Decentralized finance, an opportunity, or a threat for traditional institutions? (2/2)

This is the second part of our thesis regarding the relationship between DeFi and TradFi. We will now focus on the differences between both words, frictions, but also on new use cases and ways both can collaborate. Please note that since the writing of this article, additional collaborations have been started.

Here is a link to the previous section : Link

For the sake of simplicity, we will focus on retail banking and exclude corporate banking. Before the age of internet banking was a highly inconvenient business for the customers. Clients had to get out of their homes and offices and visit their nearest branch or ATM. Clients were accustomed to being cared for by their banker their whole life and changing from one bank to another was a painful and long process, involving lots of paperwork and lots of in person meetings. In the age before internet most of the clients were highly uneducated in terms of personal finance and banking transactions, coupled with very little options to compare the offering proposed by different banks, the customer was always the victim of high asymmetry of information, offering to the banks a privileged position in their relationship.  

With the advent of internet several things changed. The first one is of course the availability of information and knowledge. The customer is now able to compare the offerings and quickly check the conditions that are being offered by different suppliers, including fin techs and new services that could not reach customers in the past, but which are playing on equal grounds with traditional banks in the internet space.

The first websites offered by banks were basically simple brochures, detailing the addresses of the branches and probably some static information and limited content regarding the history of the bank itself. It was very characteristic of what we call internet 1.0, a push only service sending information with very limited interaction options. Eventually banks realized that offering services through the web might mean less branches, less overhead, more automation and better margins and profits. But also, better services for the clients, no more queuing in front of a teller in a bank branch for a simple transfer operation, more customized experiences and ultimately less fees and better rates for the customers. At the beginning customers were still quite afraid of wiring money online and making payments, it was difficult to go from writing a check or handing out cash from hand to hand to doing the whole operation online, without a human contact to certify that the operation went through. The rise of e-commerce platforms democratized internet payments. Becoming more confident, the banking customers were happy to use solutions such as PayPal for their payments, the dematerialization of payments was in full swing.

The next big thing was mobile banking, with the arrival of the smartphones, complex apps where now an option, offering to the banks a new way to interact with their customers. For the customers it meant that they basically had their bank in their pocket, being able to consult their balances and process payments on the go from anywhere, new identification options were also introduced by mobile banking further improving the general security of the services. The crisis in 2008 sent shockwaves within the banking world. Regulators crafted new laws and regulations to make sure that similar events do not happen again, some of the banks got bailed out by the state (de facto by taxpayers’ money), and the global trust from retail clients for banks tanked. Clients who paid fees, lost their life savings, and then had to bail out the same banks with their own tax money can indeed have reasons to complain.

In Europe, new regulations PSD, and then PSD2 also enforced new standards in terms of payments and offered a new legal framework articulated around SEPA. Those regulations have paved the way for cheaper innovation and permitted access to smaller providers that could not afford to deal with the previous complexities of payments to be able to join and start offering services on mobile. Often the fintech’s would focus on a single aspect of banking and try to offer a better service than the traditional banks themselves. TransferWise (currently known as Wise) and Revolut initially focused on exchange rates and currency swaps. And did it well.

Banks woke up hangover from the 2008 crisis and started to witness that part of their value chains and services were progressively captured by those small new challengers, they were also losing on the mobile app and innovation side. Therefore, Several banks partnered up with fintech’s or spin out new agile products outside of the bank, in Switzerland we can think of VIAC, Frankly or Yuh as prime examples of traditional banking players trying their hand at fintech products.

Many things have changed since the era of safes behind crates holding gold and cash for the rich customers in vaults. The time of cash is gone, digital payments are the new norm. Today the bank customer is entitled to carry its safe in his pocket, being able to pay with a swipe, pay a bill or book a transfer in an increasingly convenient manner. The concurrence is harsh, and the innovation is running fast, further disintermediating the final customer from the banking provider.

Banks have for a long time benefited from their position of power, but with the rise of the internet and a globalized concurrence composed of other banks and agile FinTech’s the place of the bank among society has changed.

Older generations are still accustomed to a long-standing relationship with their bank branch and their banker, combined with less comfort using smart phones and the internet, the relationship between them and the banks did not change that much. But for the younger generations, the change is drastic. Those users are digital natives, they are used to swap between apps constantly and they are informed, they won’t have any problems changing their banking partner based on their offers or special promotions.

For the first time in time the banks are on the backfoot regarding their retail clients. Interacting via screens and over internet made them indistinguishable, for a young professional a bank is a place where the salary is being wired and where bills are paid, nothing more and as such the pressure is on the banks to constantly offer better services. Most people today operate a vast number of financial apps and banks, often between 5 and 10. In conclusion, our thesis is that the relationship between the banks and the customers has become infrequent, indirect, and impersonal, hindering loyalty, and pushing the users to find alternative products that might fit their needs better.

Let’s summarize what key challenges are banks facing today.

• The customer is now pro-active in his choices, to boost loyalty banks need to propose a perfect user experience which encapsulates transparency, speed, customization, and simplicity
• The customer needs are becoming more and more specific, a fact well understood by fintech’s that are targeting very accurately those needs
• The mega trend of digitalization pushes banks to offer more and more diversified products, banks struggle to adapt their monolithic IT systems, not tailored to that effect
• Financial products can now be offered without any sophisticated bank account and openly, internationally
• FinTech’s are penetrating more and more the daily lives of the customers, users are now accustomed to use Venmo or Twint for their day-to-day payments
• FinTech’s started as payment providers but are now capturing an increasing number of bank segments, including wealth management (robinhood) and FX operations (wise)
• Big Tech (Amazon, Google, Microsoft, Baidu…), strong of their experience in the digital space and their data warehouses are starting to position themselves in the financial space as well, this is a serious threat to banking

But all is not grim, banks have aces down their sleeves as well, they have been collecting data on our financial habits for decades, and as such are in a prime position to design and ship customized products that will be addressing exactly our needs, whatever they are and how they evolve. Banks also have the advantage of having vast experience in regulatory and regulation, including KYC, reporting, AML standards etc. While fintech’s can innovate fast and develop beautiful, focused products, they will eventually face a wall when expending their operations or jurisdictions, and that’s the moment where the full weight of support functions, that are necessary in big banks, will eventually start to be important for those smaller players and will slow down their agility.

