Opportunities & Challenges for Banks in the Context of Decentralized Finance
Authors: Dominik Jocham (BEI) and Markus Abbassi (Kaleido Privatbank)
This article is the second part of a three-part series on “Decentralized Finance – a Hype, a Threat or an Opportunity for Regulated Financial Institutions?” . The second article was written in collaboration with Markus Abbassi (Head Digital Assets, Kaleido Privatbank), who contributed his technical expertise and critically reviewed the structure and content of the article. We thank Markus for his valuable input and the lively exchange.
The term decentralized finance (DeFi) refers to a decentralized, blockchain-based architecture for processing financial transactions without intermediaries. In the first part of the series of articles on decentralized finance, we explained how selected DeFi use cases work, such as decentralized exchanges (DEX) or automated asset management (AAM). With their high accessibility, the reduced counterparty risk by processing transactions via smart contracts or the stability of the decentralized infrastructure, DeFi applications offer advantages over traditional financial architectures. On the other hand, a lack of regulatory certainty, insufficient know-how in dealing with DeFi applications among the general population, or even the lack of enforceability of contracts are challenges that still stand in the way of widespread adoption of DeFi applications.
Against this backdrop, we will show in this article why offering access to digital assets and DeFi business models is worthwhile for financial institutions and what challenges they have to overcome in order to provide such an offering to their customers. The basic prerequisite for offering decentralized finance is existing direct access to digital assets. Based on practical examples, positioning possibilities for regulated institutions will be presented as well as concrete opportunities and challenges.
As explained in the first part of this series of articles, the potential returns from an investment in digital assets or in DeFi business models are currently far above those of traditional investment methods. The resulting interest on the part of investors also makes decentralized finance attractive for financial institutions. By expanding their offering to include digital assets and related services, the latter can not only acquire new customers, but also achieve higher margins for their services thanks to the greater earnings potential. The expansion of the offering can be divided into three levels that build on each other: expanding the digital asset offering to include DeFi tokens, participating in DeFi business models, and offering asset servicing to third parties. A basic offering of digital assets, e.g., trading in and custody of digital assets, forms the foundation for the development of new revenue sources in the context of decentralized finance.
Expanding the Existing Range of Digital Assets
In recent years, the initial skepticism of financial institutions toward digital assets has steadily subsided, and the number of institutions with a corresponding offering is growing. A current example is the National Association of German Cooperative Banks, which is working on prototypes for a digital assets offering for potentially 18 million customers. In Switzerland, various retail and private banks are already on the market with such an offering, e.g. the online bank Swissquote, the crypto banks SEBA Bank & Sygnum, and the transaction bank Incore. However, numerous traditional financial institutions also already offer their customers access to digital assets. This is mostly still indirect access via, for example, exchange-traded products (ETPs) or certificates that invest in digital assets, as these securities can be easily integrated into the institutions’ existing technical infrastructure; however, some banks are also already working on direct access to digital assets. These digital assets are often the so-called “blue chips” Bitcoin or Ethereum. The product range can then be expanded to include further coins as well as a comprehensive range of services, which in addition to staking also includes, for example, the lending of these digital assets.
The next logical step is access to DeFi applications and tokens. If, for example, a bank offers its customers direct access to digital assets via online or mobile banking, it can expand this offering to include DeFi tokens. These promise a revenue opportunity for investors not only through price gains of the protocol or governance tokens, but also through a cash flow component through the underlying decentralized financial application (e.g., revenue as a liquidity provider in the context of decentralized exchanges; more details follow in the next section). In addition, the inclusion of DeFi tokens provides investors with the opportunity to design their own digital asset portfolio in a topic-specific manner, comparable to classic investment focuses (e.g. biotech, mobility or technology). Ideally, an offer of DeFi tokens is combined with direct participation in DeFi business models to counteract the dilution of DeFi tokens (more on this in the next section).
