Understanding DeFi and its Benefits to the Banking Sector

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 seen the light of day. 

What is Institutional DeFi?

Institutional DeFi refers to using DeFi protocols by major institutions to tokenize actual assets with institutional-level controls for consumer protection and regulatory compliance, as opposed to expanding 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 only a while ago. Thanks to digitization, there is increased efficiency, reducing workloads for bank branches and automation. 

But even when banks were digitalized, data remained dispersed, making reconciliation difficult. Although transactions took place online, bookkeeping needed to be done independently. DeFi alters this by uniting bookkeeping and transaction execution on the same network. Thus, an edge over conventional digitizing.

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 given to behavioural problems.

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

Today, some items in the DeFi wouldn’t withstand the typical level of due diligence banks perform. Unheard of 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 are still a relatively novel piece of technology. As a result, regulatory and legal bodies across the globe have begun to provide some guidance on the same. 

An example is Nevada in the United States, where the legal enforceability of smart contracts has been established. Yet, like yesterday, a broader agreement among nations is needed to establish a comprehensive legal framework to seal the 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 keep track of whale activity to assess the 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 important. 

Banks have previously experimented with DeFi using permissioned blockchains, which allowed only specific participants to join. However, institutional players have recently become more open to the idea, as seen in 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 workers to ensure compliance and risk standards can fulfil regulatory checks.

On the other hand, in the first quarter of 2022, approximately $10 billion (£7.9 billion) worth of cryptocurrencies were held via illegitimate addresses, according to a recent Chainalysis research. Per the estimate, fraudsters laundered circa $8.6 billion (£7.1 billion) worth of cryptocurrencies in 2021.

Once more, a compromise must be found where institutional DeFi players may authenticate themselves using strong KYC procedures. Also, users must follow any AML restrictions and on-chain analytics that the institutions require in order 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.