What is clear is that banks need to reinvent themselves, open up, partner and become more as platforms. Becoming an “open bank” permits to externalize the costly innovation process and become an orchestrator in the network, a key central actor in the value chain. Integrating new products faster, integrating partner apps and offerings will speed up the time to market. For a long time, the Open Banking trend and the heavy leverage of APIs was seen as the enabler for “banking as a platform”, this is true, but to go one step further, our thesis is that decentralized finance and blockchain product also have the capability to enhance the bank’s offering and transform them into regulated marketplaces for financial products.

We have seen what the term DeFi refers to in the previous chapters. TradFI refers to traditional finance and describes the traditional companies active in the space, such as banks or insurers. In this section we will detail the main differences between both groups of companies.

Autonomy and efficiency: Traditional banks and financial markets are burdened by monolithic systems, very high legacy technical debt and are greatly dependent on human capital and interactions. Trades must be approved; compliance officers must spend time reviewing transactions and operations and every process has a multitude of potential blockers. The sector is getting automatized, and things are moving faster, but nothing compared to what DeFi proposes. The blockchain is running the infrastructure and the smart contracts are providing the business logic and processes while the front ends and aggregators compose the apps. As we saw in section 3.5.4, Uniswap processed 2x less volume than Six but employs roughly 49x less employees. DeFi is vastly more autonomous and efficient today, of course this will probably not remain as is, and will probably evolve in the future as more and more requirements in terms of support functions are imposed on DeFi protocols. It remains to be seen how this will affect the efficiency of DeFi.

Availability: Traditional banks and financial markets have closing hours while the blockchain is running 24/7, at least the main ones. Bitcoin has an uptime of 99.98% (buybitcoinworldwide, 2022)[i] and Ethereum has simply never gone down. As such the infrastructure is always available, users can trade on decentralized exchanges at any point in time and can deposit or repay loans in the middle of the night as the service would be the same as during the day, nobody must process transactions or click on buttons to validate payments and wires, everything is handled in the background. This argument is one of the main ones that appeal to bankers when discussing about blockchain technology.

Transparency: The main public blockchains are open ledgers, from the very first transactions until the very latest one, every single bit of information is recorded in an immutable way. As such it is very easy to verify how much a given address holds in terms of crypto assets, all the past transactions that happened, where the funds went or how much liquidity a DeFi protocol have in a near real time basis. Two important points were raised here, so let’s develop this idea. First, the transparency regarding the transactions; it is quite frequent to hear that blockchain is anonymous, that blockchain is usually used for black market interactions and dodgy trades, that blockchain is used by criminals as it is a mean to obfuscate transactions. In real life, police authorities love when criminals are using blockchains to move around money, as all the money movements are trackable and will stay in the open ledger forever. If the criminals were using wires, it would take lots of effort to reconcile and have access to the data, on a blockchain, all you must do is either use a classic blockchain explorer such as etherscan.io or leverage more sophisticated services such as the one offered by Chainalysis or TRM labs as explained in section 3.5.10. This permits to solve past crimes, as the ledger is always here. The second point is regarding the transparency of the financial state and figures of DeFi protocols. DeFi protocols are running on sets of smart contracts, those are public, and anyone can audit the contracts, check the code, fork it to recreate the exact same protocol somewhere else or check the crypto balances in the smart contracts. As such, anyone can have a real time view as well on the treasuries and the total value locked in a protocol, in traditional finance this would mean that at any point in time we would have access to the treasuries, exact numbers of assets and their positions, debt, customers, transactions and any financial data relative to any bank on the planet, DeFi permits that. The DeFi Llama website is only one of the options to check the figures relative to the most popular DeFi protocols. In the illustration below we can see some of the data relative to the lending and borrowing protocol Compound, but the website offers a multitude of other indicators and data, gathered every second from the blockchain.

---

[i] Buybitcoinworldwide (2022). Bitcoin Uptime Tracker. Link

Interoperability and composability: Traditional banks are used to interact among themselves, whether to conduct trades on the market or structure complex transactions and deals. But they lack a common infrastructure stack, they conduct trades using excel sheets, emails, Bloomberg and phone calls, the interoperability of the systems or the products is already difficult within a bank, connecting with the outside and other banks is even more complex and remains very sporadic, it is a distant dream today. DeFi on the other hand proposes simplified integration and composability, as all the products are open sourced and function via calls to smart contract it is in fact very easy to integrate offering from one protocol directly into another. The products are composable, can be reused extremely easily and can be combined to create more value. This also means that there is a strong risk of domino effect that can spread from one failing protocol to a multitude of others as the bricks of the Lego tower are crumbling.

Innovation speed: Innovation speed is very fast in the DeFi space for a couple of reasons, the first and main one is of course the lack of regulatory oversight and the “build first comply later” type of mentality. Banks have been burdened with a lot of regulatory oversight and as such are way less agile and flexible in terms of what they can and can’t do. But an interesting second reason is the fact that most of the code in DeFi is open source, any new developer can “fork” the GitHub repo and launch the exact same smart contracts as an established platform. As such developers do not need to reinvent the wheel constantly and can innovate directly on top of what has been achieved, this is an extraordinary accelerator in terms of innovation.  