Participating in DeFi Business Models
The business models underlying DeFi, such as decentralized lending or automated asset management (AAM), represent a further opportunity to increase returns for both investors and the financial institution. From an investor perspective, this tends to generate higher returns than comparable products from the traditional financial world. For example, lending the stablecoin USDC in a DeFi context can generate returns of up to 7.25%. In the classical financial world, such an offer can best be compared with an asset management mandate of the financial institution. Here, for example, a bank actively manages the assets of investors according to previously agreed criteria and without first obtaining the investor’s approval for every investment decision. Investors benefit from the investment expertise and ideally from the bank’s ability to generate a return for the investor, while the bank in return receives a stable fee flow through the management mandate.
If this concept is applied to DeFi, the financial institution acts as an active manager of digital assets and invests them in corresponding DeFi applications in agreement with the investor. In the case of decentralized lending, the financial institution acts as a lender on behalf of the customer. By providing liquidity to the lending pool, lenders receive a reward in the form of the digital asset provided (e.g. USDC). They can either hold these assets or in turn provide them as loans. The latter is referred to as yield farming and aims to maximize the return received from providing liquidity for decentralized lending.
In the case of automated asset management, where the investment process is, as the name suggest, automated, digital assets are not invested by the financial institution but transferred to the vault of the smart contract and invested in other DeFi applications according to the investment strategy of the smart contract. For example, digital assets are transferred to lending pools (borrowing-lending) or liquidity pools (decentralized exchanges, DEX) and generate returns. Investors receive these returns, minus a fee for the AAM.
In the case of decentralized exchanges, a liquidity provider token (LPT) can be paid out by DeFi applications to liquidity providers as a reward for the liquidity provided. These tokens can in turn be transferred to a liquidity or lending pool to generate new returns for investors themselves. This investment strategy is called liquidity mining, i.e., maximizing one’s own return by repeatedly providing liquidity in the form of digital assets and liquidity provider or lending tokens in various DeFi applications. Minting LPT or lending tokens through the DeFi application dilutes the value of existing tokens as the overall supply increases. Consequently, it makes sense to keep lending or investing the tokens.
But why are these business models so relevant for financial institutions? For investors with digital assets, a bank not only offers a safe place to hold the private keys, but it can also invest the assets in DeFi applications during the custody period and provide new revenue opportunities for investors. In addition to a consolidated view of their assets, the financial institution also provides them with an all-around worry-free package, meaning that they do not have to deal with individual protocols and investment strategies. This service creates added value for the client and can therefore be charged with a clear conscience.
Expanding the Scope of Service Provision
A third opportunity in the context of DeFi and financial institutions is asset servicing for third parties. In addition to direct investments in digital assets, as mentioned above, traditional securities based on digital assets are driving institutional adoption, e.g., derivatives such as exchange-traded products (ETPs). These derivatives offer investors indirect access to digital assets by purchasing the derivative instead of the digital assets. According to the specifications in the securities prospectus, investments are made in various digital assets, e.g., Bitcoin. Due to the International Securities Identification Number (ISIN) that each security receives, it can basically be mapped in the custody account of most banks like any other security and the investor does not need any prior knowledge in dealing with digital assets (e.g. concerning safekeeping of the private key, or triggering a blockchain transaction, etc.). In recent years, digital assets securitized in this way have gained a lot of popularity and have found their way into the offerings of traditional financial institutions (e.g. Leonteq in Switzerland) as well as blockchain companies (e.g. the Austrian crypto exchange Bitpanda). For such an offering, these companies rely on asset servicing activities provided by a custodian such as the custody of assets or the calculation of the trading value. These activities originate from the traditional securities business. If DeFi is added to the range of investable digital assets, new product opportunities arise for issuers, e.g., a security that participates in the business models of DeFi applications. The financial institution takes over the custody of the digital assets and actively manages them (see opportunity “Participating in DeFi business models” for details). In this context, however, investors should be aware that, in contrast to a direct investment, an additional counterparty risk arises in the case of an ETP, since an additional legal entity is involved, for example in the form of a special purpose vehicle (SPV) or fund. In terms of efficient implementation, the question then also arises as to how many such products need to exist in the market and whether implementation should lie with specialized service providers or with the banks themselves.
