The Impact of Decentralized Finance (DeFi) on Traditional Banking

Decentralized Finance, commonly known as DeFi, can be quite perplexing to those unfamiliar with its intricacies. People often wonder if it is connected to cryptocurrencies or Non-Fungible Tokens, or if it falls under the umbrella of fintech. In reality, DeFi is a broad term encompassing traditional financial services and products that operate on an unregulated and decentralized blockchain infrastructure.

While DeFi relies on cryptocurrencies to function, its core objective is to bypass the involvement of financial institutions and governments. In some ways, it resembles a global crowdsourcing endeavor, with millions of users worldwide accessing financial services with just an internet connection. Despite its potential, DeFi's current market share within the overall cryptocurrency market remains relatively small, accounting for only a few percent, so you'll need the help of a DeFi development company if you're new to the game.

Overview of DeFi and its disruptive potential in fintech

DeFi began gaining attention around 2017 with the rise of projects like MakerDAO. However, its roots can be traced back to the introduction of Ethereum's smart contracts in 2015, enabling the development of decentralized applications (dApps) for various financial services. Cryptocurrency bank software development for DeFi involves creating platforms and applications that facilitate financial services and transactions within the cryptocurrency ecosystem. 

The significant growth of DeFi occurred in 2020 and 2021, as numerous projects launched, offering decentralized exchanges, lending platforms, yield farming, and more. Since then, DeFi decentralized finance has rapidly evolved, becoming a major trend in the cryptocurrency and blockchain space, reshaping the future of finance and disrupting traditional financial systems. Grand View Research states that the worldwide DeFi market was valued at USD 13.61 billion in 2022, and it is predicted to face a unprecedented compound annual growth rate of 46 percent from 2023 to 2030.

DeFi explanation and functioning

What is DeFi? It’s a financial ecosystem created using blockchain technology. It operates without the need for intermediaries like financial institutions. Instead, smart contracts on decentralized platforms execute transactions and protocols, enabling users to access various financial services. Users connect to these platforms through digital wallets, enabling them to interact directly with the DeFi protocols. Users can lend their digital assets to others and earn interest, borrow assets by providing collateral, trade cryptocurrencies on decentralized exchanges, and participate in liquidity pools to earn rewards.

Decentralized finance applications are built on four main layers:

Settlement Layer is the underlying blockchain network, such as Ethereum, where the transactions and smart contracts are executed. It provides the foundation for DeFi applications and ensures secure and transparent transactions.

Protocol Layer consists of the smart contracts that govern the rules and functionalities of specific DeFi services, like lending, borrowing, or trading. These smart contracts enable automated and trustless interactions between users.

Application Layer comprises the actual DeFi applications and platforms that users interact with. It includes decentralized exchanges (DEXs), lending platforms, yield farming protocols, and other financial services, built on top of the underlying protocols and settlement layer.

Aggregator Layer is not always a distinct layer, but rather a service that consolidates and optimizes DeFi opportunities from multiple platforms. Aggregators enable users to access better prices and liquidity across different protocols, making it easier to find the most favorable options for trading, borrowing, or lending.

What does the future holds for DeFi in fintech?

Over the upcoming five years, active investors anticipate the market to bifurcate into two distinct categories: permissioned and permissionless DeFi.

Permissioned DeFi refers to decentralized finance applications that operate on a restricted basis, allowing access only to authorized users or institutions. These platforms typically require users to go through a verification process and adhere to certain compliance standards. Permissioned DeFi is expected to gain popularity among institutions due to its ability to combine blockchain technology advantages with traditional finance compliance standards. Even a small portion of traditional financial activity shifting to the blockchain could present a market opportunity worth over $1 trillion.

Permissionless DeFi is characterized by its open and inclusive nature, allowing anyone to participate without the need for authorization or identity verification. Permissionless DeFi, which currently constitutes a significant portion of the DeFi space and caters more to individual users, will play a crucial role. 

When combined, the overall DeFi market has the potential to reach a valuation ranging from $500 billion to $2 trillion by 2028. However, the growth of DeFi will not solely rely on increased use cases. Factors such as infrastructure development, regulatory advancements, and financial innovation will significantly influence the expansion and success of the DeFi ecosystem.

Advantages of DeFi over centralized finance (CeFi)

Advantages provided by DeFi make it a disruptive and promising alternative to traditional banking. The following are some of them:

Availability. DeFi is accessible to any person having an internet connection and a suitable digital wallet. This enables the unbanked and underbanked people worldwide to use quality and innovative financial services without the need for intermediaries.

Investors’ ability to make a profit. DeFi offers investors the advantage of generating income through various yield-generating opportunities, including liquidity provision, governance participation, and flash loans. These income streams allow investors to earn returns on their digital assets and participate in decentralized financial activities, offering potential yields that may surpass traditional investment options.

High-level security. The decentralized nature and robust encryption make DeFi platforms more secure, reducing the risk of hacks, fraud, and unauthorized access. Users retain control over their private keys and funds, minimizing the reliance on centralized intermediaries, which enhances the overall security and trustworthiness of the DeFi ecosystem.

These and other advantages of DeFi invariably impact traditional financial systems. Let’s see how exactly. 

