Cointelligence is proud to present this article written by our CEO On Yavin and Chief Editor AJ Reardon. It was recently published in the Journal of Digital Banking, Volume 5, Number 3 Winter 2020-21. Due to the long lead times in academic journal publishing, the article was written in mid-2020, and of course the DeFi industry has continued to grow and change since then. However, the core takeaways of the article remain the same.
Introduction
Decentralized finance, or DeFi, has become a popular buzzword, especially with proponents of distributed ledger technology, blockchain, and cryptocurrency. Just as cryptocurrency was designed to ultimately take control of money away from governments, DeFi aims to take control of personal finance away from banks and investment firms.
But do customers really have to look to DeFi to get the solutions they need and want? And should banks see DeFi as an enemy, or as a source of inspiration? In this article, we aim to propose that banks can incorporate elements of DeFi into their current and future digital platforms, and that many customers may be best served by staying with a forward-thinking financial establishment rather than embracing a fully decentralized model.
Currently, DeFi does not seem like a big threat for major banks. Many of its ideas are now in the development stage, with providers still trying to get the proper licensing to bring their solutions to market. And early adoption is primarily limited to decentralization die-hards, or people dabbling in DeFi while still keeping the majority of their funds with traditional institutions. It will take some time for DeFi providers to reach a point where they have been established long enough and provided reliable enough service that they can lure the average consumer away from the bank they’ve been with for years or even decades.
However, just because something doesn’t seem like a threat currently doesn’t mean that it’s not worth watching out for. Blockbuster Video thought Netflix was a joke when they first launched, and now one is obsolete while the other is producing award-winning shows to rival those on premium cable networks. If Blockbuster had tried to adopt Netflix’s distribution model early on, they might still be a major player in entertainment.
Currently, customer satisfaction with traditional banks is actually pretty high. Perhaps due to improvements in digital banking offerings and customer service. JD Power and Associates found that in 2020, US customer satisfaction for retail banks was up 11 points from 2019, to 833 out of 1000 points1. A 2019 survey by Statista for UK banks showed that of the 22 banks surveyed, customer satisfaction ranged from 58-86%, with most banks receiving a score in the 70% range2.
If banks want to maintain this upward trend of customer satisfaction, they need to continue to innovate and provide customers with what they want, when they want it. One of the big draws of DeFi, besides granting people more control over their money, is the idea that it will speed up all financial processes. We live in an age of high-speed downloads, same day Amazon deliveries, and on-demand streaming of our favorite television shows. In this atmosphere, people are not content to wait days for a money transfer or a loan approval.
What is Decentralized Finance?
Many in the digital banking industry may already be familiar with the concept of decentralized finance, or DeFi. However, for those who have not yet encountered the technology or would like a refresher, we’ve prepared a brief introduction.
Decentralized finance refers to a category of online financial platforms where one or more function is managed via smart contracts or other decentralized, blockchain-enabled, automated processes, rather than by a centralized system. However, as of this writing there is no DeFi platform which is 100% truly decentralized. Each one still involves some degree of centralization in one or more aspect of its management.
DeFi platforms are built on a blockchain. Currently, Ethereum is the most popular protocol for these decentralized apps (aka dapps), and the fact that the majority of DeFi dapps are built on Ethereum makes it very easy for users to mix and match them in order to create a single dashboard to handle all of their financial instruments. This modular nature leads to proponents of the technology to call it “money Lego.”
A thorough explanation of blockchain technology and smart contracts is outside the scope of this article. In the simplest of terms, however, smart contracts use “if this, then that” logic to manage operations autonomously. In terms of the financial world, this might express itself in the form of automated payments: “If 1st of the month, then make rent payment to landlord”, although many other more complicated systems are possible, using multiple smart contracts to determine the disbursement of funds.
The Promise of Decentralized Finance
The aim of decentralization is to take control away from the establishment. Whether that establishment is a national government, regulators, or a centuries-old bank, proponents of decentralization see institutions as inherently corrupt, and believe that people deserve greater freedom of how they store or spend their money. They also believe that the layers of bureaucracy slow things down to a pace that is not congruent with modern life, making it too difficult to send money across national borders or secure a loan to take advantage of a narrow window of opportunity.