Opportunities – an Initial Conclusion
By pursuing one of the above-mentioned opportunities, financial institutions are well prepared to face a future in which decentralized finance becomes more widely adopted. Particularly with regard to the increasing regulation of digital assets, financial institutions have suitable capabilities for mapping new regulations as they already need to comply with a multitude of different regulations in their traditional business. From the investor’s point of view, this can lead to a leap of faith that digital assets and DeFi applications are handled professionally and in accordance with the relevant regulations. The current developments in the direction of Web 3.0 favor companies that deal with possible effects on their business model at an early stage. In the context of digital assets and DeFi, it can be assumed that transactions in a Web 3.0 context will be predominantly executed in a decentralized manner by means of digital assets. Consequently, the role of central financial institutions as transaction processors definitely needs to be rethought.
The question now is why financial institutions do not yet fully exploit these opportunities. As with most investments with promising returns, there are challenges in dealing with DeFi applications that have not yet been comprehensively resolved.
Currently, there are various challenges in developing revenue sources in the context of DeFi applications. The most fundamental of these is the disruptive potential of DeFi for the existing financial industry built on centralized intermediaries. Another issue is the predominantly unregulated nature of DeFi applications, which poses challenges especially for supervised institutions.
Disruption of Business Model by DeFi
Decentralized finance is expected to be able to replace the existing business models of central intermediaries such as brokers, banks or stock exchanges. The automated processing of complex transactions by means of smart contracts calls existing structures in the financial industry into question and potentially renders them superfluous. The use of blockchain-based smart contracts can achieve a comparable level of trust in financial transactions without the involvement of central intermediaries while increasing settlement speed. Eliminating the need for intermediaries can be expected to make DeFi transactions more cost-effective as well as more efficient. The increasing adoption of digital assets among the general population as well as global trends such as Web 3.0 serve as additional catalysts for the spread of DeFi applications. Consequently, the further proliferation of DeFi applications indeed challenges established business models involving multiple central intermediaries.
Studying DeFi applications enables banks to assess the disruption potential for their own business model at an early stage and to derive measures. Initial measures include the development of know-how, the identification of efficiency and effectiveness potentials in their own service provision, or the structured examination of market developments in collaboration with relevant market participants from the blockchain/DeFi industry. Possible positioning fields for banks include custody of digital assets (incl. DeFi) or the role as trusted intermediaries at the interface to DeFi business models (e.g., when switching from fiat to digital assets and vice versa). In summary, banks can position themselves as active shapers in DeFi and be part of the change.
Knowhow & Skills in Dealing with DeFi
Dealing with digital assets in a regulated context requires different skills & knowhow in different departments of a financial institution. These range from conducting and evaluating the results of an on-chain due diligence (OCDD) in the compliance department, to developing a risk management framework that identifies and describes the risks of DeFi transactions and their impact on the rest of the business, to managing the technical custody of digital assets. The OCDD in particular is extremely relevant for banks from a compliance perspective, as comparable compliance standards to those applied to fiat transactions must also be adhered to for blockchain transactions. During OCDD, the transaction history of the digital assets concerned is examined, in particular via which wallets these specific digital assets were transferred in the past. Due to the high transparency of a public blockchain, transactions on the blockchain can be traced back to the first block created.
Dealing with DeFi requires further skills, such as understanding DeFi business models, evaluating individual protocols, or assessing the quality of smart contracts. As more and more financial institutions deal with the topic of digital assets and such skills are sought after in the labor market, recruiting specialists can be challenging and costly.
An important component of a digital asset or decentralized finance offering is the secure custody of private keys for accessing the digital assets. Particularly in an institutional setting, great weight should be attached to this issue, as large amounts tend to be held in custody, often for third parties.
Initially, the private key for the safekeeping of digital assets was often stored as a paper wallet, i.e., the private key was written on a physical piece of paper and stored securely. With the increasing adoption of digital assets, professional custody solutions for different use cases have become established. Depending on customer needs or operational considerations, institutional custody solutions offer the division of the private key into several components (“multi-signature”), customer-specific attributable wallets (“segregated wallets”) or integrated OCDD checks. They also offer interfaces to traditional systems, insurance protection or third-party certification.
