Corporate Innovation/Opinion/

Four ways big banks can get to grips with decentralised finance

More than $120bn of value is stored in decentralised finance. It's no longer an unwelcome disruption for banks — it's an existential threat.

Leon Gauhman

By Leon Gauhman

The rules of finance are being rewritten at a rapid pace. Not only were markets recently stunned by Reddit’s ability to stick it to Wall Street, but a much bigger curveball is also bearing down on the titans of investment. At the time of writing, the ‘total valued locked’ (TVL) in decentralised finance, or DeFi, stands at $120.78bn — a staggering 700% growth in the last six months.

DeFi isn’t merely yet another unwelcome disruption for incumbent banks, it’s an existential threat.

This blockchain-enabled innovation has the potential to upend the global financial system by stripping transaction costs and stepping up the fight for next-level efficiency and speed. What’s more the whole point of DeFi is that it bypasses the need for centralised licensed custodians of money: aka, incumbent banks. What this means is that DeFi isn’t merely yet another unwelcome  disruption for incumbent banks, it’s an existential threat. 

Here are four ways they should respond:

1. Take bold steps towards cryptocurrency integration

DeFi and cryptocurrency are part of a wider cultural shift whereby consumers increasingly place value in digital assets such as NFTs and crypto. If banks want to embrace DeFi, they need to embrace this shift by acknowledging that not only is crypto is here to stay, there are trillions of dollars of value stored within it.

A pivotal move would be to allow consumers wider access to that value via their banking services.

A pivotal move would be to allow consumers wider access to DeFi via their banking services.

Some banks are making moves in the right direction: Revolut has enabled crypto trading since 2017 and has just added dogecoin to its offeringBBVA recently launched its first bitcoin transaction and custody service; while JP Morgan Chase became one of the first banks to trial the use of its own JPM digital coin in a real-world setting.

But for the most part the traditional sector still has the crypto handbrake on with HSBC and Barclays both sounding cautious notes. This resistance is understandable, but incumbents that continue to hesitate, risk becoming the financial sector’s equivalent of Blockbuster.

2. Embrace DeFi and help shape regulation

Financial regulators and central banks are crawling all over the issue of crypto assets and DeFi, recognising that they can no longer simply afford to see regulation and compliance as ways to block this next phase of evolution. Incumbent banks need to align themselves with this activity — ensuring they have an active role in shaping future regulation via technical instruments.

DeFi presents a big opportunity for legacy banks to avoid mistakes around open banking.

DeFi presents a big opportunity for legacy banks to avoid mistakes around open banking where the sector’s inertia meant it was left to regulators to push through API-driven innovation.

Options for banks to take a more proactive approach to DeFi include developing greenfield DeFi propositions in collaboration with the DeFI community and collaborating with regulators to work out how to build regulation around those propositions — while still preserving the decentralised nature of DeFi.

At the same time, banks need to evolve their own internal compliance workflows to connect their banking services and the wider fiat economy to the opportunities that DeFi is likely to offer. Viewing DeFi through an innovation lens is key. How can compliance frameworks be adjusted to enable DeFi to fulfil its potential?

One potential way forward is to shift the culture within banks’ compliance departments away from a risk-averse approach to an innovation-first approach,  by breaking down silos and encouraging compliance teams to work with engineers, designers and product people to test different compliance frameworks and try to innovate within those spaces. After all, compliance has adjusted to radical changes in onboarding: 20 years ago it was unthinkable that consumers could open a bank account on their mobile phone in 5 minutes.

3. Create bridges and develop middle way options  

Incumbent banks should be using their weight and resources to develop credible and trustworthy pathways between the centralised financial services ecosystem and the new world order of DeFi.

It’s true that banks have been experimenting with solutions like Ripple, however these efforts have tended to be small proof of concepts projects. There are no large-scale, exciting Ripple applications: Santander, for example, does not want to use Ripple’s XRP cryptocurrency for its international payments network despite being a major partner.