Although customer satisfaction with banks may be up in general, critics of the financial industry are not entirely without merit. From the Experian hack in 2017 to Wells Fargo and other banks being caught opening bank accounts for customers without their permission in order to make sales quotas3, the financial industry has done a lot to lose consumer confidence in the 21st century.
And current bank customers may not even be the primary target audience for DeFi platforms. Many DeFi solutions are looking to engage with the unbanked or underbanked -- people who currently have limited access to traditional financial services. This includes those in developing countries, rural areas, and people working in shadow economies.
The Current State of DeFi
Although there have been some exciting developments in DeFi, it is so far failing to live up to its grander promise. Despite being intended to bank the unbanked, for the most part DeFi products require one to already have cryptocurrency, and to have cryptocurrency, one must often have access to a bank in order to use fiat funds to purchase cryptocurrency.
MakerDAO is usually held up as the best example of operational DeFi products. The platform has been live since late 2017 without any malfunction or shutdown, despite a 95% drop of the price value of their collateral. On the other hand, DeFi platform bZx was attacked twice within a single week in February of 20204, showing that there are still serious vulnerabilities in this new technology and that not every platform is properly equipped to protect users’ assets.
Another example of a DeFi project is ConsenSys Codefi, which has enabled tokenization of real estate in both the UK and Europe. Their Daisy product also allows companies to easily accept cryptocurrency for subscriptions, usage fees, and other payments, which makes it much easier for people to use cryptocurrency in “real world” applications.
Some DeFi projects have made it easier for people to gain access to investment products, via synthetics. This has made investment strategies that were previously only available to the elite now available to people of more modest means.
And thus, DeFi remains primarily a tool of the privileged -- those who not only already have assets, but have them in a bank account and have enough assets that they can tie some up in cryptocurrencies, which are currently not viable to pay most expenses (for instance, very few landlords or utility companies will accept crypto payments). Plus they have to be willing and able to risk their assets on a platform that may not be as secure or stable as it is presenting itself to be.
How is DeFi Already Being Used By Banks?
Many banks and financial institutions are already adopting DeFi concepts. Smart contracts are being utilized to make financial transactions faster and more efficient, but primarily by investment banks. So far, retail banks have been slow to adopt blockchain-based solutions, perhaps due to regulatory red tape and perhaps because the demand does not yet justify the cost.
Some retail banks and businesses have partnered with Ripple for crypto and fiat money transfers on the blockchain5, although many of these announced partnerships have failed to result in actual implementation. Other banks, such as JPMorgan, have experimented with creating their own digital currencies6, or using blockchains for specific contracts or transactions. These do not necessarily represent a truly decentralized financial transaction, though, but rather a centralized application of a technology originally designed for decentralized use.
For the most part, we only find DeFi being offered by decentralized start-up banks, in the form of crypto lending and other cryptocurrency-centric offerings that will have limited real-world applications until we see mass adoption of digital currencies. Many of these banks and investing platforms are not even yet operational, still waiting on the receipt of their banking license or other regulatory permissions that would allow them to legally begin operations.
For retail banks, we’re seeing a bit of a chicken-egg situation. Banks won’t adopt DeFi concepts until there’s a demand for it, but most customers won’t be interested until they know about the possibilities. Once we reach a critical tipping point where cryptocurrency, DLT, and DeFi are gaining acceptance, we will likely see more rapid adoption, and those banks which were already investigating the possibilities and deploying them on a small scale will be poised to take advantage of sudden increased interest.
What are the Benefits of DeFi and DLT?
The banking industry as a whole stands to benefit from the adoption of blockchain technology and DeFi concepts. Ultimately, the streamlining and automation of many processes that currently require manual processing would save both time and money, as well as increasing convenience for the customer by untethering transactions from a need to physically go to a bank branch during office hours.
Banks are predicted to spend $9.3B annually on fraud detection and prevention tools by the year 20227, in an attempt to stem the tide of financial fraud. While a switch to a decentralized process would carry an initial cost, and require a buy-in from multiple banks willing to adopt the decentralized solution, over time it could result in a significant reduction in fraud cases and the associated costs.
As more of Generation Z’s digital natives mature and enter the job market, they may be more interested in a decentralized digital banking option, especially one that offers cross-border functionality. Digital natives are often also digital nomads, working remotely from wherever their travels take them, freelancing for clients in multiple countries, who pay them in multiple currencies. A digital bank which is able to easily process these payments and convert currencies with minimal fees, or allow their customers to transact with borderless cryptocurrencies, is likely to attract this new breed of customer more readily than the traditional land-bound banks their parents relied on.