The technology and infrastructure are now available, but implementation in legacy systems of financial institutions remains a challenge. Examples include different trading hours in the core banking system (CBS) and the continuously open trading venues for digital assets (both central crypto exchanges and DEX) or the reconciliation between booked holdings in the core banking system and the blockchain. In particular, the different trading hours between the crypto exchanges available around the clock and the posting options in the core banking system pose an operational challenge. Often, bookings in the core banking system are not possible around the clock because the CBS is not available for a certain time as part of end-of-day processing. The same applies to trading departments, which are based on trading hours in the traditional securities business and are usually not staffed on weekends and public holidays. Thus, during these times, investors are not able to react to market movements and to profit from them or to reduce their own risk.
The number of regulations dealing with digital assets has steadily increased in recent years, e.g. with the various legislative amendments around the topic of distributed ledger technology as well as the introduction of register securities in Switzerland, the extension of the scope of the Travel Rule to digital assets or the Token and Trustworthy Technology Service Providers Act (TVTG) in Liechtenstein. Further regulations are foreseeable such as the Markets in Crypto Assets in the EU (MiCA; framework for the overall regulation of DLT-based assets such as stablecoins or digital assets as well as related services such as the custody of private keys). The DeFi sector is often affected as well, but to a different extent than “classic” digital assets such as Bitcoin. It can be observed that often traditional regulatory concepts from established industries are applied to the relatively young asset class of digital assets. For a financial institution offering access to digital assets (also called Virtual Asset Service Provider (VASP)), these are operationally more efficient to implement for Bitcoin than for DeFi applications. This is mainly due to the decentralized nature of DeFi applications based on smart contracts. Unlike trading of digital assets such as Bitcoin or Ethereum on more centralized crypto exchanges, trading in DeFi via decentralized exchanges takes place in an automated manner and via smart contract. In this sense, there is no central counterparty that can be efficiently addressed by means of regulation (as e.g., the operators of the crypto exchange in the case of a centralized crypto exchange).
Another key question is how to assess the counterparty and ultimately the so-called beneficial owner (BO) in DeFi. Due to the peer-2-peer nature with an intermediary smart contract, which in turn is not a formal legal entity, it is almost impossible in current DeFi applications to identify the “effective” counterparty in a trade or in the granting of credit. Financial institutions are generally required to verify the recipient(s) of a transaction before execution or to trade only with approved counterparties, for example, to comply with sanctions regulations or to prevent violations of money laundering regulations.
The blockchain industry has developed rapidly in recent years, especially in terms of solving challenges and creating new business models. In the following, In the following, we present selected use cases to illustrate initial approaches that enable access to decentralized finance for regulated institutions.
Selected Use Cases
Whitelisting for DeFi access
US-based institutional custody solutions provider Fireblocks has partnered with lending protocol Aave to develop the product Aave Arc and provide identified trading parties with access to a DeFi lending pool. Fireblocks contributes the technical infrastructure for access, digital asset custody and trading party onboarding. Customers of Fireblocks who wish to use this service must go through a know-your-client process before being given access to the lending pool. This process is also known as “whitelisting,” which can be thought of as a regulatory compliant version of a guest list. Aave Arc brings the DeFi application as well as technology to this process.
White-listed users of Aave Arc are offered the same functionalities as in the open Aave DeFi application and can act as lender, borrower or liquidator (ensuring repayment of capital in the event of a loan default).
Aave Arc solves several challenges in the context of DeFi for financial institutions: On the one hand the counterparty in the lending pool is identified and on the other hand the infrastructure meets institutional requirements in terms of technology (e.g. external, independent certification of the infrastructure and processes or suitable interfaces to connect with existing internal IT structure) or integration depth into existing systems. Consequently, one must question the extent to which this is really a decentralized solution and how the returns to be generated behave in relation to the risk, as well as what influence such whitelisting can have on liquidity.