Rise of DeFi and influences on traditional banking

In 2021, Anchorage Digital Bank made history by becoming the pioneering federally chartered bank specializing in digital assets, and it continues to hold its unique position as the sole federally chartered cryptocurrency bank. Anchorage Digital Bank's primary objective is to offer institutions seamless and effective access to a comprehensive range of crypto-related services, including custody solutions, trading options, financing opportunities, staking capabilities, and governance services. By obtaining the license, Anchorage has gained the authority to function as a custodian for conventional banks seeking to incorporate cryptocurrency services into their offerings.

The future of cryptocurrency and blockchain technology investments remains a subject of ongoing discussion and speculation. Some envision a scenario where banks adopt smart contracts to enhance or even replace their existing processes. Smart contracts have the potential to streamline functions that currently require manual processing, presenting advantages for community banks and payment system participants. A World Bank report reinforces this notion, suggesting that DeFi technology, including smart contracts, could enhance the efficiency of consumer credit issuance, such as home and auto loans, which currently involves labor-intensive manual procedures. 

Furthermore, DeFi technology could automate loan servicing. Integrating smart contracts into traditional banking and finance companies might enable cost reduction and faster processing times, allowing them to adapt and stay relevant in the expanding DeFi market. Embracing these benefits could assist traditional financial intermediaries in maintaining their relevance as DeFi continues to expand its reach.

Examples of successful DeFi projects impacting financial services

The following are examples of DeFi apps that are built on the Ethereum blockchain and creatively strengthen the DeFi ecosystem:

Aave is a decentralized liquidity protocol and lending platform in the world of DeFi. Using the app, you can lend and borrow multiple cryptocurrencies with no need for intermediaries. The protocol works via smart contracts which enables peer-to-peer interactions.

Synthetix is a DeFi protocol helping you make and trade synthetic assets ("synths"). These synths are tokenized representations of real-world assets, such as fiat currencies, cryptocurrencies, commodities, and stocks.

Uniswap enables users to trade cryptocurrencies and tokens right from their Ethereum wallets without intermediaries or a centralized exchange. The app operates on the automated market maker (AMM) model, which uses liquidity pools to facilitate trading. Instead of relying on traditional order books, Uniswap relies on smart contracts and liquidity providers to create liquidity pools for various token pairs.

The DeFi apps above are both challenging and provide opportunities to traditional financial markets. Further in the article, we explore the most worthwhile challenges and prospects.

Challenges and opportunities for traditional banking presented by DeFi

While DeFi poses challenges to traditional banking, it also presents opportunities for collaboration, efficiency gains, financial inclusion, and innovation. Traditional banks that adapt and embrace DeFi principles may find themselves well-positioned to thrive in this evolving financial landscape.

Challenges:

Disintermediation. As DeFi eliminates the need for intermediaries like traditional banks, they may lose their role as the central authority for financial transactions and services.

Loss of control. The fact that individuals have direct control over their funds and assets through DeFi platforms diminishes the control that traditional banks have over customer funds, which could potentially lead to a loss of revenue for banks.

Regulatory uncertainty. Since DeFi operates in a decentralized and borderless manner, it’s challenging for regulators to enforce traditional financial regulations. This can create uncertainty in terms of compliance, consumer protection, and systemic risks, as the regulatory landscape struggles to keep pace with rapidly evolving DeFi platforms.

Opportunities:

Collaboration and partnerships. Traditional banks can explore collaborations and partnerships with DeFi platforms to leverage their innovative solutions and expand their services. This could include offering DeFi-related products, integrating DeFi protocols into their systems, or investing in promising DeFi projects.

Efficiency and cost reduction. DeFi has the potential to streamline financial processes, reduce operational costs, and increase efficiency. Traditional banks can adopt DeFi principles to optimize their back-end operations, such as settlement systems, cross-border transfers, and record-keeping.

Innovation. DeFi stimulates the emergence of new financial products and services. Traditional banks can draw inspiration from DeFi projects to create new offerings, such as tokenized assets, decentralized lending, or yield farming, which could attract tech-savvy customers and drive innovation within the banking sector.

Having viewed how DeFi has been disrupting the traditional finance industry, let’s compare DeFi and traditional banking in terms of security which is vital to ensure when providing financial services.  

Security measures and risks: DeFi vs traditional finance 

Both DeFi and traditional financial institutions have their strengths and weaknesses in terms of security. While DeFi offers transparency and user control, it also faces risks associated with its decentralized and nascent nature. Traditional banking provides stability and regulatory protection but remains exposed to centralization and cybersecurity threats. As the DeFi space evolves, traditional banks must adapt, embrace innovation such as AI and ML in finance, and leverage their expertise to navigate the changing financial landscape successfully. 

Examples of risks and security measures in DeFi and traditional banking

As for DeFi, it’s risky that smart contracts may have coding flaws or be subject to complex interactions that could be exploited by hackers. As a corresponding security measure, DeFi projects should undergo regular smart contract audits by independent firms to identify vulnerabilities and ensure code integrity.

As for traditional banks, they are still vulnerable to fraud and scams perpetrated by both external and internal parties. Banks must implement comprehensive fraud detection systems to properly monitor transactions and detect suspicious activities.

As the DeFi space continues to evolve, it is crucial for traditional banks to adapt, embrace innovation, and leverage their expertise to navigate the changing financial landscape successfully. Collaborations between DeFi and traditional banking could potentially lead to a hybrid financial system that offers the best of both worlds - the efficiency and inclusivity of DeFi combined with the stability and regulatory oversight of traditional banking. The future of finance undoubtedly lies in striking a delicate balance between the two, fostering an ecosystem where financial services are accessible, secure, and tailored to the diverse needs of a global community.