16 min read

What is DeFi in banking?

Blockchain

FinTech

Trends

Before you dive into the article, try to forget everything you thought you knew about banking. Decentralized finance, or DeFi, is changing the way we deal with money by cutting out the traditional middlemen, such as banks or investment companies, and eliminating supervision of financial authorities. DeFi promises a world where users control their transactions directly in secure and transparent environments.

At the core of DeFi lies blockchain which is a distributed ledger. It consists of cryptographically linked blocks or nodes of recorded transaction records. To conduct financial activities, DeFi leverages tokens as digital assets. For digital process automation, smart contracts are used. These are agreements written on blockchain networks and based most often on EVM-compatible which execute automatically as soon as predefined conditions have been met.

Brief history of DeFi in banking

The history of DeFi begins with the introduction of Bitcoin in 2009 as the first cryptocurrency enabled decentralized peer-to-peer transactions. However, its volatile price, scalability issues, and high transaction costs made it too unreliable for the everyday’s use.

Which is why, for the first five years, users relied on Bitcoin for only basic transactions and used it as an investment tool. And the next two milestones of DeFi evolution were the development of the Omni Protocol and Tether – the first successful stablecoin. Tether retained the benefits of a decentralized digital asset and combined them with stable coin price, since such coins are pledged to fiat currencies. Transactions with stablecoins are much more reliable, since no sudden price drops or hikes would drive the transaction costs.

Yet another turning point for DeFi was the launch of Etherium in 2015 and the introduction of smart contracts. These also enabled the creation of complex decentralized applications (dApps) on its blockchain, such as lending platforms, decentralized exchanges (DEXs), and more.

New DEX platforms like Uniswap and Curve Finance further contributed to the increase in DeFi adoption. They enabled large-scale cryptocurrency trading outside of centralized exchanges.

Nowadays, while presenting particular challenges, DeFi holds significance for present and future due to its decentralized, transparent, and accessible nature. With its faster and more cost-effective services, DeFi enables greater control over individuals assets and financial decisions and eliminates the intermediaries.

Advantages and disadvantages of DeFi in banking

The key question for everyone considering the shift from conventional finance solutions to DeFi is what are the advantages and disadvantages of DeFi. Below are several pros and cons that are important to consider.

Advantages of DeFi in banking

Lower transaction costs
Faster transaction processing
Decentralization and transparency
Greater accessibility

Disadvantages of DeFi in banking

Lack of regulation
Increased risk of hacks and scams
Volatility of cryptocurrencies
Limited acceptance by traditional financial institutions

DeFi banking applications

DeFi is actively reshaping the financial landscape by offering a decentralized alternative to traditional banking services. This section explores the wide range of DeFi banking applications and the ways they address everyday financial needs.

Decentralized exchanges

The rise of decentralized finances (DEXs) represents a significant step in the evolution of decentralized finance. Unlike the centralized equivalents (CEXs), which operate through companies and rely on market makers to manage order books, DEXs use blockchain technology and smart contracts to enable fully transparent trading.

CEXs, while being familiar, pose certain risks because of their centralized nature.

Vulnerability to hacks, potential government intervention, data breaches and privacy concerns are constant threats. DEXs, on the other hand, hand over control to users. Smart contracts instead of financial corporations govern all the exchange components, from trade execution and liquidity provision to withdrawals and deposits. This eliminates the need for intermediaries and offers users transparency throughout the trading process.

This difference in custody is critical: with CEXs, users lose control of their funds once they deposit them while DEXs allow users to trade directly from their personal wallets, enhancing security and promoting user autonomy.

It is worth mentioning that different DEXs may operate in different ways. While some, such as dYdX, have adopted order book systems similar to CEXs, the majority, including Uniswap, Bancor, PancakeSwap, and SushiSwap, take another approach: Automated Market Makers (AMMs).

Automated market makers (AMMs)

An automated market maker (AMM) replaces the traditional order book model of centralized exchanges with on-chain liquidity pools. These pools are filled by liquidity providers who lend their cryptocurrency in exchange for a share of the trading fees. The pools become the counterparty to every trade. Users interact directly with the AMM’s smart contract, bypassing the need for order matching.

This innovative approach has several advantages. Decentralization is paramount, as control shifts from a central authority to the users through smart contracts and governance models. This also ensures a non-custodial environment where users retain full control of their assets throughout the trading process, interacting directly from their wallets. Market manipulation, a concern with centralized exchanges, is mitigated by the absence of a central entity that could benefit from such practices. Security is enhanced by the decentralized and distributed nature of DEXs, as hackers can only target liquidity pools, not individual user accounts. Finally, the open and permissionless nature of DEXs allows any token to be listed without the approval of a central authority, promoting greater accessibility to tokens.