Regulation: Banking is an old and traditional sector, it had the opportunity to go through various market cycles, crisis, exceptionally good times, wars and as such evolved immensely since the first days. Banking has been part of our daily lives for centuries and as such regulators and governments had the time to craft more and more rules to frame the business. The last main event was of course the subprime crisis in 2008-2009, where banking giants such as Lehman Brothers went bankrupt and forced regulators and legislators to act regarding lending practices, tax policies, credit, or capital reserve requirements. For DeFi the situation is quite the opposite, this sector is nascent, it basically appeared out of nowhere in the last 2 years. As such regulators are still not quite sure about what to do and how to regulate properly without killing all innovation. What is sure is that whether it is the EU, the US or the UK, all main governmental agencies are looking into the topic.

Products offered: Product wise both worlds are very different, DeFi aims at replicating what traditional finance offers but is nowhere near the depth of products and services that the traditional financial sector can field. The traditional financial sector is dealing with every type of loan that is possible, not only over-collateralized and Lombard-style loans, but it also addresses the daily needs of retail clients with bank accounts, credit and debit cards, bills and invoice processing, they serve institutions via corporate finance, M&A, investment banking, they serve rich individuals with private bank services, in terms of comparison there is no discussion to be had. DeFi is here for 2 years, it only addresses a very small portion of what banks are offering.

The Bis provides the following insight regarding the primary function of banking activity: “Banks perform a crucial role in the economy by intermediating funds from savers and depositors to activities that support enterprise and help drive economic growth. Banks’ safety and soundness are key to financial stability, and the manner in which they conduct their business, therefore, is central to economic health” (BIS, 2015)[i]. And it is true, banks are a key intermediary between deposits and lending, they fuel the economy while enabling depositors to safely store their wealth. It is quite clear that the DeFi sector is far from this mission of economic growth, but it should be noted that the DeFi space is creating new products and new mechanisms that are totally new, whether it is the AMM (automated market making), the oracles or the high automation brought by smart contracts, DeFi is building new kinds of products that could provide value in the future as well and fuel economic growth.  

Governance: Finally, governance is an interesting aspect to consider when we compare both worlds. Banks are for their immense part corporations where the corporate governance can be defined as such by the BIS:” it is the set of relationships between the company’s management, its board, its shareholders and other stakeholders which provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance. It helps define the way authority and responsibility are allocated and how corporate decisions are made” (BIS, 2015)[ii]. The primary objective of corporate governance for banks is to safeguard stakeholders’ interest, whether those are shareholders, depositors, and various other actors. The structure is inflexible with controls at every level. In the DeFi space, the governance is usually more decentralized and takes the form of a DAO (a decentralized autonomous organization). But what is a DAO?

Anyone that has read a little bit about crypto over the past year has high chances of having come across the term ‘DAO’. One example is the ConstitutionDAO that tried, but failed, to buy an original copy of the US constitution last year.

There is no exact definition for a DAO or Decentralized Autonomous Organization. A DAO could be described as a group of people that organizes itself around a shared purpose through decentralized governance. That sounds quite vague. Let’s break it down:

• Decentralized: Governance is distributed across members, and it is run on open blockchain infrastructure
• Autonomous: Self-governing, the ability to self-preserve without outside influence
• Organization: Coordination & collaboration around shared objectives

In a nutshell, DAOs are the equivalent of traditional companies in the web3 space. A collective of people, a distributed community, an open workforce, that collaborates on a project or on a protocol. Interested participants can hop in and off to contribute from anywhere without any prerequisites in terms of geographies or socio-economic origins, and work together on a common goal.

In most DAO setups, the decision process is quite straight forward, users that hold governance tokens of a protocol receive governance powers, proportionally to their balance. The governance token permits the users to either propose new improvements to the protocol or to vote on the existing proposals to push them into production eventually. In some way the DAO token holders are indeed like stock owners, with the key difference that they benefit from more utility embedded in their “shares”, as they are empowered to create new improvement proposals and vote in a dynamic way, anytime and anywhere, instead of waiting for the annual shareholder meeting. Another key difference would be that unlike regular corporations, DAOs do not have to focus on returning value to their shareholders, which enables them to focus on the product itself and build innovative and interesting features rather than focus on generating cash each quarter.

Often crypto projects are not a DAO from the day of inception. Indeed, in most cases the project is initially centralized around the core team that develops the protocol. Once there is product-market fit and sufficient community participation, one could start to decentralize control of the project. Jesse Walden calls this “progressive decentralization”[iii]. An example of a project that is decentralizing its governance in stages is MakerDAO, the very first DeFi protocol. The protocol was initially run and controlled by the MakerDAO Foundation, which had a traditional organizational structure, but it announced last year that it would dissolve the Foundation and hand over control to the DAO itself, thereby moving to full decentralization (CoinDesk, 2021)[iv].

---

[i] Bank for International Settlements (2015). Corporate governance principles for banks. Link

[ii] Bank for International Settlements (2015). Corporate governance principles for banks. Link

[iii] Andreessen horowitz (2021). Progressive Decentralization: A playbook for building crypto applications. Jesse Walden. Link

[iv] Coindesk (2021). MakerDAO moves to full decentralization; Maker Foundation to close in “Months”. Brady Dale. Link

For illustrative purposes, the diagram below describes the governance process for AAVe, the lending and borrowing protocol.

DAOs are one of the governance models of the DeFi protocols, and probably the most exciting one, nevertheless it has started to bring scrutiny from the regulators. The CFTC has recently sued the Ooki DAO in the US, and allegedly the governance token holders who vote and propose improvements. The CFTC stated “DAOs are not immune from enforcement and my not violate the law with impunity” (The block, 2022)[i]. The CFTC also said that as multiple members of the DAO were residing in the United States while they were active in the governance of the DAO, and that as such the US regulation applied.

