BCG Platinion; The barriers to decentralised finance
As the rate of digital transformation in the finance sector has increased in recent years, new innovative technologies and solutions have been viewed as outliers rather than part of traditional finance institutions. For instance, decentralised finance (DeFI) belongs to the crypto and blockchain communities, rather than that of banks.
However, this is changing. Our most recent research has revealed that a quarter (23%) of insurance, banking and trading companies have already introduced services based around DeFi, while half (55%) are assessing it and its applications.
Driving this transformation are the changing demands and expectations of customers in a digital world, creating a need for newer models of financing. This in turn is creating an opportunity for traditional finance institutions to bridge the gap between the ‘fringe’ technologies such as crypto and blockchain, and financial services.
That said, DeFi adoption is still in its earliest stages, and much remains to be done to address challenges around security and regulation, and only once those concerns have been addressed will uptake of the technology grow and its widespread benefits be seen.
The benefits of DeFi
One of the biggest reasons for the slow adoption of DeFi is that traditional centralised finance models are already effective. This understandably creates concern when switching to DeFi. But as DeFi’s use cases have grown, businesses have increasingly begun considering whether it could become a long-term alternative or at least addition to the services offered by centralised finance.
One of the biggest arguments in favour of DeFi is that it can help provide access to financial applications for individuals and institutions that perhaps couldn’t before – and its decentralised nature would remove the need for a trusted mediator, streamlining the process.
Already the financial services sector invests roughly $1.7 billion in blockchain services per year but due to regulations and low levels of liquidity this has had little impact to date.
However, DeFi can address some of the challenges that even traditional finance models face; for example it brings considerable benefit to economies that lack widespread traditional financial institutions, better supporting small and medium enterprises (SMEs) that are growing in those countries.
While centralised finance services often benefit institutions that have larger balance sheets – with a focus on them pursuing partnerships with similarly sized businesses to increase shareholder value – SMEs, which simply don’t have the capital to run that type of a model, cannot benefit in the same way.
The biggest opportunity for traditional financial institutions isn’t going to come from these established large businesses, but rather emerging economies and SMEs. By adopting DeFi, banking services will be removing many of the barriers facing these, in turn creating new opportunities for growth and economic prosperity.
Security and Fraud
With any new technology – especially where finances are concerned – there will be security concerns. And arguably the most significant drawback in DeFi is smart contract risk.
As with centralised finance, fraud remains a considerable worry, and indeed over two-thirds (70%) of companies believe that security concerns over fraud is preventing company-wide adoption of DeFi. Almost all financial institutions have fraud-risk but are reluctant to add any further vulnerabilities through the adoption of DeFi.
When it comes to DeFi, its digital nature means that the most common method of attack involves the exploitation of bugs in code and the manipulation of external price feeds for assets within protocols.
This has already happened in the last year, with notable incidents including DeFi lending platform bZx being attacked, allowing the oracle price of collateral to be changed. What’s more, $72m worth of assets from smart contracts were stolen from the Decentralised Autonomous Organisation (DAO). Critics of DeFi point to these two incidents as a reason to not consider its adoption.
However, these incidents have been valuable for better understanding the challenges facing DeFi, with each attack exposing a new vulnerability in the system, which can then be addressed to prevent them from happening in future.
Not only this, but thanks to its fast-moving nature, these attacks actually encourage developers and security professionals to take a proactive approach to security; identifying and preventing flaws before cyberattackers can even strike. And as with all digital technologies, as it matures DeFi will become more secure and will eventually match – or even exceed – the security of centralised models.
Breaking down the barriers of finance
Despite these challenges, it’s clear that traditional financial intuitions have acknowledged DeFi’s potential and are beginning to view it more seriously as an alternative service.
The most important component now for building businesses’ confidence in adopting the technology is security. Financial institutions understand that there is always an element of risk when it comes to change, but the benefits that a decentralised model can bring small businesses and emerging economies outweighs the drawbacks of ignoring it.
By working alongside experienced professionals in the crypto and blockchain communities, financial institutions will steadily begin building the next generation of financial services around DeFi. This, in turn, will remove barriers for both emerging economies and SMEs looking to do business on a local and global scale – boosting the economic welfare of millions worldwide.
By; Kaj Burchardi, Managing Director of BCG Platinion