Decentralized finance is a better option than traditional banking for smaller businesses in emerging markets.
- Decentralized finance (DeFi), is a new tool that allows small businesses to access financial services in developing countries, especially for small loans and remittances.
- DeFi is being seen by the transaction banking industry as a way to improve the inflexibility of current processes.
- The increased use of DeFi in transaction banks could create new capital opportunities for larger businesses and increase liquidity for SMEs.
Last summer, decentralized finance saw a revival. Bitcoin and ether cryptocurrencies are becoming more accepted as payment methods. USD Coin (USDC), which is a digital currency, has made significant strides towards becoming an asset that will not lose its value in the future.
The blockchain technology underpinning cryptocurrency and its supporting infrastructure are also on the way to providing a system for financial rails that is parallel to and connected to traditional financial infrastructure.
Coinbase and Compound Treasury both offer USDC-based loans with a minimum 4% yield. This is far higher than traditional products that have a similar risk. Smaller platforms also offer cross-border capital access at rates that are more variable and would not be available otherwise. This growth in loan products has been driven by the retail sector, which is made up of individuals who trade and hold crypto assets. US Bank and Morgan Stanley offer crypto products to their wealth management clients. What about businesses?
DeFi, which is literally decentralized finance and blockchain-based forms of finance that do not rely on banks, has been adopted by small businesses in developing countries whose financial needs are not being met by traditional banks. Some businesses use payment companies such as BitPesa, Tranglo, and the major DeFi exchanges for direct payments, or to convert payment amounts into USD-backed stablecoins for cross-border transfer.
What is Blockchain?
DeFi is now being seen as a disruptive force and growth engine in the greater transaction banking industry. Transaction banking is designed to address the operational requirements and daily transactions of financial institutions and businesses. These services are typically only available to top-tier customers of banks. They focus on managing the liquidity of companies, cash flows, and trade, as well as other tools that can be used to facilitate corporate transactions domestically and internationally. The industry's transaction banking revenue reached $1 Trillion in 2020.
Samantha Pelosi (SVP of Payments and Innovation, BAFT), the largest trade association for transaction banks, stated that DeFi offers traditional financial institutions potential efficiency gains and democratization of financing. DeFi eliminates the need to have relationships with trusted intermediaries. This makes DeFi disruptive and alien to traditional banks.
Nearly all international commercial banks have tried blockchain transaction banking services. However, they are slow and cumbersome. They are focused on streamlining bank processes and replacing traditional financial instruments with standard digital assets. This means that transactions are still approved and executed within the traditional banking system or established fintechs. A business's credit risk is determined based on its financial statements. It applies only to the business and does not allow for risk distribution across its systems. Client support infrastructure is extensive. This means that clients cannot be served without high fees. These practices can limit capital opportunities for larger companies and freeze out SMEs.
DeFi platforms are an alternative system and not a plug-in for existing banks. Because of their decentralization, transaction onboarding and market-based risks assessments are easier to scale across businesses' systems. Access to relevant information isn't dependent on centralized processing nor a prior relationship. Before DeFi, businesses would need to conduct anti-money laundering checks and "know your customers" check on all sources of capital. They also had to convince their counterparts that they were interested in the same transaction banking programs. They would also not be allowed to provide evidence of their performance on any debts or payables other than financial statements.
DeFi allows the exchange of trusted data within a system. This helps to reduce these obstacles to financial services for businesses. However, DeFi was not considered a viable alternative for their bank's services by most companies until now due to the volatility of crypto assets and regulatory uncertainty. Tesla's $1.5 billion purchase of bitcoin in bitcoin was driven by bitcoin's direct financial value as an asset and not its transaction banking requirements.
DeFi has previously addressed the complicated requirements of portable digital ID for business and provided a roadmap to provide access to financial performance records in transaction banking. However, it is missing two essential elements: an exchange with fiat currency and interoperability among different blockchains so that parties can freely interact with each other. For cryptocurrency to be able to provide a stable store value that can be used to currency and have an easy-to-use interface with traditional financial systems, the former is essential. For transactions to be scaled in the fragmented blockchain space, interoperability is essential.
What does the World Economic Forum do about blockchain?
Blockchain technology is an emerging technology that allows for secure and decentralized storage and transfer of information and value. Blockchain can be used for many purposes, including the electronic transfer and payment of funds. Bitcoin is the most popular example. Blockchain has the potential to be an effective tool for tracking goods and data as well as documentation and transactions. It has many applications that are almost limitless. It could eliminate intermediaries, reduce corruption, empower users, and increase trust. This is how blockchain could be useful in many industries.
However, blockchain has significant trade-offs in efficiency and scalability. This is why policy-makers are becoming more aware of the risks associated with it. These include ransomware attacks, fraud, and illicit activity. There are also concerns about the environmental impact and energy consumption of certain blockchain networks. This is a critical issue that is often overlooked. Cryptocurrency, so-called "stablecoins", and decentralized applications based on blockchain technology pose risks to end-users. They can also present risks to financial stability and greater risk to the general public, depending on how widely adopted they are.
Recent developments in DeFi have made substantial progress towards addressing these gaps. The first is the availability of stablecoins pegged to USD, such USDC, USDT(Tether), BUSD, Binance, Dai (Maker) and USDT (Tether). Curve and other robust cryptocurrency exchanges make it easy to convert USD-backed stablecoins to USDC. Interoperability protocols such as Popskip and Inter-Blockchain Communication protocol have been made available for private and public blockchains.
These capabilities will allow financial institutions and businesses to have more options for conducting business without the bank system. This can create significant efficiencies for larger companies as well as liquidity for SMEs. This is true for all major types of transaction banking services, including cash management and liquidity provision, trade finance, payments and escrow services, as well as custody of assets and cash management.
Non-blockchain fintech platforms provide these services without becoming banks. DeFi adds smart contract-driven workflows to business workflows. These are workflows that are executed at least partially by smart contracts and not manual intervention or non-blockchain-based automation. Companies that have custody of cryptocurrencies such as Paxos and Anchorage are seeking bank charters from the US Office of the Comptroller of the Currency. This will allow them to act as trust banks and offer regulatory safety and security to the corporate treasury.
DeFi can bridge the gap between SME financing gaps worldwide, with a total of $5 trillion.
DeFi supports in many ways the abandonment of the historical primacy of client relationships. Pelosi says that transaction banking is a relationship-driven industry. This business model relies on the fact that once a corporate client selects a bank to provide a service, and the relationship manager establishes trust with the bank, the client will then use other services. However, this has been changing over time. CGI's 2020 survey on transaction banking found that 30.5% of businesses have between two and five bank accounts, while 45.8% are looking into changing their banking relationships.
DeFi-based transaction banks strengthen the current trend of services being atomized and financial management relying more on technology, workflow management, and risk arbitrage to identify credit opportunities. Non-DeFi systems that are not decentralized do not have the same ease of onboarding that is available for DeFi-based systems. With centralized systems that don't communicate with each other, it is almost impossible to manage credit and workflow.
This last need is more pressing than ever for SMEs. Large enterprises are more efficient in transactions services than SMEs, but SMEs need credit to continue their business operations and survive. A 2020 report from the World Trade Organization and the International Chamber of Commerce and Trade Finance Global estimates that the gap in financing for SMEs amounts to $5 trillion. The need for financing has been a major concern for banks and fintech platforms. However, the existing structures that are available to service businesses are not well-suited to this problem. Although AI and general digitization platforms appeared to offer the best opportunity for immediate relief, DeFi's explosive growth has also accelerated the impact of blockchain.