What Your Bank is Learning from DeFi

TLDR: DeFi is banking for crypto and it’s bringing innovation to the institutions it was meant to disintermediate.

When you own an asset, you’re probably hoping to create some yield from it. But what if that asset is Bitcoin?

The traditional answer would be to put it in the bank. Of course your options here are limited since 2022’s regulatory environment makes it difficult for traditional financial providers to hold cryptocurrency on their books. Even if you could use a bank, your preference might be to use the entirely separate digital infrastructure that has developed where you transact only in digital assets.

This blog explains what this Decentralized Finance (DeFi) infrastructure is and what it does and doesn’t share with traditional banking.

1. A few distinguishing features

The DeFi ecosystem has seen immense growth in the past two years. But what is it exactly?

DeFi is an umbrella term that covers both the infrastructure and the tokens that allow you to execute financial transactions using a cryptocurrency like Bitcoin. There are three features that set this ecosystem apart from traditional finance.

The first is that it is all built on blockchain infrastructure. The reason is that DeFi transactions require features like programmability, transparency, accessibility, and composability.

The second is that the ecosystem is composed of applications rather than institutions. The primary categories of applications include decentralized and centralized exchanges (where you trade), wallets (where you hold your assets and how you interact with exchanges) and tokens (what you exchange).

A third feature is the absence of intermediaries. Individual wallets interact directly with exchanges to execute transactions. This is possible because services operate through automated protocols.

Now that we understand what it is, let’s talk about the two categories of activities that take place in DeFi.

2. Replicating traditional finance

The first category of DeFi’s major activities replicate the types of transactions that you can do with your real-world assets. These activities can include: lending, borrowing, managing assets, and trading derivatives.

You might prefer to use DeFi because the platforms execute these activities much more cheaply. A 2022 IMF report finds DeFi platforms have the lowest marginal costs among both banks and non-banks. Of course, the reason that DeFi is cheaper for the same types of transactions is a combination of underpricing riskiness and absence of the need to maintain regulatory buffers.

Soon you may have more traditional options to source yield from your cryptocurrency. Despite the current challenges, crypto is being de-risked as an asset class. Some traditional financial institutions offer limited custody services, and some start up asset managers have crypto index funds. The scale of both are limited today due to expectations that regulations will change their business.

3. Plus, wholly novel activities

The second set of activities you can do in DeFi are things that are impossible in its absence.

The first unique activity is pooled liquidity and automated market making (AMM). In a traditional trade, you have an order book, two counterparties and an intermediary. Using a liquidity pool, you have no counterparty, just a smart contract.

A second activity is yield farming. This involves participation in multiple liquidity pools to search for arbitrage opportunities. Once you contribute tokens to a liquidity pool (staking), you gain yield, which you can take across different protocols.

A third novel activity created by DeFi is a financial instrument called a flash loan. This is a loan taken out and settled in the same block transaction. It is effectively risk-free and zero-duration.

A final set of new activities include, of course, novel types of scams that can only exist in a DeFi ecosystem. These include things like rug pulls. Since anyone can create a liquidity pool, this can occur when a team creates a token, increases its value and then disappears with the funds. Rug pulls are a new, but quickly growing revenue earner with 2021 revenue 81% higher than 2020.

4. What your bank is learning from DeFi

Banks are not blind to all this innovation. Traditional financial institutions are actively considering how to incorporate elements of DeFi into their day-to-day. There are three ways that your bank may be working on this.

The first is that banks are improving their existing offerings by recognizing the consumer demand that DeFi is addressing. Cross-border transactions are an area where traditional finance is particularly slow and complex. This is an area where technical features of DeFi—such as allowing 24/7 trades and coverage of multiple geographies with a single type of “currency”—could improve banks’ existing process.

The second is that central banks are exploring DeFi market structures for regulated digital currencies. Central banks are already looking at how AMM is used in liquidity pools as one way to address excess CBDC holdings.

The third is a recognition of risk. The risks of DeFi are unique and problematic and will soon come to traditional finance. It is already clear that institutional investors want their banks to be able to custody and create yield for their crypto holdings. Banks are looking at what’s happening in DeFi to understand the new types of threats that will come into the financial system.

The future will have room for both traditional and decentralized finance. Even as we see markets converging due to regulation and knowledge spillovers, there are some customers and activities that will concentrate in one or the other.