What are the Risks of DeFi?
Perhaps the biggest obstacle to widespread adoption of DeFi technology is that it is still a risky industry. In order to safely engage with DeFi platforms, users must currently know how to navigate acquiring and storing cryptocurrency, and be able to research the platforms themselves to determine which ones appear to have the best security protocols and terms of use. And even that is no guarantee, as even dapps which were considered well-designed and trustworthy have suffered hacks and other attacks, as mentioned earlier in this article.
One of the primary selling points of DeFi can also be one of its greatest weaknesses. Transparency is considered a hallmark of any decentralized solution. However, in some instances this transparency also makes it easier for hackers to identify and target weaknesses in the protocol. If a dapp is using an opensource protocol like Ethereum, is pseudonymous, and is bug-free, then transparency is usually not an issue.
That said, successful DeFi platforms are carrying millions of dollars in their code. They must be sure that they are secure when they are presenting such a tempting target to hackers. DeFi projects must take their responsibility seriously and be sure that their code goes through multiple reviews and audits and ample testing before going live.
This is especially important as many decentralized platforms lack the robust insurance that protects both traditional and digital banks, which can make it difficult if not impossible for users to recover their funds in the event of an attack.
Another hallmark of decentralized finance is the idea that it is “trustless” – in essence, you do not need to “trust” a centralized organization to uphold their promises, because the smart contract will automatically obey the rules that govern its operations. Many see this as leveling the financial playing field, as a smart contract will not discriminate against someone due to race, gender, or other perceived qualities.
However, there is still an element of trust any time a user chooses to commit their funds to any financial platform, whether centralized or decentralized. Users must trust that the platform in question is accurately portraying their means and aims. Hence the transparency element in dapps – users who understand blockchain technology can review the smart contract code and verify that it functions as promised, as well as look for any potential security failings or exploitable loopholes. Those without such technological know-how, however, are unable to perform their own due diligence and must hope that someone else has published a publicly-viewable smart contract review. Even aside from the DeFi platforms themselves, many people still lack a certain degree of trust and faith in cryptocurrency as a whole. Between market volatility, wallet security concerns, and exit scams perpetuated by centralized exchanges, the average user is likely hesitant to commit too much of their personal capital to any dapp.
Aside from the concerns of individual users, there are also institutional concerns with DeFi. Much like cryptocurrency, the pseudonymous and decentralized nature of these platforms may make them attractive for criminals and terrorists. If these bad actors made use of dapps with poor or non-existent KYC and AML requirements, it would be difficult if not impossible to track them. These concerns could lead to regulators shutting down DeFi platforms, to the detriment of the non-criminal users.
What DeFi Concepts Should Digital Banks Adopt, and How?
Despite the risks and concerns associated with DeFi, it would be a mistake for the financial industry to simply adopt smart contract technology and otherwise ignore the promise of DeFi concepts and other applications of distributed ledger technology and the blockchain. Digital banks are uniquely poised to offer a technologically-savvy user base the benefits of certain DeFi solutions, with the stability of an established, licensed, and insured financial platform.
Decentralized solutions for credit scores and KYC could lead to more efficiency as well as more customer satisfaction. The Experian data breach of 2017 created an upswell in resentment over mandatory participation in credit rating agencies that were apparently incapable of adequately protecting private information. While it would take significant change on a governmental level to abolish the three current credit rating agencies and replace them with a decentralized alternative, it’s an idea worth considering.
Paired with digital fingerprinting, a decentralized credit tracking agency could significantly cut down on credit and identity fraud. In 2018, the Consumer Sentinel Network (under the auspices of the FTC), received 3 million reports of theft and fraud, 1.4 million of which were fraud-related. Approximately one quarter of those fraud cases resulted in a loss of money8. Such cases not only hurt consumers, they also hurt the banks and financial institutions who are defrauded when fake accounts are opened under a stolen identity.
Digital fingerprints, unlike a name and identity number, cannot be easily stolen and reproduced in order to commit identity fraud. Such a system would offer greater protection to consumers, and greater security for digital banks.