Finally, let’s finish with Openness: according to McKinsey, “2.5 billion adults, just over half of the world’s adult population, do not use formal financial services to save or borrow” (McKinsey, 2009)[ii]. Opening an account is easy in Switzerland, it’s quite easy across the whole developed world, but this is not a global standard. In the underdeveloped world opening an account is not easy, it requires an ID, it is prone to gatekeeping and prejudice, ATM are not available everywhere. The situation is evolving, and the bankability of the masses is progressing, but today, access to financial products through regular actors is not reaching 20% of the world population.

Eventually, once a customer has an account, the access to products is also inequal, it depends on your credit score, it depends on your wealth, it depends on your marital and family situation and as such can also be closed. We already touched based on the openness for DeFi protocols in a previous section, in DeFi everything is open, any user can connect to any DeFi protocol using their wallet, a wallet that can be created in seconds and that is reachable and usable as long as the user has an internet connection. This is a fundamental difference between TradFi and DeFi, and one that is regularly put in front of what makes DeFi special. As mentioned By Rune Christensen from MakerDAO at the World Economic Forum in 2021: “It doesn’t matter if you’re a hedge fund manager on Wall Street or if you’re one of the 1.7 billion people that don’t even have a bank account. With DeFi, you have complete access.” (Yahoo finance, 2021)[iii].

---

[i] The Block (2022). CFTC files lawsuit against decentralized autonomous organization. Michael McSweeney. Link

[ii] McKinsey (2009). Half the world is unbanked, Alberto Chaia, Aparna Dalal, Tony Goland, Maria Jose Gonzalez, Jonathan Morduch, Robert Schiff. Link

[iii] Yahoo Finance (2021). With DeFi, You have complete access. Ryan James. Link

But the DeFi space and the traditional banking space are also similar in some ways.

Technology usage: both worlds are heavily using tech to create, transmit and process transactions. While decentralized finance leverages the blockchain infrastructure to both keep the “golden source” of the ledger and to transmit and process transactions, the traditional finance world uses CSDs (central securities depositories), internal data bases and the SWIFT network to relay messages. In both cases the reliance on technology for infrastructure, storage and messaging is key.

Financial service offerings: We saw in the previous section that the offering proposed by both sides is still quite unbalanced in favor of traditional banking. But TradFi and DeFi are also offering some similar services to their users. The website defipulse.com lists the following categories in their DeFi List:

Out of this list, a vast majority of the listed products are common both to the banking world and the DeFi space, with a different level of maturity and openness of course.

Search for yield and attractive financial products: In traditional finance, the retail and private customers are searching for ways to manage their wealth and make it grow. You deposit your money into a bank account and then search for ways to make it grow. Banks are in competition to provide you with the most effective strategies and the best yields. In all fairness, today the banks are also in competition with fintech players and brokers that will often provide this service better. In any case, in the DeFi space the situation is quite similar, the users are looking for the best yields and are often jumping from one protocol to another following the best strategies and interests. Getting a return on investment, or interest has always been one of the corner stones of banking, and DeFi is not different, for centuries banks have been devising the most sophisticated liquidity management techniques regarding the rations between deposits and lending and have been crafting more and more complex investment products to satisfy the hunger of the investors. The DeFi space is currently in the same state, finding the best practices in terms of risk management, liquidity ratios and deploying new products that might attend to user needs, and desire for high yields.

Stability/Hacks: In DeFi and in TradFi the focus on security and risk management is paramount. As seen in Chapter 4 of this work, the DeFi space has been subject to a multitude of hacks and exploits that lead to approximately $ 3.6 bn of losses (cryptosec, 2022)[i], at the same time numerous DeFi protocols also fell due to the lack of proper risk management practices, such as the Terra collapse earlier this year that led to losses in the dozens of billions of dollars. Similar problems have been plaguing the banking space for decades as well, the subprime crisis in 2009 appeared due to lack of proper controls and due diligence on mortgages and the combination of bad debt into MBS (mortgage-backed securities) that traded well until the underlying loans started to default. In terms of security, as the banks are manipulating highly sensible client financial data, the standards must be excellent, nevertheless enormous hacks are also occurring there. Even if the data is stored in servers scattered across highly protected data centers around the world with best-in-class data defense software and engineers, still, the biggest banks are getting penetrated regularly, resulting in losses of private data and nefarious activities (Upguard, 2022)[ii].

In the end, what brings together both worlds is that banks and defi protocols are bridges for individuals or corporations to access financial services, such as liquidity, trading, payments and yield generating deposits, what brings them apart is their maturity level, depth in terms of service, regulation and speed of innovation.

---

[i] CryptoSec (2022). Documented timeline of DeFi Exploits. Link

[ii] UpGuard (2022). 10 biggest data breaches in Finance. Edward Kost. Link

DeFi and TradFi have an interesting love/hate relationship. If we go back in time, to January 03, 2009, when the very first block (genesis block) on the bitcoin blockchain was mined, the following message was encoded in the first block: “Chancellor on Brink of Second Bailout for Banks”.

This easter egg, hidden in the block data is referring to the headline of the day from the Times newspaper:

This sets the tone on why the bitcoin network, father of all other blockchains was created in the first place. It is therefore no surprise that the DeFi space also fostered this ethos of “us vs them”, the philosophy was truly articulated around the construction of a decentralized and autonomous parallel financial system that would not discriminate, that would be open, somehow private and collaborative. Especially for the people employed by the DeFi protocols, it becomes increasingly difficult to bank themselves and the company, as traditional banks are simply refusing to serve them with basic financial tools, necessary in our day and age, this does only exacerbate the mildly defiant relationship.

The tweet above is from Marc Zeller, the integration lead at the AAVe protocol, who is having problems with his regular banking activities due to his professional life working at a DeFi protocol.

