Challenger Banks Editor's Choice Europe

Why Traditional Banks are Embracing DeFi to Catch Up To Challenger Banks

Challenger banks have led innovation and digital transformation for the past few years, with decentralised finance being at the forefront of that. 

Kaj Burchardi, Managing Director of BCG Platinion, shares his thoughts on the barriers facing the adoption of decentralised finance.

Kaj
Kaj Burchardi, Managing Director of BCG Platinion

Over the last few years, challenger banks have led an explosion of digital transformation across the finance sector. In a bid to differentiate themselves from their traditional financial service competitors, challenger banks have embraced innovative technologies that address customer challenges that simply did not exist before the digital age.

However, many of these transformative technologies have been often viewed as outliers in the finance industry, such as decentralised finance belonging to the crypto and blockchain communities, rather than banks.

But the success of challenger banks is now bringing about a revolution in the finance industry. Our most recent research shows that almost a quarter (23%) of insurance, banking and trading companies have now tested services based around DeFi, while over half (55%) are already assessing it and its applications. The latest crypto announcements of large banks around the world are confirming this.

As crypto becomes more mainstream as the likes of VISA begins to allow transactions across its payment network, there is clearly a growing need for traditional banks to turn to newer models of financing. In turn, this is creating an opportunity for financial institutions to bridge the gap between the ‘fringe’ technologies such as crypto and blockchain, and financial services.

In spite of this growing adoption, there’s much to be done before DeFi adoption becomes the norm in finance; and challenges around security and regulation are proving some of the biggest stumbling blocks. To be able to significantly grow the adoption of decentralised finance and for traditional financial institutions to realise its benefits, we must properly address these security concerns as an industry.

Removing barriers to finance with DeFi

But this all begs the question: If DeFi has so much potential, then why has it taken to long for traditional banks to adopt it? It’s actually quite simple, traditional centralised finance models are already effective. This inevitably creates concerns when switching to DeFi, as it is unproven and could pose a risk to the regular operations of the bank. It also takes time, investment and technical talent to integrate DeFi into existing systems. But as DeFi’s use cases have grown, businesses have increasingly started to consider whether it could become a long-term alternative or at least an addition to the services offered by centralised finance.

In fact, the financial services sector already invests roughly $1.7 billion in blockchain services globally per year, but due to regulations and low levels of liquidity, this has had a limited impact.

That said, the benefits of DeFi significantly outweigh its challenges. One of the biggest advantages of adopting DeFi is that it removes many of the barriers to accessing financial applications for individuals and institutions that couldn’t access them before – and its decentralised nature removes the need for a trusted mediator, streamlining banking processes.

Not only this, but DeFi can even address some of the challenges that traditional finance models face; for example it brings considerable benefits to economies that have less established traditional financial services, better supporting small and medium enterprises (SMEs) that are operating in those countries.

What’s more, centralised finance services typically benefit institutions that have larger balance sheets – with a focus on helping them pursue partnerships with similarly sized businesses to increase shareholder value. However, SMEs simply don’t have the capital to run that type of a model and 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.

Addressing security and fraud

As with any new technology that concerns finances, however, there are inevitably security concerns – and potentially the most significant drawback in DeFi is smart contract risk.

In particular, fraud is a considerable worry, with nearly three-quarters (70%) of companies claiming that security and fraud concerns are preventing company-wide adoption of DeFi. Although almost all financial institutions have fraud-risk, many are reluctant to add further vulnerabilities through DeFi.

DeFi’s digital nature means that the most common method of attack involves the exploitation of bugs in its code and the manipulation of external price feeds for assets within protocols. This has already happened in the last year, with $72m worth of assets from smart contracts being stolen from the Decentralised Autonomous Organisation (DAO) and DeFi lending platform bZx being attacked.

The upside of this, is that for every attack that exposes a new vulnerability in the system, experts are able to better address and understand the challenges facing DeFi, helping to patch against and prevent future attacks.

These attacks actually encourage developers and security professionals to proactively identify and prevent flaws before cyberattackers can take advantage of them. And as it matures DeFi will become more secure and eventually match – or even exceed – the security of centralised models.

DeFi taking finance globally

As challenger banks continue to succeed and DeFi receives recognition from international payments providers, traditional financial institutions have no choice but to acknowledge DeFi’s potential and consider it as an alternative service for customers.

The most important component for building businesses’ confidence in adopting the technology now rests with improving security. There will always be an element of risk when adopting new technologies, but the benefits that a decentralised model can bring small businesses and emerging economies outweighs any risks.

Thankfully, the crypto and blockchain communities are already well established and have experts who can help financial institutions begin bringing DeFi into their financial services. This will help ensure that banking services will be able to use DeFi to remove barriers for both emerging economies and SMEs looking to do business on a global and local level – helping them compete with challenger banks and provide services to millions more worldwide.

Author

  • Polly is a journalist, content creator and general opinion holder from North Wales. She has written for a number of publications, usually hovering around the topics of fintech, tech, lifestyle and body positivity.

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