Combining these technologies with smart contracts would make it faster and easier than ever for digital banks to approve and execute loans, in either digital or fiat currencies. Using a digital fingerprint and a decentralized credit database, a customer could quickly and easily apply for a personal or business loan via a digital banking portal, without any intervention from bank personnel. This provides value for the customer, in terms of greater convenience and faster access to loans, and value to the digital bank in terms of decreased labor costs and increased customer satisfaction.
But perhaps the biggest takeaway from DeFi shouldn’t be about making things more convenient for digital banks and their current customers, but that central promise of making banking and financial products more accessible for those who have previously been unbanked.
This far, DeFi has primarily served those who already have resources. The promise is there to “bank the unbanked”, but that promise has not yet been fully realized. Digital banks have already made banking more accessible to those who might have a hard time accessing a physical bank branch (such as those homebound with disabilities, those in rural areas, and those who work long hours). Can digital banks take the next step and reach those people who are currently being underserved by the financial industry?
Who Are the Unbanked?
In developed countries like the United States, the unbanked consist primarily of those with unreliable incomes, and undocumented immigrants9. In the United Kingdom, the Financial Inclusion Commission discovered that 1.5 million adults were “financially excluded.” They found that financially excluded groups included “people with low or unstable incomes, or who have experienced a significant life shock. Lone parents, single pensioners, migrants, long-term sick or disabled people, the long-term unemployed, and households headed by students or part-time workers are some of the groups most commonly excluded from financial services.”10 The Commission found that around 50% of these excluded people did not want a bank account.
Many unbanked people lack the monetary resources to open an account, or fear overdraft fees if their expenditures exceed their income. Ironically, this fear of overdrafts can often lead them to engage with predatory check cashing or loan companies, whose rates can over time add up to far more than the occasional overdraft fee.
Likewise, many people in developed countries are underbanked -- that is to say that they may have a bank account, but still rely on “payday loans” or other non-bank financial services.
In order to reach such customers, digital banks would need to provide bank accounts with very low initial deposit rates and forgiving overdraft protection plans. These might be partnered with financial education resources provided through their app, in order to help such customers learn how to better manage their limited resources.
Another service that digital banks could provide for the unbanked and underbanked is fast and easy loans with fair interest rates. This brings us back to the concept of DeFi. Fast loans enabled by smart contracts could fulfill the same function as the current predatory loan providers that the unbanked and underbanked rely on. People turn to these services because they need money quickly, whether to pay the bills or to cover a sudden minor emergency (such as a car repair or unexpected medical expense). In these instances, they may not be able to wait for a traditional bank to approve them for a loan, or may fear that their bad or non-existent credit score will cause them to be rejected.
Other customers underserved by current financial services include the self-employed, gig economy workers, and artists. While these people may have access to banking services, the unreliable, sometimes difficult to track nature of their income can make it hard for them to secure loans. People in these positions are often looking for access to the sort of financial instruments that other people receive through their work, such as 401(k)s and investment services.
Making Investment More Accessible
A big driver of interest in cryptocurrency, tokenization, and DeFi, has been the possibility of making investment instruments accessible to a larger portion of the population. Increasingly, people in the middle and lower classes are realizing that wealth cannot be built through hard work and ingenuity alone. It must be grown through careful investments. But the old adage holds true: you have to spend money to make money. And many investment schemes require a larger buy-in than the average person has at their disposal, especially those with unreliable income streams.
Digital banks can take a page from DeFi’s book by creating novel investment opportunities for investors of more modest means.
Tokenization is one method that DeFi is using to make investment more approachable. Real estate has long been considered one of the most solid investment opportunities, but most Millennial and Gen Z customers can’t even afford to buy a house for themselves, let alone an investment property. Tokenization allows retail investors to own a fractional share of a real estate property, scaled to their own means.
More novel forms of tokenization, such as sports players and entertainers tokenizing their contracts, may be outside the scope of digital banking, but they certainly show how people are looking to turn this technology to their own advantage, creating new instruments for investors and getting the most they can out of their compensation agreements.
Likewise, the rise of apps that allow people to make microinvestments, even rounding up their change on purchases and funneling that into an investment account, clearly show that even people of modest means have a real interest in making their money work for them.
Digital banks will be well-served by making investments more accessible to retail customers no matter what their income level, in order to take the market share away from DeFi platforms and apps. By providing entry-level investment opportunities, online financial advice (which can often be provided via AI chatbots), and financial counseling, digital banks can help previously unbanked and underbanked customers enter the world of investment.