With time the relationship is getting better and the DeFi protocols understand that they will probably not be able to survive and thrive alone, that they might get valuable insights and council from experienced bankers and that it might be beneficial to find ways to partner instead of being adversaries. As such, protocols are onboarding banks in their governance and are trying to increase their user base by offering their products through banks. As DeFi is getting out of the woods and attracts more and more scrutiny from regulators, it will have to find ways to navigate this complex environment, banks are a privileged partner for that.

On the opposite side, the banking old guard was especially dubitative concerning bitcoin, blockchain and DeFi. In September 2017, James Dimon (CEO JPMorgan) was famously calling bitcoin a “fraud” used by “Murderers, drug dealers and North Koreans” (Guardian, 2017)[i]. Since then, the tide has turned and most of the big banks are experimenting with Blockchain, including JPMorgan which created the “JPM Coin”. We are even seeing the birth of crypto banks in Switzerland, holding banking licenses, and regulated by the FINMA, providing crypto services and limited integration with DeFi protocols or even an Ethereum Staking service that was announced by Seba bank in September 2022 (Seba, 2022)[ii]. We believe that a turning point has been reached and that, if not fully accepted, blockchain and DeFi are considered now as interesting topics to at least explore or to learn about.

---

[i] The Guardian (2017). Bitcoin is a fraud that will blow up, says JP Morgan Boss. Link

[ii] Seba Bank (2022). Seba Bank launches Ethereum staking to enable institutional access to staking economy. Link

DeFi has been (and remains today) a dilemma and a head cracker for regulators, given its decentralized nature, openness, and extreme complexity in terms of operating models, infrastructure, tech stack and counterparts to talk to. Following its fast growth in 2020 and 2021 regulators are now taking a magnifying lens and trying to make sense out of this new kind of animal.

2022 has been an important year for regulation in DeFi. Since more than a year, the Brussels meeting room are full of discussions around MiCA, the acronym for the new European regulation around Crypto. Mica is part of a series of measures relating to digital finance in Europe, it aims at regulating crypto assets that are not entirely covered by existing regulations on financials instruments. The regulation is currently still being discuss and drafted, in the agreement published end of June, DeFi and NFT were notably out of scope of the regulation. DeFi was judged too complex and changing at such a pace that drafting a regulatory approach would have been difficult. More reflection is needed to carefully craft the right framework around it. An example of a measure that was included in the text in June was the necessity for the travel rule for exchange-to-exchange transactions (for any amount) and for the transfers from exchanges to private wallets (ledger, Metamask…) if the amount exceeds 1000 EUR. But it should be noted that there would be no need for travel rule for transfers between private wallets. In late September 2022, new rules are still being drafted and might be included in Mica, previously out of scope, NFTs are now pulled backed into the regulation (if they are fractionized, then they might be considered as fungible and hence be in scope of the regulation). A second amendment concerns the algorithmic stable coins, previously not covered by the regulation. The relevant news for us is that the DeFi sector seems to be still out of scope for MiCA, but that the European commission will write a report on the regulatory treatment of DeFi in the next 18 months. MiCA should be enforced in 2024 or 2025, DeFi will be probably next.

In the USA the year started with the highly awaited executive order by president Biden (The White House, 2022)[i], signed beginning of March. The order was positively received within the crypto community, given its tone and list of key priorities for federal agencies regarding crypto:

1. We must protect consumers, investors, and businesses in the United States. 
2. We must protect United States and global financial stability and mitigate systemic risk
3. We must mitigate the illicit finance and national security risks posed by misuse of digital assets.
4. We must reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets
5. We must promote access to safe and affordable financial services.  Many Americans are underbanked, and the costs of cross-border money transfers and payments are high.
6. We must support technological advances that promote responsible development and use of digital assets.

Currently DeFi in the US is assimilable to the wild west, no regulatory framework is designed or applicable. Regulation in the US is facing two major challenges, the first is quite straight forward, the lack of understanding and education inhibits regulators to produce a holistic and well-balanced framework. As such the first step should be focalized on education, in partnership with actors from the DeFi space. The second challenge is very much US-specific, it is difficult to align all the government agencies around a unified regulatory framework, the SEC, the FED, the IRS, FATF or the CFTC? All agencies are trying to have a say, which results in coordination problems. What is sure is that regulation is coming, as mentioned by federal reserve chairman Jerome Powell at a conference in September 2022, the “significant structural issues of DeFi” (TechCrunch, 2022)[ii] are calling for more appropriate regulation. SEC’s chair Gary Gensler believes that “existing securities laws are already fitting the crypto markets” (CoinDesk, 2022)[iii]. SEC is on a mission to recognize all crypto assets as securities but is currently facing difficulties to make this point stand, as demonstrated by the preliminary results of its lawsuit with Ripple. In reaction to the Ripple case, Adam Levitin, professor of law at Georgetown university wrote in a tweet “The question of whether something is a security is fact-specific, and there are important factual differences among coins” (Axios, 2022)[iv].  

Following the crash of the Terra ecosystem in May 2022, the treasury secretary Janet Yellen said that “We’ve had a real-life demonstration of the risks,” and that “We really need a regulatory framework to guard against the risks,” (AP news, 2022)[v].

The latest piece of information of 2022 is probably the most important one, in September the white house has released its first ever framework on regulating Crypto (The White House, 2022)[vi]. The guidelines follow the executive order published in March, in essence the main recommendations can be narrowed down to:

• Encourage regulators such as the SEC and the CFTC to continue making efforts to enforce law in the crypto sector and collect data on consumer complaints.
• US Treasury will lead a collaboration with financial institutions to help identify and mitigate cyber risk. The treasury will complete assessment on illicit finance risk embedded in DeFi and on NFTs by mid-2023.
• The possibility to eventually amend the bank secrecy act and laws against unlicensed money transmission to also cover digital assets service providers.