However, it is important to acknowledge that AMMs also present challenges. DEXs rely heavily on users to provide liquidity to the pools, and insufficient liquidity can hinder trading activity and impact pricing. Order execution on DEXs can be slower than on centralized exchanges, often due to the lack of sophisticated trading tools. While DEXs have seen significant growth in trading volume, the lack of an order book can result in high slippage, especially for larger orders. Finally, trading on DEXs typically involves a fixed fee for all trades, in addition to gas fees (transaction costs) charged by the underlying blockchain network (such as Ethereum). These gas fees can fluctuate significantly depending on network congestion, potentially leading to high transaction costs.

Lending and borrowing platforms

Lending and borrowing are the other key components of the decentralized finance ecosystem as alternatives to traditional lending models.

Centralized institutions such as banks act as so-called gatekeepers and feature an approval algorithm. The approval process includes strict requirements such as good credit score, stable employment, and minimum collateral. This system naturally excludes those without or with limited access to traditional banking services.

DeFi lending protocols break down these barriers and promote financial inclusion thanks to open and permissionless access to credit. Regardless of background, location, or credit history, anyone with the necessary assets can borrow funds. In addition, these protocols often operate without the stressful identity verification procedures such as know-your-customer (KYC) policies common in traditional finance.

DeFi further propelled the popularity of decentralized lending through the integration of protocols such as Compound, Aave, Maker and bZx. These platforms connect lenders and borrowers directly so that lenders can earn attractive interest rates on their crypto assets and borrowers can gain access to instant liquidity: all without the burden of paperwork and in a secure and anonymous environment.

A particularly innovative feature of DeFi Lending is the concept of flash loans. Unlike traditional loans, flash loans require no collateral and allow users to borrow substantial amounts, potentially millions of dollars. However, these loans come with an extremely short repayment window – they must be repaid before the transaction block is completed. This unique feature makes flash loans suitable for rapid-profit operations such as arbitrage trading and debt refinancing. However, if not managed carefully, they introduce potential vulnerabilities that may be exploited for fraudulent activities.

Stablecoins

The natural fluctuations of cryptocurrency prices pose a significant challenge to the DeFi ecosystem. Stablecoins have emerged as a solution to provide price stability and mitigate the risks associated with market volatility.

Stablecoins are tokens designed to maintain a fixed value. They are typically tied to a fiat currency or commodity, like the US dollar or gold. This aims to reduce the impact of market volatility, allowing users to protect their capital during periods of uncertainty. In addition, stablecoins offer a convenient way to lock in profits by converting volatile cryptocurrencies into a more stable asset.

While the US dollar remains the dominant peg for stablecoins, the mechanisms used to maintain this peg vary widely from project to project. Broadly speaking, stablecoins can be divided into three types: fiat-collateralized, crypto-collateralized, and algorithmic stablecoins.

Fiat-collateralized stablecoins, as the name implies, are backed by fiat currency reserves held by the issuing entity. Tether (USDT), one of the most widely used stablecoins, is an example of this approach. It claims to hold one US dollar in reserve for every USDT token issued. However, this model relies heavily on trust, as users must have confidence that the issuer maintains adequate reserves and operates transparently. Given the certain degree of reliance on centralized institutions to hold these reserves, fiat-collateralized stablecoins introduce a level of centralization.

In contrast, crypto-collateralized stablecoins use other cryptocurrencies as collateral to maintain their peg. However, this presents a challenge: the inherent volatility of these underlying crypto assets. To mitigate the risk of the stablecoin losing its peg due to fluctuations in the value of the collateral, these schemes are designed to be over-collateralized. DAI, a prominent example built on the Ethereum network, uses smart contracts and over-collateralized positions to ensure its peg to the US dollar.

The transparency of smart contracts allows users to independently verify the collateralization ratio, the value of the locked assets, and the mechanisms governing DAI’s stability. This transparency reinforces DAI’s decentralized nature and fosters trust within the ecosystem.

Algorithmic stablecoins aim to maintain price stability through algorithms and smart contracts, often without relying on collateralization. They typically use mechanisms like expanding and contracting the stablecoin supply based on market demand to maintain the peg.

Payment gateways

While DeFi has progressed in replicating traditional financial services, its adoption in everyday business faces a significant hurdle: integration with existing payment systems. This is where DeFi payment gateways come into play.

