Opportunities and risks of the DeFi market for users and banks
Decentralised Finance (DeFi) refers to the collection of financial services provided through decentralised protocols on public blockchains. The key characteristic of DeFi is that transactions occur through a protocol that utilises smart contracts to automatically connect the involved parties. Unlike the traditional financial system, known as Centralised Finance (CeFi), DeFi does not rely on a centralised authority that oversees and approves operations, instead, digital protocols are kept between all participants in coordination procedures.
The Association of German Banks has been monitoring the development of DeFi for some years now. There is no question that DeFi has the potential to complement existing financial services offerings effectively, provided that the DeFi market continues to mature. Banks will continue to play a significant role in a market that features DeFi. However, the absence of regulatory clarity surrounding DeFi protocols presents a challenge for regulated institutions to engage with DeFi providers or expand their market presence.
Like most emerging technologies, participants in the DeFi space are primarily spreading the word about the enormous potential that the decentralisation of financial services will offer users in the future. However, there are also significant risks associated with the use of DeFi applications. Banks, regulators and clients should make sure they understand the opportunities that come with entering the DeFi sector, as well as any potential risks they could be taking on.
As the technology evolves, it is important for us to support our members in their ventures into this space. Below, we outline the potential opportunities and risks of the DeFi ecosystem from the perspectives of both users and banks.
Opportunities for the user
DeFi provides improved access with low entry barriers. Users can access DeFi platforms from almost any smartphone and, in most cases, a classic bank account is not required. Users also profit from a higher degree of anonymity compared to CeFi, making it more appealing to individuals who prioritise data privacy. Moreover, there is better overall direct control over their assets as they have full control over their personal wallet and transactions can be carried out at any time or place via smart contracts.
DeFi protocols also provide higher transparency as users have 24/7 insight into their cash flows and access to on-chain proof of reserves. On top of which, public chains allow verification of transactions and smart contract codes. Lastly, the potential returns from DeFi applications, such as lending and liquidity provision, make the use of these technologies more attractive compared to traditional financial products. Moreover, users with more advanced technical knowledge can generate returns from the use of Distributed Ledger Technology (DLT), such as staking.
Risks for the user
The use of a smart contract as the sole “intermediary” in transactions also represents a risk. Transactions with DeFi protocols are nearly impossible to reverse, which is dangerous in the event of a hacker attack. Additionally, weaknesses in the program code of the protocols can lead to financial losses. In addition, user errors in the safekeeping of private keys or interaction with smart contracts can result in the loss of crypto assets. A lack of technological knowledge and competence by users can also facilitate fraud.
Users are exposed to high levels of volatility. DeFi tokens and assets may experience significant price fluctuations and potential losses if the collateral in smart contracts is liquidated. Another point of concern is that the provision of liquidity to Decentralised Exchanges (DEXs) can lead to unstable losses due to price changes in the deposited assets. The complex functionality of the protocols and of the smart contracts often makes it difficult to anticipate actual losses.
The presence of unregulated providers in the market introduces additional risks and uncertainties for users. The liability issues are unclear in the event of potential losses in value of the invested capital due to hacks or vulnerabilities in the platforms.
Opportunities for the banks
Partnerships or integrations with DeFi Platforms can be viewed as innovative extensions of the business model. Banks looking to develop their own tailor-made smart contracts can improve user experience. Utilising DeFi platforms may lead to enhanced efficiency gains thanks to the automation of processes through smart contracts and an improved control of liquidity. The use of DeFi applications simplifies market entry and means greater access to new client groups, resulting in a higher market expansion such as EU-wide offers. Also, it expands service capabilities as automated DeFi applications enable 24/7 availability of lending services. Furthermore, overall risks get minimised by eliminating counterparty risks through DvP (delivery versus payment) contracts.
Risks for the banks
The decentralised approach could lead to the cannibalisation of financial intermediaries. There is also the possibility of counterparty risk. Cooperating with new DeFi platforms carries the risk of financial losses and reputational damage due to the current volatile market situation and low degree of transparency, as the platform providers are not regulated. Venturing into the DeFi space poses greater regulatory challenges. This uncertainty surrounding regulation exposes banks to compliance risks including liability, money laundering and tax-related concerns. As a result, investments in DeFi may be withheld and there is high risk of international fragmentation.
Integrating DeFi also entails operational risks, as banks need to adapt their infrastructure and risk management to handle smart contracts. Security protocols and cybersecurity measures must be adapted to align with the decentralised protocols and keep up with dynamic market developments.
Overall, we support the developments in the DeFi space and the innovations that come with it, but it is crucial that it is executed effectively. Most importantly, regulatory gaps need to be closed to ensure customer protection as well as financial stability. It is also important for everyone to acquire knowledge and develop the necessary technological skills to fully engage with it. Future regulations will determine how traditional finance interacts with DeFi, as the regulatory environment is still evolving. Once the regulatory framework is clear and risks can be better assessed, traditional institutions would then be able to adjust and integrate DeFi technologies at a larger scale.