Another interesting event that occurred in August 2022 and that could represent a precedent, it was the addition of 45 public Ethereum addresses to the sanction blacklist by the US treasury department’s office of foreign assets control (OFAC) (US. Department of the treasury, 2022)[vii]. Ethereum addresses were already present in the list prior to this, but those were belonging to identified bad actors, this time the OFAC added the addresses of the Tornado Cash smart contracts. Tornado Cash is basically a mixer, that permits to send funds in entry and receive back the funds on another address while obfuscating the route between both addresses. It is a privacy tool that permits to break the link between wallets that are sending and receiving funds. It is being used for legitimate reasons (Ethereum’s creator Vitalik used tornado cash to send funds to support Ukraine) or for bad reasons (usage by the famous north Korean hacker Lazarus group). The banning of Tornado Cash is a special event as it is the first time that the addresses added to the sanction list are not linked to persons bur rather to a protocol. This in turn has raised concerns among the crypto community that it might ignite censorship at the base layer of Ethereum, in total contradiction of its initial vision of openness and inclusion.

As we can see, the regulation was the hot topic of 2022, regulators and state agencies are working hard to make sense of this new industry and provide a comprehensive, holistic, and carefully balanced legal framework. Regulation is necessary for DeFi to grow and is especially relevant in the context of regulated entities, such as banks, that would like to interact or propose DeFi services to their customers. Regulation will come, remains to be seen in which form. Closer to home, in Switzerland, FINMA regulated entities such as SDX, Sygnum, Seba and Bitcoin Suisse are already offering regulated banking services for DeFi protocols.

To conclude this section, here are a few additional examples of policy makers laying the groundwork for regulatory approaches to protect investors:

• AUG-21: SEC imposed cease and desist order on operators of DeFi money market. Platform offering +30 million unregistered securities offerings about profitability and operations
• OCT-21: FATF releases updated guidance that DeFi protocol operators may be subject to FATF riles where they are providing or actively facilitating VASP services
• MAR-22: BOE’s financial policy committee (FPC) stated in financial stability document that crypto activity in DeFi where “economically equivalent to. traditional financial services sector, the regulator permitter should be adapted to ensure it is regulated in the same way”

---

[i] The white house (2022). Executive Order on Ensuring Responsible Development of Digital Assets. Link

[ii] Techcrunch (2022). Fed’s Powell calls for DeFi regulation following “significant structural issues”. Manish Singh. Link

[iii] CoinDesk (2022). Sec’s Gensler holds firm that existing laws make sense for crypto. Nikhilesh De. Link

[iv] Axios (2022). Coming court ruling in crypto company vs SEC could have “Ripple” effect. Crystal Kim. Link

[v] AP News(2022). Crypto meltdown prompts Yellen to call for new regulation. Fatima Hussein. Link

[vi] The White house (2022). White house Releases first ever comprehensive framework for responsible development of digital assets. Link

[vii] US Department of the treasury (2022). U.S. Treasury sanctions notorious virtual currency mixer Tornado Cash. Link

Incumbent banks have roughly two choices when it comes to integrating DeFi services to their offerings. They could choose to take the risk and get involved or sit it out and wait for more clarity, both choices are valid, the main requisite would be to reassess the decision frequently as things evolve. Potential interactions between Banks and DeFi could take several forms, we list the main ones below:

• Banks integrating DeFi services and proposing them to their customers, an example could be a bank proposing to their clients the ability to deposit some of their cash positions in AAVe for a yield
• Banks becoming actors in the DeFi space, an example could be a bank becoming a liquidity provider for a decentralized exchange
• Banks providing banking services to DeFi protocols, an example could be a bank proposing credit lines, treasury services or cash accounts to a DeFi protocol
• Banks integrating DeFi protocols to conduct internal activities and transaction, an example could be a special liquidity pool used by various branches of a bank to fluidify the transfers and swaps of currencies

But what could be the benefits for banks that would choose to experiment with DeFi integration?

• The first benefit is Operational and IT efficiency through full end-to-end automation, leveraging smart contracts. As seen in previous sections, integrating DeFi offerings, either as a new product for the customers or an internal tool will provide benefits in terms of headcount and efficiency.
• The second benefit would be Native 7x24h, Blockchain is running all day every day, and as such it is an infrastructure layer that is always accessible. Trades, transactions, and operations could be performed at any time, on the weekend and during the nights.
• Thirdly, DeFi would offer new markets, new asset classes & introduce new participants into the banking space. The bank would be able to naturally grow its customer base and even potentially convert those new users into regular banking clients, at the same time the bank would be able to offer new ranges of products for their existing customers.
• Fourthly, banks could turn some of their standard services into commodities by disintermediating some of the intermediaries that inflate prices of transactions such as payments or FX operations.
• Finally, banks could leverage the nearly instant settlement offered by blockchains to improve the current t+2 standard.

Let’s now explore what could banks do concretely in the DeFi space, for this exercise we will be using the DeFi stack framework that we presented in an earlier section, the framework is proposed by Dr. Fabian Schär from the university of Basel (Schär, 2020)[i].

---

[i] Decentralized Finance: On blockchain- and Smart Contract-based Financial Markets (2020). Fabian Schär. Link

The settlement layer is the lowest level, it represents the infrastructure offered by blockchain networks, the capacity to broadcast and process transactions. The Ethereum blockchain is the main infrastructure used by the DeFi space today and the Ether token is the native crypto currency that is used to pay for processing transactions. In this layer banks could:

1. Use infrastructure for settlement: the infrastructure is running 24/7, it is managed by the blockchain and does not need any bank resources to maintain or expensive data centers and servers to run. Banks could use the infrastructure to run some of their trades or for settlement.
2. Banks could run validator nodes on blockchains, by validating transactions banks would earn a predictable and sound revenue while being part of the ecosystem. Banks could also run the validator nodes as a service, on behalf of interested retail or corporate clients. This would offer a new revenue opportunity for the bank and for the customers. 
3. Banks could propose new kinds of transaction services, such as confidential blockchain transaction that would use zero knowledge proofs to transfer value non-publicly between customers wallets, in a regulated way. 