Traditional payment gateways act as intermediaries, facilitating transactions between customers, businesses, and financial institutions. However, this centralized model comes with drawbacks, including fees, delays, and potential points of failure.

DeFi payment gateways use blockchain technologies to allow businesses to accept cryptocurrency payments directly, bypassing intermediaries and their associated costs. Smart contracts automate the payment process and ensure faster transaction speeds, reduced fees, and increased transparency.

In addition, DeFi payment gateways can integrate with different blockchain networks, promoting interoperability and expanding the reach of DeFi applications. This opens up new opportunities for cross-border payments, microtransactions, and programmable payments and thereby enables new business models and revenue streams.

However, DeFi payment gateways face several obstacles that hinder widespread adoption. So the lack of clear regulations, which can create uncertainty for users and businesses alike along with complex user interfaces that can be intimidating for those new to cryptocurrency, require careful consideration.

Despite these barriers, DeFi payment gateways have immense potential to build a more efficient and accessible financial system.

How DeFi is changing banking

The rapid growth of Decentralized Finance (DeFi) is revolutionizing the financial world. Its increasing adoption is driven by demands for more inclusive services and improved security, and it will reshape how we interact with money and financial systems.

The shift towards decentralized financial services

With smart contracts, DeFi platforms enable peer-to-peer transactions with no middlemen such as banks. This shift gives users greater control over their assets and financial decisions, promotes financial inclusion and reduces reliance on traditional intermediaries.

The impact of DeFi on traditional banking institutions

The rise of DeFi presents both challenges and opportunities for traditional banking institutions. On the one hand, DeFi’s potential to exclude intermediaries from core banking functions such as lending, borrowing, and payments poses a significant competitive threat. DeFi platforms often offer higher interest rates on deposits and charge lower fees on loans compared to traditional banks, attracting customers seeking better returns and lower costs. On the other hand, strategically thinking and innovative banks are seeking ways to integrate DeFi solutions into their existing infrastructure. This includes embracing blockchain technology to improve efficiency, transparency, and security of transactions. In addition, such banks are exploring new revenue streams through DeFi-enabled products and services.

The potential for DeFi to disrupt the financial industry

DeFi has the real potential to significantly disrupt the financial industry by democratizing access to financial services, reducing fee and transaction costs, and increasing efficiency. The transparent nature of DeFi protocols is leading to the development of financial products and services tailored to the needs of a wider user audience. Since the vulnerability to fraud and cyberattacks are eliminated by the blockchain, this enhanced security factor further contributes to the rising popularity of DeFi.

DeFi in banking regulation

The rapid evolution of DeFi has evolved faster than regulatory frameworks, creating a complex environment for both early adopters and regulators. This section delves into the regulatory landscape, inherent risks, and potential mitigation strategies for DeFi in banking.

Current state of DeFi regulations

Currently, there is no comprehensive regulatory framework specifically designed for DeFi in the banking industry. Because of that, regulators around the world are struggling with how to apply existing financial regulations to this rapidly evolving space. Nonless, more regions recognize the need for tailored regulations and take proactive steps toward developing DeFi-specific frameworks. The European Union, for instance, is working on the Markets in Crypto-Assets Regulation (MiCA), which aims to regulate crypto assets, including those used in DeFi.

Future of DeFi regulations

The future of DeFi depends on the development of balanced and effective regulatory frameworks. These frameworks should prioritize investor protection and ensure market integrity without hindering innovation typical for the domain. This balance requires a comprehensive approach that involves a combination of industry collaboration, technological advancements, and regulatory oversight to ensure the legitimacy of decentralized finance while mitigating risks. Currently, potential regulatory approaches across different regions include licensing requirements for DeFi platforms, consumer protection measures, and mechanisms to address systemic risk.

Risks and challenges of DeFi in banking

While DeFi holds great promise, it’s not without its drawbacks. Several risks and challenges need to be addressed for it to thrive in the long term.

One major concern is cybersecurity. Because DeFi relies heavily on smart contracts, any vulnerabilities in its code can be exploited by hackers, potentially leading to significant financial losses for users.

While the decentralized nature of DeFi is a strength in many ways, it also presents a challenge in terms of governance and accountability. Without a central authority, establishing clear lines of responsibility and resolving disputes can be complex.

The DeFi market is relatively young and therefore prone to volatility and manipulation. Rapid price changes and the potential for market manipulation pose risks to investors.

The limitations of smart contracts also present challenges. Network congestion can lead to high transaction fees and slow execution speeds, hindering the efficiency of DeFi applications.

