money and other assets. A key advantage is also a significant reduction in costs, as self-service operations using a decentralized application (DApp) are sufficient to operate smart contracts. Making a loan, buying insurance, trading assets or making payments – these and other financial operations can be performed in a peer-to-peer model, directly between stakeholders. In this model, the number of parties to the transaction is greatly reduced, making it simpler, faster and cheaper.
Transfer of various financial operations to the system based on blockchain is to be comprehensive. The idea is to create an ecosystem of financial services, which will be completely different from the traditional system in terms of assumptions and technology, but which will perform similar functions and meet the same needs of customers.
What is more, DeFi will allow to create not only the already known financial products that will operate in a decentralized manner, but also completely new products. The potential for their creation is enormous, because the DeFi specific features (e.g. programmability, easy composability) are conducive to creating innovative services of very different nature.
Dizzying digitalization of the financial sector
Banking institutions have been investing heavily in the development of digital services for years and the pace of these processes was definitely accelerated by COVID-19 pandemic. It is worth mentioning that it is Poland where a lot of innovative solutions are being created by fintech industry for banks.
The priority is the user experience (UX), which refers to the speed and ease of performing various operations, including opening a bank account (e.g. selfie account), concluding credit agreements (e.g. with 1 click in the application), making payments (e.g. with a smartphone or smartwatch or virtual payment card), etc. Digitalization of the banking sector also involves automation of internal processes or application of solutions for high personalization of services.
In addition, about 90 countries are working intensively on digital central bank currencies (CBDC), which, however, cannot be equated with cryptocurrencies, as they are to remain under the full control of central banks.
Old meets new
So, a lot is really happening in the financial sector on the topic of digitalization, but banking and payment institutions, etc. need to go a step further. Modern technologies such as blockchain and DeFi have a considerable impact on the perception of traditional financial structures and instruments – they often emphasize their conservativeness, cost inefficiency and too long time of performing operations. It is expected that DeFi protocols will be more and more effective in forcing changes in standards or parameters of products offered by banks. Already in the near future, new trends may redefine financial markets to unlock greater value and respond to customer expectations.
The traditional financial sector and the decentralized one can and should intersect, exploiting their advantages. This will create enhanced products based on the most efficient, reliable technology solutions. Ultimately, a universal, global, more efficient and decentralized financial management space will take shape, and thus a more open digital economy.
Those entities that join the DeFi ecosystem at the very beginning of the process and embrace the area of stockenized assets will gain direct access to global, non-stop financial markets. In turn, decentralized finance will gain the capital necessary for development, access to a huge number of users and legitimacy in the eyes of more cautious market participants.
How can financial institutions leverage DeFi?
But how specifically can the traditional financial sector take advantage of the new approach to finance? Experts see many areas where financial institutions and DeFi can successfully combine. These include, in particular, guaranteeing access to digital assets (storing cryptographic keys), tokenization of various types of assets, e.g. works of art or real estate, and linking to fiat currency (or possibly CBDC) systems. Banks’ customer service services, which are not provided at all under DeFi, may also be of great importance. As a side note, we should add that big opportunities are also opening up for the insurtech industry, e.g. in the area of digital asset protection.
The first attempts to use the potential of DeFi by banking and payment institutions are already being made. A great example of well-thought-out actions is the cooperation of a Swiss bank Incore and fintech Crypto Finance Group. Thanks to the cooperation a new token standard has been created that supports compliance with AML (Anti-Money Laundering and Countering the Financing of Terrorism) regulations. The next step is expected to be for the bank to make DeFi and cryptocurrency services and products available. Other banks that operate in this area include State Street, BNY Mellon, Goldman Sachs, Societe Generale or Sygnum. In Poland, the implementation of similar services is considered by Citi Bank or BNP Paribas Securities Services. Various projects based on DeFi are being or will be implemented by ViSA or PayPal. There are also international projects such as Financial Stability Board, which aims to develop an efficient global payment system based on blockchain.
Merger of DeFi and Metaverse – opportunities for financial sector
Interesting opportunities for the financial sector may also be offered by Metaverse – a space of virtual reality in which the user using an avatar leads an alternative personal and professional life. The idea will be tested in time, but brands such as Nike and Gucci are already planning to expand their product range with digital products that can be purchased for their avatars. Transactions made in the Metaverse will be able to involve virtual as well as real products or services, which opens up possibilities for a variety of industries.
The implementation of the plan requires not only the provision of an efficient technological infrastructure, but also the preparation of solutions that will allow safe, fast and easy financial operations in a new type of space. The natural solution for Metaverse is precisely DeFi and NFT tokens (non-convertible tokens). These 3 elements support each other and all use blockchain technology. Tokens can be used as a means of payment for trading on the Metaverse, and they can be purchased on the DeFi network, which creates the appropriate infrastructure for financial transactions in the virtual world. Keep in mind that NFT tokens are not only a means of payment, they can also be traded in the real world.
One thing is certain – the development of Metaverse will pose a huge challenge for the financial industry, which will have to meet new user needs. The consumer market will force a significant acceleration of the digitization of assets, and it should also become easier to combine digital assets with traditional forms of financing.
DeFi – threats and challenges
DeFi has a huge potential to radically change the world of finance. However, it should not be forgotten that it is a very young, complex ecosystem in which products and services with significant risks are made available. Various issues concerning technological, operational, financial and legal layers are problematic. One of the basic conditions for the success of the project is the introduction of proper regulations that will provide decentralized finance with legal certainty and enable effective risk management in the new environment. Numerous regulations have already been adopted at the level of EU and national law, and the intensified debate on consumer safety in particular is still ongoing.
For the success of the “revolution” it will be crucial to understand how DeFi works, the opportunities and risks it brings (for users, the financial industry and the economy in general) and to act on this knowledge. Banking institutions should especially care about this, because it may determine their “to be or not to be” in the new global financial reality. The benefits generated by the decentralized financial system and digital economy based on it are too significant to be ignored by the world.
DeFi issues will be one of the main topics of the 11th FinTech & 10th InsurTech Digital Congress, which will be held on March 23-24, 2022 at the Westin Warsaw Hotel and online.
The congress framework program and tickets are available on the event website.
11.FinTech & 10.InsurTech Digital Congress is an elite forum for exchanging ideas and forming strategic partnerships. Experts of the forum present the latest trends in technologies of the financial and insurance sector, which can have significant implications for the development of many industries. Previous editions of FinTech & InsurTech Digital Congress were very successful, bringing numerous participants closer to the most current issues concerning, among others, opportunities and threats of the digital world, blockchain technology and AI, new business models of banks and many others. The Congress has become a permanent part of the FinTech industry calendar in the region.
The article was written in cooperation with FinTech & InsurTech Digital Congress