The asset layer represents the capacity to emit customizable tokens of various sorts on blockchains. Over the course of the last couple of years various token standards have been created on blockchains (such as ERC-20, 1400, 721, 1055), those standards offer a predefined framework to emit tokens and manage their lifecycle.

1. A token is easy to emit, an issuance is just a technical transaction that anyone could do. What brings value to the token is the trust that is granted to the emitter and the token itself. As such when we trade USDC ERC-20 tokens, we trust that the Circle company behind the token is actively managing its asset backing to ensure the pegging to the dollar. Banks have traditionally been trusted partners for finance operations as such they would be in a prime position to be the trusted entities that deal with token issuance and management.
2. One of the main difficulties for small DeFi retail users today is the transaction costs. As interactions with smart contracts are as costly for small or big transactions (the transaction fees would be the same for a deposit of 100 or 1 billion USD into AAVe) it gatekeeps smaller wallets from compounding interests frequently to improve yields but makes it easy for bigger wallets. As such aggregating the interest collection, either for distribution or compounding would be a prime use cases for banks and their vast user bases.
3. Emission, distribution, and collection of tokens in the DeFi space is currently done without many best practices in terms of anti-money laundering and know your customer. We expect this to change in the future as regulators turn their attention to the DeFi Space. Banks are experts in the domain and could propose services to identify holders and ensure compliance at any stage of a transaction.
4. In our opinion the biggest opportunity for banks is Custody. We prefer to store our wealth in banks instead of our mattresses for evident risk reasons, we consider the banks to be a less risky and more convenient vehicle to hold it. When dealing with crypto, some early days users will continue to enforce the “not your keys not your coins” and stick to self-managed wallets, but for most users, a centralized exchange or a bank would be a far better option. A regular user would be at risk or losing his wallet, the private keys or getting simply hacked and losing all the balances in the wallet, in crypto there is no way back, once gone the funds are gone for good. As such Banks could be the trusted and preferred partners to custody and operate wallets for their clients. This would also offer the added benefit to include the crypto wealth into the assets under management of the bank and enable the customers to get new collateral sources for their loans and credit lines, as well as customized reporting.
5. Finally, banks have been active in asset management for centuries. Growing and multiplying the wealth of the customers has been a mission but also a source of income for banks. In past years it has been quite apparent that crypto users (and developers) lack basic risk management frameworks. Banks could become the asset managers, devising sound and complex strategies, based on models and centuries of experience in that field with a mature risk management framework.

The protocol layer contains all the “rules to play” for a DeFi protocol, those are sets of smart contracts that are written and published by the protocols themselves. The smart contracts directly dictate in a deterministic and transparent way what can a user do or cannot do for a given protocol.

1. Connection to protocols: Banks can develop connecting interfaces to protocols and leverage the products for their internal processes and offerings. We will see a few examples of this specific opportunity in the following sections of this document. Bank could offer loans via DeFi protocols to their customers or propose cash deposits in the form of deposits on lending protocols or even FX operations leveraging decentralized exchanges such as Curve and Uniswap. 
2. Institutional versions of protocols: Banks could partner with DeFi protocols with the objective of creating private and permissioned versions of those, reserved for KYC and validated participants, consortiums that would interact on an open network but within permissioned space
3. Manage treasuries and operations: Banks could for instance diversify the treasuries of the DeFi protocols, to make them more diverse and more sound. Banks have been offering corporate banking for centuries and as such would be perfect partners to manage the day-to-day financial needs and the long-term planning for DeFi protocols. Cash management, salaries management, investments, diversification, risk management, credit lines, investment banking or even M&A are all topics where Banks have a real added value in comparison to nascent and heavily tech oriented DeFi protocols.

Finally, the application layer contains the front end and integration tools for the protocols to present, publish and enhance the accessibility to their services, whether those are websites or more complex interfaces.

1. Integration / interfaces: Banks have been developing digital products for their customers for the last 2 decades, the competition with the fintech’s have also pushed the banks to really focus on a perfect user experience. User experience in DeFi is extremely poor today, transactions are difficult, risky, do not go through every time and are prone to stress and fear. Banks could perfectly develop new dashboards, new apps, and new ways to access decentralized finance via curated, smooth, and easy user interfaces that would abstract the complexities and the pain away from the user. Bank could perfectly integrate and white label DeFi solution directly in their online offerings transparently.
2. Curation and aggregation: We presented earlier in this document our thesis that banks will become more like platforms in the future, a financial services provider that will cater to the needs of the users. One way for banks to generate value in that setup would be to also aggregate and curate products offered by smaller players and integrate those in their offerings. As such, accessing DeFi through a dashboard operated by a bank would benefit the user from a convenience perspective and would put the bank at the center of the eco system. Users would be able to track all their positions and conduct operations along the whole DeFi Space, from their e-banking platform.
3. Asset overview, portfolio visualization and tax statements: Banks are great at aggregating wealth of the clients and providing them tailor made products and reporting capabilities. The DeFi space is not special in that regards, eventually customers will need to report their gains and their positions. A bank that would include the DeFi wealth into the portfolio overview and in the tax reporting for their customer would be in a prime position to serve the customers of tomorrow.