Securitization of Liquidity Provider Tokens (LPT)
The Swiss bank Sygnum has chosen a different way to access DeFi assets and has securitized various LPT. From an investor perspective, this addresses various challenges, for example, the banking & securities house license ensures that relevant regulations are complied with. The securitization of the DeFi tokens builds on an existing, recognized and widely used infrastructure (including ISIN) and thus increases the accessibility of the product. As custodian for the DeFi tokens, Sygnum takes over the blockchain-relevant transactions, thus further reducing the operational risk as well as the effort for the investor. On the other hand, the securitization of LPT means that direct participation in business models of DeFi applications, for example yield farming or liquidity mining, is not possible.
For Sygnum Bank, this new DeFi product means the expansion of its own investment universe as well as positioning itself as a pioneer in the handling of DeFi tokens in a regulated environment.
Using a DeFi Application to Expand Your Own Business Model
Switzerland-based broker Bitcoin Suisse launched a product in April 2022 that allows select customers to obtain blockchain-based loans from the DeFi application Liquity. Bitcoin Suisse customers can deposit their Ethereum held in custody by the broker in the Liquity smart contract and receive the token LUSD, a stablecoin pegged to the dollar, in return. They can subsequently exchange the token for a legal currency, such as CHF. The minting of the LUSD is automated without the involvement of an intermediary through the smart contract. For investors, there are basically no further fees apart from the transaction fees on the blockchain, a one-time start-up fee for the use of the smart contract and the minting fee for the LUSD. For the investor, the broker takes over the handling of the digital assets on the blockchain, the transaction to the smart contract and any desired exchange of the LUSD. In fact, the broker offers its customers the possibility to use the digital assets in custody as collateral for liquidity, comparable to a classic Lombard loan.
Summary & Outlook
Decentralized finance offers several opportunities for financial institutions with a basic digital asset offering to expand their own service delivery and to create a promising starting position for participating in revenue opportunities from digital assets and from business models that will evolve in the future. Challenges for financial institutions, such as connecting the necessary infrastructure to existing systems or ensuring the verification of counterparties, are gradually being addressed by individual solutions, but have not yet been comprehensively solved. For the DeFi industry, the adoption of DeFi tokens and DeFi applications by financial institutions offers a great opportunity to broaden the user base, access new liquidity and establishing a central point of contact for traditional investor groups. The selected use cases demonstrate how licensed financial institutions and blockchain companies can begin to take advantage of DeFi opportunities and participate in the development of this subcategory of digital assets.
Each financial institution can already begin to address the greatest challenge by using a structured approach to assess the effects of DeFi on its respective business model and challenge its understanding of what it means to be an intermediary. In particular, financial institutions must question their self-image of being intermediaries and gatekeepers in the traditional financial world and think increasingly in the direction of becoming cooperation partners for customers. In the future, a bank could, e.g., hold part of the customer’s private key in safekeeping and extend its strengths as a trustworthy and secure custodian of valuables into the context of digital assets.
In the third and for the time being last part of this article series, the focus will be on the new generation of DeFi applications, in particular the so-called Layer-2 solutions built on top of an existing blockchain, and how these, in combination with new blockchain-based services, aim to further shape the development of DeFi.
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 In traditional finance, the term blue chip refers to companies and stocks that have steadily increased in value over a long period of time and are considered safe. Alluded to are the blue poker chips that were the most valuable chips in the game at the time the term was adopted in the financial world; Ask CryptoVantage: What Are Considered “Blue-Chip” Cryptos? (CryptoVantage, 2022); retrieved 05/25/2022, from https://www.cryptovantage.com/news/ask-cryptovantage-what-are-considered-blue-chip-cryptos/
 If you want to read more into the topic of governance tokens, you can find out more at: What are Governance Tokens? How Token Owners Shape a DAO’s Direction (decrypt, 2022) ; Retrieved 6/2/2022, from https://decrypt.co/resources/what-are-governance-tokens-how-token-owners-shape-dao
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 Minting refers to the creation of new tokens based on a predetermined input. This is a typical mechanism for digital assets that are linked to a certain value (e.g. stablecoins). When the minted tokens are redeemed, they are usually destroyed.
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