How Decentralized Finance will transform business financial services? Especially for SMEs

Cryptocurrency seems to be the talk of everyone these days. However, it is hard to generalize the technology and its potential. On one side you have Bitcoin, the original cryptocurrency that first gained attention with a white paper in 2008. Since then, Bitcoin has grown rapidly as a digital store of value surpassing $1 trillion in market cap and forcing banks, traditional financial institutions and even crypto-skeptics to take it seriously.

On the other side of the spectrum stand smart contracts and Decentralized Finance (DeFi). Still in early stages of their development and years behind mass market adoption and acceptance of Bitcoin, both smart contracts and DeFi have the potential to be even more valuable given their many use cases and potential to digitize, democratize and transform global finance.

But why should you care about DeFi, even if you never intend to care about or own Bitcoin? Because it may change the future of financial services.

Think of how financial products are sold and serviced today: When you go to a bank or lender, you conform to their rules and rates, often with limited transparency. These financial institutions control the gates, and we are forced to trust them and their policies. This trust is easy (and important) to have in some countries but not as obvious in others with high rates of inflation, corruption and monopolistic banking infrastructure. In these markets, people often do not have access to a safe and stable place to deposit their assets, borrow money or even make long term investments.

Transaction banking addresses the operational needs and day-to-day transactions of businesses and financial institutions. Usually, only companies who are top customers of banks are able to have ready access to these services, which focus on managing the liquidity of a company, cash flows, trade and supply chain finance and other instruments needed to facilitate domestic and international corporate transactions.

The approval and execution of transactions still ultimately go through the framework of traditional banking or more established fintechs. For example, a business’ credit risk is assessed based on financial statements and only applies to that specific business, without the ability to distribute risk across its system. The infrastructure around client support is also quite extensive, which means clients cannot be serviced without a high threshold cost. These practices hamper capital opportunities for larger enterprises and freeze out SMEs.

Enter DeFi, which essentially enables financial services to operate in a fully open, borderless, widely accessible, and transparent digital form – as digital smart contracts hosted on a blockchain that is transparent and secure under a clear set of rules. Prior to DeFi, a business would have to complete anti-money laundering and “know your customer” checks for every source of capital and convince their counterparts to onboard to the same transaction banking programmes. They also would not be able to present evidence of performance on their debt or payables outside of financial statements.

DeFi allows for the exchange of trustable data across a system, mitigating these barriers to business financial services. Until now, however, most companies did not seriously consider DeFi as a viable alternative to their bank’s services because of the volatility of crypto-assets, regulatory uncertainty and the immature technology involved. Even Tesla’s purchase of $1.5 billion in bitcoin was motivated by the direct financial value of bitcoin as an asset, not by its transaction banking needs.

While DeFi previously solved the complex requirements around portable digital ID for businesses and has a roadmap for providing access to financial performance track records in transaction banking, it completely lacks two crucial elements: a one-to-one exchange with fiat currency; and interoperability between different blockchains so that counterparties could freely interact with one another. The former is necessary for cryptocurrency to offer a stable store of value that can be used as currency and to have an easily accessible interface with the traditional financial system. Interoperability is crucial for transactions to occur at scale in the highly fragmented blockchain space.

Two recent developments in DeFi have made significant progress towards plugging these gaps. First, availability of stablecoin pegged to the USD, such as USDC, USDT (Tether), BUSD (Binance) and Dai (Maker), is growing. Tools like Curve and robust cryptocurrency exchanges allow for easy conversion from one USD-backed stablecoin to another. Second, interoperability protocols, such as the Inter-Blockchain Communication protocol and Popskip, have been released for both public and private blockchains.

Each of these capabilities means that businesses and financial institutions will have many more options to conduct business independent of the banking system, with the potential to create sizable efficiencies for larger companies and open up liquidity for SMEs. That is true for each of the major categories of transaction banking services: provision of short-term liquidity and cash management, trade finance, payments, escrow services and custody of assets.

Non-blockchain fintech platforms already provide the first three without becoming banks, and DeFi adds the features of smart contract-driven workflows (business workflows that are at least partially executed by blockchain-based smart contracts, not by manual intervention or non-blockchain-based automation) and use of cryptocurrencies, a parallel, highly liquid asset class. As for the last two categories, companies that keep custody of cryptocurrency, such as Paxos, Anchorage and Kraken, are increasingly pursuing bank charters from the US Office of the Comptroller of the Currency to serve as a trust bank, offering security and regulatory safety to corporate treasury departments attracted to the cost and ease of blockchain-based services.

In many ways, DeFi supports the move away from the historic primacy of the client relationship. Transaction banking is a relationship-driven business. The business model has relied on the fact that once a corporate client chooses a particular bank for one service and the bank’s relationship manager establishes trust, then the client will use other services as well. This has been changing for some time, however. According to CGI’s 2020 survey of transaction banking, 30.5% of businesses work with between two and five banks, and 45.8% are reviewing their banking relationships for a possible switch.

DeFi-based transaction banking strengthens the existing trend where services are atomized, and financial management relies more on technology, workflow management and risk arbitrage for credit opportunities.The crucial values that DeFi adds to these changes are permissionless access and the greater emphasis on interoperability. Non-DeFi decentralized systems do not yet have the ease of user onboarding that encourages adoption. Workflow management and credit arbitrage across systems are almost impossible with centralized systems that do not communicate with one another.

Nowhere is that last requirement more urgent than it is for SMEs. While large enterprises seek efficiency in transaction services, SMEs require access to credit for continued business operation and survival. According to a 2020 report by the World Trade Organization, International Chamber of Commerce and Trade Finance Global, the shortfall in financing for SMEs is $5 trillion. Banks and fintech platforms have been scrambling to find a way to address that need, but the existing frameworks for servicing businesses are not a great fit. While AI and general digitization platforms seemed to be the best chance for immediate relief, the explosive growth of DeFi has also expedited the impact of blockchain.

There is still a long way to go but don’t be surprised if, within the next five years, DeFi is something we may all interact with every day.