Blockchain, FinTech Fueling Decentralized Finance (DeFi)

From 2010 - 2018, FinTech entered the mainstream of the financial services industry, gained exposure with a few big names, and spread out globally through a wave of startups (which became unicorns). Blockchain finds itself in a similar position to early FinTech — better known in payments, but struggling to gain adoption through top use cases and leading companies.

At the midpoint of 2021, blockchain is pushing beyond comparisons to FinTech and coming into a league of its own. Multiple sectors (outside of banking) are applying vendor partnerships with blockchain firms for increased efficiency and better unit economics. Insurance is a top example — most InsurTech companies have some integration with blockchain in their processes. Healthcare, government data, and identity verification are others with early signs of success.

Decentralized Finance (or DeFi) appears as the pivotal driver for mainstream global adoption. As an emerging area in financial services, DeFi is applying the lessons learned from FinTech and technology from blockchain towards the future of banking.

FinTech and Blockchain

From our previous posts, we discussed blockchain as a decentralized network for digitally recording transactions, which can’t be manipulated or controlled by intermediaries. Well-known cryptocurrencies (such as bitcoin) operate through blockchain networks.

Banks, processors, and payment networks are the intermediaries in today’s payment and banking landscape. At its full potential, blockchain directly connects two parties for instant delivery of funds and settlement without any 3rd parties being involved.

Banks and financial institutions quickly responded with their own blockchain projects and partnerships. Since 2017, about 88% of banks communicated concern about losing revenue to blockchain startups. Investments in blockchain increased close to 90% between 2018 - 2019 (to $3B). Overall, nearly 82% of financial institutions are expected to build collaborative efforts with these companies in the next 3 years.

Ripple is the most notable partner for banks, working with 200+ organizations that include American Express, Bank of America, and UBS. Optimizing cross-border payments for speed and costs is a challenge addressed by Ripple’s platform and native token, XRP. Standard bank (SWIFT network) transfers can cost senders more than $50 versus a blockchain-enabled transaction that cost less than $1 and settles in seconds (not days or weeks).

At its core, FinTech still relies on partner banks (or other licensed entities) to facilitate payments, account opening, and card issuance. Most of the top fintech apps are designed with 3+ vendors, sponsor banks, and/or other parties. Supplementing the latest technology (such as artificial intelligence, machine learning), helps keep FinTech ahead of traditional banks and payment providers. Adding blockchain to the user experience from fintech startups would offer a next level financial services platform.

Blockchain embedded into FinTech = defi

Besides optimizing payments and transfers, decentralized finance (or DeFi) offers a version of FinTech enhanced with blockchain components. It’s an umbrella concept for financial services offered on public blockchains. The result is an open, global alternative to current products and structures. Investing, saving, trading, and lending are accessible to all individuals with an online mobile device (such as the unbanked and underbanked) and those looking to borrow against crypto holdings.

All services are enabled with digital currencies instead of government-issued ones (e.g. USD, Euro). DeFi leverages stablecoins (tokens with value pegged to fiat currencies like the dollar), which minimizes volatility from popular coins such as bitcoin and ether. There is no intermediary or centralized body through which transactions must be processed.

When combined with smart contracts (i.e. programmatically transferring funds based on certain conditions being met), there’s no need for paperwork or 3rd party governance (such as brokers). Since the stablecoins in DeFi don’t require high outputs of energy for mining, there’s also an environmental benefit with a lower carbon footprint.

DECENTRALIZED FINANCE emerges as a new player

Last year, a 10-fold increase of capital infused decentralized networks. Many top VCs (such as Andreesen Horowitz and Bain Capital Venture) provided early stage funding to startups. There was $20B in total capital placed into DeFi by January 2021.

Users access DeFi platforms through software known as dApps (or decentralized apps), which mostly run on the Ethereum blockchain network. After connecting their digital wallet to a dApp, a service can then be selected from a drop-down menu to handle similar functions to modern-day banking apps (e.g. deposit, transfer, payments). Web3 enabled browsers allow users to transact on Ethereum and other blockchains.

With DeFi, many traders have turned to derivatives and arbitrage strategies across various dApps in search of increased profits. Leverage (e.g. using current holdings to place larger bets) is a key factor in feeding the volatile markets of bitcoin and other coins in the last month. With prices diving down since April, many of these leveraged positions are being programmatically liquidated and causing valuations to fall even further. The usage of stablecoins in DeFi minimizes some of this risk for users.

TOP DEFI USE CASES for BANKING AND FINANCIAL SERVICES

Savings: The combination of rising inflation and low interest on bank deposits make earnings on savings balances difficult. As an alternative, DeFi has programs offering higher rates with stablecoins while still securing the principal amounts on deposit. Some of the firms with these products are Dharma, Argent, and PoolTogether.

Payment Solutions: Blockchain had already optimized legacy payment rails with speed and settlement times. DeFi takes this further by making it available to not just to institutions, but individuals — many who don’t have a bank account or card. The unbanked segment (especially those sending money monthly to family in their native country) have an improved, cost-saving solution.

P2P Borrowing and Lending: The direct connection between transacting parties encourages DeFi to be used as a peer-to-peer (P2P) model. Without the need for an intermediary, borrowing and lending (backed by smart contracts) has become a vital use case. Compound and PoolTogether are established firms with autonomous interest-based protocols for borrowers and lenders.

Decentralized Exchange: These exchanges offer not only cryptocurrency trading, but also asset and derivatives. All transactions process and settle faster than traditional platforms. The lack of 3rd parties helps minimize potential market or asset manipulation. There’s also less overhead with these exchanges, which means less fees to users.

Margin Trading: Within the scope of DeFi, asset owners utilize smart contracts in borrowing for margin trading. The lending protocols don’t need to be enforced by an outside broker. Compound and dYdX are firms currently using enhanced controls for blockchain lending.

WHAT’s NEXT FOR DECENTRALIZED FINANCE?

The blend of blockchain and cryptocurrency adoption will be the ultimate driver for DeFi in the next year. Regulators continue to narrow in on guidance and controls to minimize fraudulent use and criminal activity. New oversight of users and transactions can also restrict some of its decentralized aspects that are both compelling and disruptive.

The most promising of use cases comes from the higher interest rate that’s possible through DeFi. The current state of inflation and low bank deposit rates has consumers turning to cryptocurrency alternatives, which tends to be highly volatile as a store of value. By pegging user balances into stablecoins, the fluctuation in value goes away.

A prominent platform with a strong reputation for security and stability needs to lead the DeFi movement in banking. This is where a dynamic partner bank can collaborate with an established blockchain firm to deliver a trusted solution. JPMorgan Chase is far ahead of other top tier banks in the US and has its own experience in blockchain with its Onyx platform, making it the best option from existing financial institutions.

Regardless of which company or use case brings DeFi to the forefront, expect more individuals and businesses to test the waters this year and providers to double down on solutions as soon as 2022.

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