Why Serve the Unbanked and Underbanked?
Banks are in the business of managing wealth, and it may not seem worthwhile to actively court customers who do not bring much wealth with them. These customers must be viewed as a long-term investment, however. While they may come to the bank with limited means, by providing the tools that they need to better shepherd their resources, banks will be helping them grow their wealth over time, and hopefully set their children up to be better off than they were.
Giving people access to simple financial instruments, breaking them out of a cycle of predatory loans, freeing them from inflated fees for check cashing and cash card activation, can help them escape poverty. And as they escape poverty, they’ll need more bank services: auto loans for the new cars they can now afford, college savings accounts for their children, investment accounts for the little bit extra they have each month.
Providing the unbanked and underbanked with access to the financial services they need helps them become more full and active participants in the local and national economy, to the benefit of everyone within that economy, digital banks included.
What is the Benefit of Adopting DeFi Principles?
Is it worthwhile for digital banks to look to adopt the principles underlying the DeFi movement?
This decision has to be driven by more than just an altruistic desire to help the unbanked, underbanked, and financially excluded members of society. There has to be a tangible benefit to shareholders in order for a digital bank to be able to establish a use case for DeFi concepts or technology.
The two primary benefits for digital banks would appear to be potentially reducing costs by streamlining operations, and reaching new target markets.
If DeFi concepts can be used to make KYC, AML, loan approval, and other day-to-day operations of the digital bank faster and more efficient, this may save the organization money. DLT and smart contracts are one way to automate work which previously had to be performed by human employees. Adoption of these technologies could either result in a reduction of workforce, or allow a workforce to accomplish more in each day, by freeing them up to focus on the work that is still better performed by a human intelligence.
In terms of new target markets, we have already discussed the potential of reaching the financially excluded. Would DeFi concepts make digital banking more attractive to the 50% of the underserved population who currently does not want a bank account? Would it make it less risky for digital banks to work with populations who have unreliable income? It would require a certain amount of market research, and perhaps liaising with organizations that serve these unbanked populations, to truly explore the value prop here.
But another potential target market would be DeFi proponents themselves. The drive for DeFi is powered by dissatisfaction with traditional banking, but even most DeFi proponents acknowledge the current limits of the industry. If digital banking can offer this market some of the benefits and functionality of dapps, while bringing the stability and liquidity of a licensed and insured financial instrument provider, they may win over these potential customers (at least until such a time as the DeFi market grows large enough to be self-sustaining).
Conclusion
It may be some time before we see DeFi become anything more than a rallying cry for crypto-anarchists and bitcoin maximalists. But that’s no reason to completely ignore the promise of DeFi. Many of today’s DeFi products are being developed by people who have worked in the banking industry, and see these platforms as a way to correct the deficiencies they saw in the current offerings.
Banking has a reputation for being resistant to change. While not inaccurate, it’s also not entirely fair. Banks have to work within the regulatory framework set by the countries they operate in. They cannot simply do something that seems like a good idea, if it goes against the law, or against the charter of the bank. But that doesn’t mean that there isn’t room to innovate, as has been shown by the digital banking industry.
It’s well past time that digital banks seriously considered how they can apply smart contracts, decentralized identity tracking, and other blockchain-enabled solutions to their offerings. It’s well past time that they made greater effort to reach underserved populations, and bring more people into the financial fold.
DeFi didn’t come out of nowhere. It arose from a need for banking to rise to the challenges of a 21st century life. It arose from digital nomads frustrated with currency conversion, and from rural communities in developing countries looking to grow their wealth, and yes, from people who just want to be able to invest in cryptocurrency. All of these customers have valid needs, needs which digital banking could meet while DeFi continues to try to find its feet.
References:
1. ‘Big Banks Raising Customer Satisfaction with Effective Digital Advice Tools, J.D. Power Finds’, available at: https://www.jdpower.com/business/press-releases/2020-us-retail-banking-advice-satisfaction-study (accessed 13th March 2020)
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3. ‘Wells Fargo Forced To Pay $3 Billion For The Bank’s Fake Account Scandal’, available at: https://www.forbes.com/sites/jackkelly/2020/02/24/wells-fargo-forced-to-pay-3-billion-for-the-banks-fake-account-scandal/#799b44e342d2 (accessed 13th March 2020)
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