Instead, any significant moves to develop a bridge between traditional finance and cryptocurrency have come from crypto players like Coinbase. Having launched its IPO in April 2021 and joining organisations like the DeFi Alliance, Coinbase is establishing itself as the kind of bridge-building industry thought leader and pioneer that banks should strive to emulate.

Now that Coinbase has paved the way, there is no reason why major banks couldn’t follow suit and offer an equivalent product — a Lloyds Bank or an HSBC Coinbase, for instance — allowing customers interested in cryptocurrency trading to have a wider choice of platforms.

If DeFi moves mainstream, central bank-backed digital currency could be a key pillar of its ecosystem.

For those incumbent banks unsettled by the sector’s volatility, a safer (though more slow-moving) option might be to throw their support behind the fast-emerging world of central bank digital currencies (CBDCs).  If DeFi moves mainstream, central bank-backed digital currency could be a key pillar of its ecosystem. These may offer an alternative to current stablecoins  — cryptocurrencies pegged to ‘stable’ assets such as fiat currencies — which anchor a lot of the DeFi protocols.

Banks need to start thinking about what their role will be in supporting and engaging with these officially endorsed cryptocurrencies, and see where that takes them in terms of further development of decentralised products.

HSBC and Soc Gen are among several leading banks participating in a CBDC trial led by Banque de France, the aims of which include exploring the exchange of CBDC for crypto assets and testing the rules around CBDC and cross-border payments. For the banks involved in the French trial, it’s a huge opportunity to explore and be part of experiments that are taking place at the cutting edge of innovation.

4. Engage or partner with underserved next-gen financial investors

There is a new wave of technically sophisticated risk-taking investors who want to grow their wealth but who don’t have the option to seek returns anywhere else. This group sees value in non-digital assets and rejects incumbent banks’ patronising narrative that ‘investing is too complicated for ordinary consumers’.

Reddit community r/WallStreetBets, which gave Wall Street hedge funds a run for their money over GameStop, is a case in point. For banks to get ahead of the DeFi curve, it’s critical they engage dynamically with this digital-first and financially savvy subset of the population. They have to move beyond the paternalistic mindset that says only banks know best when it comes to investing money. The last 15 years have provided enough evidence to expose the hubris of this position.

Banks have to move beyond the paternalistic mindset that says only banks know best when it comes to investing money.

There has been some movement in this direction, with Goldman Sachs announcing it will facilitate client investment in digital assets including bitcoin. This is currently limited to its private wealth management clients worth $25m+, but it could provide proof of concept for the wider wealth management sector.

Morgan Stanley, for example, has made a similar move  but with a $2m threshold. Banks wanting to engage with next gen retail investors need to further democratise access to investment in digital assets by next gen investors who expect the same opportunities as wealthier investors.

Looking ahead, the next frontier will be asset management tools that simplify managing crypto for the wider retail investor market. Given the complexity of investing in digital assets, the development of asset management funds that both democratise and streamline crypto investment seems a logical next step for banks.

The coming convergence

It’s easy to think of traditional ‘centralised’ banking infrastructure and DeFi as competitive or oppositional forces — but the reality is that the two are likely to converge over time. There’s even a chance DeFi could help financial markets become more resilient by avoiding the friction points and siloes of centralised finance.

Traditional ‘centralised’ banking infrastructure and DeFi are likely to converge over time.

Ultimately the blockchain-based principles that DeFi relies on are likely to become fused with the underlying architecture of global finance. Faster international transactions, opportunities to make money work harder, easier access to lending and an openness to innovation are just some of the potential benefits that would arise.

One thing is clear: from improved digital identity, to the tokenisation of derivatives, to payment solutions for the underbanked, DeFi is where innovation is happening: how well traditional banking responds could be key to the next phase of innovation.

Leon Gauhman is chief strategy officer at digital product consultancy Elsewhen.

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