Voice of the Industry

The opportunities of DeFi for the financial sector explained

Tuesday 18 January 2022 09:01 CET | Editor: Alin Popa | Voice of the industry

With decentralised technologies set to revolutionise the global financial system and its institutions, Douwe Lycklama from Innopay explores the opportunities of DeFi for the financial sector

In a recent article, the Harvard Business Review predicted that the current economic situation caused by the COVID-19 pandemic will ‘hasten the progress to more decentralised value chains’. In the finance sector, cryptocurrencies such as Bitcoin and the underlying blockchain protocols are driving the shift to Decentralised Finance.

Bitcoin: the first introduction to infrastructural trust

Decentralised Finance (DeFi) is a permissionless infrastructure, fully secured by encryption, that enables people and businesses to perform transactions directly with each other, without needing institutions to act as intermediaries. The roots of DeFi can be found in the 2008 Bitcoin whitepaper that set out a new system for digital cash. Bitcoin made it possible to transfer value between two ‘peers’, through open-source software and without a sign-up process (i.e. permissionless), by building trust into the technology and the governance behind it. This was the world’s first introduction to cryptocurrency and the concept of infrastructural trust.

More for less

DeFi offers the interesting potential to reduce costs and increase speed in payments by eliminating friction in terms of technology, contracting, and coordination between multiple parties. This is expected to impact many functions of today’s payment and securities market infrastructures, such as clearing houses, RTGS, secure messaging, custody, exchanges, and FX services.

Digital assets enable companies to make their idle cash work for them. It is also possible to obtain yield by depositing into decentralised lending pools such as Aave and Compound. The yield is coming from borrowers who take loans against (crypto) collateral. If the value of the collateral drops under a certain threshold, the collateral is automatically liquidated, and the loan is repaid – with no human intervention due to the use of smart contracts.

How DeFi presents opportunities for the financial industry

Over the past decades, the financial ecosystem has evolved into a global maze of payment services, systems, and rules involving numerous players, including regulatory and supervisory bodies. How can DeFi be expected to impact on this ecosystem?

Today’s payments ecosystem can be simplified into the following high-level processes and actors (see Figure 1).


Figure 1 – Simplified representation of the complex and dynamic payments ecosystem.

Figure 1 shows the ‘bank-to-bank’ chain of payments for individuals and businesses. The credit card networks are built ‘on top’ of the banking systems so that digital transactions can be performed in any place and at any time, in brick-and-mortar stores and online. DeFi technology has the potential to bypass major parts of this traditional infrastructure. After all, there is a uniform crypto address space all the way down to the individual user, as well as a low threshold for technical and legal participation in the network, which is based on the very latest internet technologies. Figure 2 shows how the payments ecosystem could look in a DeFi world.


Figure 2 – The simplified payments ecosystem in a DeFi world.

This shows that once an asset exists on a blockchain, the user has full ownership and control. Additionally, digital assets can be moved around, irrespective of borders and jurisdictions. 

Users can choose to use a service provider to manage keys and access to the various blockchains. However, these service providers have so far tended to be new market entrants. This represents a clear opportunity for the financial sector. A handful of traditional players are now embarking on buying and holding crypto assets (e.g. PayPal in 2020 ). Moreover, in 2020, the US regulator (Office of the Comptroller) allowed banks to start offering custody services , which opens new avenues for existing players.

Examples of DeFi in practice

1. Countrywide payment systems and remittance 

In September 2021, El Salvador government launched a Bitcoin and Lightning-based payment network for handling both inbound remittance payments as well as point-of-sale payments. In a matter of months, the service was set up by various independent service providers and banks to provide wallet apps (such as Chivo and Strike) and gateways to the Bitcoin and Lightning network, all based on open-source components. 

This initiative has three drivers:

  1. Cheaper remittances. About 25% of El Salvador’s GDP comes from abroad (mainly from the USA). This usually entails a 5-10% fee being paid to the traditional banking system.

