Understanding DeFi and its Benefits to the Banking Sector

“Banks do not adopt DeFi to decentralise finance, but to improve efficiency within controlled frameworks.” — DNA Crypto.

From 2020, banks and other financial institutions have increasingly engaged with Web3 services in the UK. This move also applies to DeFi, as several potential cases that could trigger a new wave of innovation have emerged. 

What is Institutional DeFi?

Institutional DeFi refers to the use of DeFi protocols by major institutions to tokenise tangible assets with institutional-level controls for consumer protection and regulatory compliance, rather than to expand institutional investments in DApps and DeFi protocols. 

One question often asked is: What extra advantages does DeFi provide to online banking?

 

• • – Automated business logic.

• • – Transparent ledgers.

• • – Tokens guarantee liquidity.

• • Use of interoperable and operable DeFi protocols.

Banking used to involve physical labour, paper-based transactions, and a network of institutions for communication, not too long ago. Thanks to digitisation, efficiency has increased, reducing workloads for bank branches and enabling automation. 

However, even after banks were digitised, data remained dispersed, making reconciliation difficult. Although transactions occurred online, bookkeeping had to be performed independently. DeFi alters this by uniting bookkeeping and transaction execution on the same network. Thus, an edge over conventional digitising.

Regulatory Compliance for Institutional DeFi

Banks undergo extensive scrutiny before providing their services to their customers. Stress situations are used to test its vulnerability, but, more importantly, a keen eye is kept on behavioural problems.

For example, if interest rates on lending products are incredibly high, they may be misrepresented to customers and therefore subject to scrutiny.

Today, some DeFi instruments wouldn’t withstand the typical level of due diligence that banks perform. Unprecedented in traditional financial services, several DeFi platforms compensate their liquidity suppliers with three- to four-digit annual percentage rates.

Legal Framework for Smart Contracts

The significance of Smart contracts in DeFi cannot be overstated. Despite their importance, smart contracts remain a relatively novel technology. As a result, regulatory and legal bodies worldwide have begun to guide on this issue. 

An example is Nevada in the United States, where the legal enforceability of smart contracts has been established. Yet, as with yesterday, a broader agreement among nations is needed to establish a comprehensive legal framework that provides a sound legal foundation for financial services using programmable money.

Data Privacy

DeFi applications have relied on the transparency of on-chain transactions to understand market dynamics. For instance, these apps track whale activity to assess market behaviour. The openness of on-chain transactions has given rise to models such as automated market making (AMM) in DeFi, enabling protocols to use real-time supply-and-demand data to calculate asset prices. 

However, veteran capital market players value transaction privacy. Brokers often act as intermediaries for institutions executing large market orders, which ensures anonymity. To achieve the success of institutional DeFi, a balance between DeFi and the privacy of traditional capital markets is essential. 

Banks have previously experimented with DeFi using permissioned blockchains, which allowed only specific participants to join. However, institutional investors have recently become more receptive to the idea, as evidenced by JPMorgan’s collaboration with Polygon. The challenge lies in achieving transaction privacy while providing on-chain information for AMM algorithms. 

AML and KYC Controls

Strong KYC and AML procedures are essential to banks and financial services companies. Banks employ between 10% and 15% of their workforce to ensure compliance and that risk standards can meet regulatory requirements.

On the other hand, in the first quarter of 2022, approximately $10 billion (£7.9 billion) in cryptocurrency was held in illicit addresses, according to recent Chainalysis research. According to the estimate, fraudsters laundered approximately $8.6 billion (GBP 7.1 billion) in cryptocurrency in 2021.

Once more, a compromise must be found that allows institutional DeFi participants to authenticate themselves through robust KYC procedures. Additionally, users must comply with any AML restrictions and on-chain analytics requirements imposed by the institutions to use the DeFi services they offer.

Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.