Finally, the lack of centralized oversight in DeFi creates opportunities for fraud and scams. Bad actors can exploit the anonymity and decentralized structure of the system to deceive users and steal funds.

Ways to mitigate risks and challenges of DeFi in banking

Building a robust and sustainable DeFi ecosystem requires a multi-layered approach to risk mitigation, moving beyond basic protections to sophisticated, interconnected solutions.

Improving the security of smart contracts

While code audits are essential, achieving true robustness requires a shift toward formal verification techniques. Mathematical models used to prove the correctness of smart contract logic can proactively eliminate vulnerabilities and reduce the risk of attacks that have plagued DeFi.

Decentralized governance beyond DAOs

DAOs have been an important development in introducing decentralized governance to the DeFi ecosystem. However, in their current form, they have limitations and drawbacks. People lose interest in voting, or a wealthy few might take control. To make governance stronger and more inclusive, we need to develop new mechanisms. On-chain reputation systems, quadratic voting, and futarchy are promising approaches for creating more resilient and representative governance structures.

Compliance as a catalyst

The integration of Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures should not be viewed as a regulatory routine, but as an opportunity to enhance trust and foster mass adoption. Leveraging privacy-enhancing technologies such as zero-knowledge proofing can enable compliance without compromising user privacy, a critical concern within the DeFi ecosystem.

Synergy

The relationship between DeFi and traditional finance should move beyond mere partnerships to a collaborative ecosystem. Integrating DeFi protocols with existing financial infrastructure, such as using real-world assets as collateral or creating hybrid CeFi-DeFi products, can open new avenues for value creation while mitigating the risks associated with both.

By embracing these approaches, the DeFi ecosystem can move toward resilience, security, and responsible innovation, unlocking its transformative potential for the global financial landscape.

Conclusion

DeFi is changing the banking domain, offering a look in a future where financial services are more accessible, efficient and user-centric. While challenges remain, DeFi’s potential to transform traditional finance is undeniable. Through risk management, innovation, and collaboration, DeFi can be transformed to a more inclusive financial system for all.

FAQs

What is DeFi in personal banking?

DeFi offers individuals direct control over their assets and access to permissionless financial services. Users can leverage DEXs for non-custodial trading, participate in lending and borrowing protocols for profit generation and collateralized loans, and utilize stablecoins for payments and hedging against volatility.

What are DeFi banks examples?

While they are not banks in the traditional sense, DeFi protocols like Aave, Compound, and MakerDAO provide banking-like services through open-source, non-custodial platforms governed by smart contracts. These protocols facilitate lending, borrowing, and stablecoin issuance.

What is DeFi in transaction banking?

DeFi is disrupting transaction banking by streamlining cross-border payments and reducing reliance on intermediaries. Stablecoin-based payment channels, coupled with Layer-2 scaling solutions like the Lightning Network, enable faster, cheaper, and more transparent cross-border settlements. Decentralized payment gateways further enhance this by allowing businesses to accept cryptocurrency payments directly.

What is DeFi banking and how is it different from traditional banking?

DeFi banking represents a paradigm shift from centralized, intermediary-based finance to a decentralized, peer-to-peer model. By leveraging blockchain technology and smart contracts, DeFi eliminates the need for traditional intermediaries, enabling greater transparency, accessibility, and control over financial services.

What are the advantages of using a DeFi bank over a traditional bank?

DeFi offers several advantages for users:

Permissionless access: No account applications or credit checks are required to access DeFi services.
Transparency and auditability: All transactions are recorded on public blockchains, providing a high level of transparency.
Composability and interoperability: DeFi protocols can interact with each other, enabling the creation of innovative financial products and services.
Programmability and automation: Smart contracts enable automated execution of financial agreements, reducing the need for manual intervention.
Potentially higher returns: DeFi landing protocols often offer higher interest rates compared to traditional savings accounts or investment products. This is because DeFi cuts out the middlemen and allows users to earn directly from their assets.

How does DeFi banking work and what technologies are used?

DeFi banking leverages the following technologies:

Blockchain: A distributed ledger that ensures secure and transparent recording of transactions.
Smart contracts: Self-executing contracts that automate financial agreements and eliminate the need for intermediaries.
Decentralized governance: DAOs and other governance mechanisms enable community-driven decision-making and protocol upgrades.

Andrew Nalichaev Blockchain expert

Date: Jul 27, 2023

Andrew Nalichaev Blockchain expert

Date: Jul 27, 2023

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