  2. Financial inclusion. Even the poorest people have been included in this move from cash to digital payments.

  3. Making Bitcoin legal tender. El Salvador is the first country in the world to do this.

Merchants in El Salvador have updated their cash register software. Users can now choose to hold their wallet balance in US dollars or in Bitcoin and can easily switch between the two, in order to limit exposure to volatility. The liquidity is provided through a government fund.

2. Merchant acceptance

Bitpay is one of the first crypto payment acceptance services for merchants. At the moment of a fiat check-out, buyers can choose crypto as their payment method. The Bitpay services calculate the corresponding amount in crypto in real-time and display this to the user. The user pays (e.g. by scanning a QR-code with a wallet app) and confirms the transaction to the merchant. Typically, the merchant receives the amount in fiat from Bitpay.

In November 2021, Regal Group (operator of 500 cinemas across the USA) announced the acceptance of digital tokens for buying movie tickets, popcorn, and drinks. By making use of the Layer 2* Flexa network, Regal allows users to directly spend a wide range of cryptocurrencies, stablecoins, and digital tokens (including Bitcoin, Ethereum, Dogecoin, Litecoin, GeminiDollar, DAI, Link, Atom, and BAT) from their wallet apps. Users pay by scanning a bar code displayed at the cash register and the transaction is settled instantly. Regal gets paid out in fiat dollars through the regulated part of Flexa.

* A Layer 2 protocol refers to a third-party integration that can be used in conjunction with a Layer 1 blockchain. The goal of the Layer 2 protocol is to improve the transaction speed at lower fees, thus allowing scalability, at the expense of a reduction in centralisation and security.

3. B2B payments

DeFi offers innovative treasurers ample opportunities. Through a growing number of regulated exchanges, they can use, hold and transfer stable coin values more quickly and cheaply. No negative interest rates apply. More adventurous treasurers are going all in with non-fiat cryptos, such as the listed company MicroStrategy led by Michael Saylor. In the summer of 2020, MicroStrategy converted all its excess cash into Bitcoin, which was a major event in the crypto and DeFi community. Since then, more companies have followed suit, including Tesla and Square.

DeFi holds the promise of faster, better, and cheaper payments, yet a number of hurdles need to be overcome, including the regulatory, commercial, and technical adoption of this nascent infrastructure. 

Nevertheless, this shift offers opportunities for incumbent financial institutions as they already have services and customers in place and seek lower costs and higher quality. An infrastructural change ‘behind the scenes’ does not necessarily have to change the basic user experience, as was demonstrated by voice over IP (VoIP) a couple of decades ago; it just makes the service better by improving quality and reducing the costs. DeFi ‘behind the scenes’ could achieve a similar outcome, with today’s market infrastructure slowly but surely migrating to this more decentralised technology stack.

This article was initially published by Innopay here

About Douwe Lycklama

Douwe Lycklama co-founded INNOPAY in 2002 and is one of the thought leaders of digital transactions, like paying, billing, identity, data sharing, and applicable regulation. His drive is to bring innovation in these areas to financial institutions, startups, businesses, and governments and help them innovate to make opportunities in digitisation a reality.

 

About INNOPAY

INNOPAY is a consultancy firm specialised in digital transactions, helping companies anywhere in the world to harness the full potential of the digital transactions’ era. Services include delivering strategy, product development and implementation support in the domain of Digital Identity, Data Sharing, Open Banking, Payments and Digital CSR. The services capture the entire strategic and operational spectrum of client’s businesses, the technology they deploy, and the way they respond to local and international regulations. We operate from our offices in Amsterdam and Frankfurt.


Free Headlines in your E-mail

Every day we send out a free e-mail with the most important headlines of the last 24 hours.

Subscribe now

Keywords: DeFi, INNOPAY, digital assets, blockchain, B2B payments
Categories: DeFi & Crypto & Web3
Companies:
Countries: World
This article is part of category

DeFi & Crypto & Web3






Industry Events