The traditional financial institutions, such as banks, have been hesitant in the last couple of years to commit and become active actors of the DeFi ecosystem. That’s why protocols have started to adapt their offerings and customize their products to match the standard of traditional finance. We presented in detail the original AAVe product, the open and public lending and borrowing protocol. But in January 2022, AAVe also launched a new adaptation, headquartered in London: AAVe ARC. In a nutshell, AAVe Arc allows institutions and the corporate world to access DeFi grade yields via permissioned liquidity pools. The Arc product is designed to be compliant with AML standards and regulations, all participating institutions having to undergo a stringent KYC verification. To get verified, Fireblocks, the first active white lister on ARC, has developed a framework that is in line with globally accepted KYC/CDD/EDD principles and FATF guidelines. At launch, 30 licensed financial institutions have been whitelisted to participate on AAVe Arc as suppliers, borrowers, and liquidators. Among the institutions are Anubi Digital, Bluefire Capital (acquired by Galaxy Digital), Canvas Digital, Celsius, CoinShares, GSR, Hidden Road, Ribbit Capital, and Wintermute. 

Today, the offering on AAVe Arc is sensibly the same as the regular product, with the only differences that the participants are selected and the number of pool options is smaller, as only WBTC, ETH, USDC and AAVe are available to lend and borrow. Institutions onboarded on the platform can assume any of the roles described, earning interest by providing liquidity, subscribing loans, or liquidating loans that are under collateralized. Banks tapping into the DeFi opportunity through permissioned, customized products will be a prime channel for banks and protocols to collaborate in the future.

Swarm markets is the first BaFin regulated DeFi platform. Aimed at both institutional and traditional traders, where users can trade tokenized securities along crypto assets, in a regulated environment. Swarm’s mission is to close the gap between crypto and traditional finance. In essence, Swarm is an automated market making (AMM) DEX powered by Balancer protocol on Ethereum with an additional regulatory layer to qualify market participants and assets allowed into the protocol, a Uniswap-like solution with a validation layer to decide who can enter and who cannot. The SMT token facilitates transactions and provides a discount / reward mechanism for participants.

The main difference with the traditional DeFi platforms is of course the fact that Swarm is regulated by BaFin:

• The managing entity is swarm capital GMBH licensed by BaFin as a securities dealer
• Swarm market pools with its compliance wrapper
• KYC/AML captured through “passport” user must connect wallet, verify an Ethereum address, and verify their identities. User information includes personal details, verifications, trading allowances and connected addresses

Swarm is what a decentralized exchange would look like if it was also aiming at targeting regulated and traditional institutions.

Bitcoin Suisse is one of Switzerland’s crypto pioneers. The company was established in 2013 and slowly transformed into a legitimate pillar of the crypto ecosystem. The company offers a wide range of crypto-financial services such as execution of trades, secured cold-storage of assets, on and off-ramping and staking. It is headquartered in Zug and manages 3+ Billion CHF in custody. It proposes a Swiss bank guarantee for client’s deposits and is a member of the self-regulatory organization Financial Services Standards Association. Bitcoin Suisse is considered as a financial intermediary and is therefore subject to Swiss AML/CFT regulations. As such, it is not a bank but is still considered as a regulated entity.

Liquity is a borrowing DeFi protocol that permits to take loans by depositing Ether, the ratio is 110% deposit to loan ratio and no payback time. The specificity of the Liquity is that the protocols only charge a one-time fee and does not charge interest on the loan and that loan is taken in the form LUSD, the stable coin operated by the protocol.  Currently Liquity has a total value locked of 430 million and processed more than 4 billion worth of loans.

Since 2022, Bitcoin Suisse if providing to its clients a unique DeFi gateway service to the ETH-collateralized loans on the Liquity protocol. By integrating directly, the DeFi protocol into their user interface, Bitcoin Suisse is providing a simplifying layer for interested parties. Customers can access 0% interest loans, in a secured and easy manner, they don’t have to install a web3 wallet, buy ETH on a centralized exchange, transfer the coins to their wallets and then interact with the Liquity protocol, everything is done directly from bitcoin Suisse. By using bitcoin Suisse, the customer also benefits from the added value of customizable alerts that will send alerts and margin calls in case the loan becomes dangerously close to liquidation.

We believe that integrating DeFi protocols in the banks user interfaces and product offerings will be one of the ways both worlds could partner in the future. Benefiting from innovative and advantageous financial products and combining those with the smooth UI and customer experience accumulated by banks over centuries. More information on the Liquity – Bitcoin Suisse partnership can be accessed in the interview with Bojan, in the dedicated section of this work. 

In July 2022, MakerDAO, the DeFi protocol behind the DAI Stablecoin and the famous French bank Société Générale have agreed to proceed with an historic collaboration. The proposition emitted by Forge (the blockchain arm of Société Générale) on the MakerDAO governance platform has been indeed accepted in July 2022 with more than 83% positive votes.

The proposition is simple, forge will now be able to operate a new RWA (Real World Asset) vault on MakerDAO where the bank will be able to deposit OHF tokens that they will be able to leverage to borrow DAI. OHF tokens are security tokens emitted by Forge and representing debt from real estate mortgages and corporate bonds, all rated AAA. The maximum number of DAI tokens that the bank will be able to borrow (or mint) is 30 million (worth USD 30 million).

This example is part of a broader strategy from MakerDAO to get closer to the traditional finance sector. According to some actors this is an essential way for DeFi to refine its value proposition, especially in times of distress and down trend. DeFi could benefit immensely from transitioning from a token game to becoming a receptacle for real and tangible assets such as the OHF token emitted by forge. The MakerDAO governance agrees with this statement as it passed several additional improvement proposals in that direction, but some voices are also raising against this shift, perceived as a treason of the initial mission of DeFi.

The Huntingdon Valley Bank operates as a community bank, it offers checking and saving accounts, cards, loans, mortgages, and online banking services to its customers in the State of Pennsylvania. It was founded in 1871 and employs a staff of 100 to 200 people. Historically HVB has focused on commercial and residential mortgages and commercial floating rate mortgages on stable properties and construction projects.

In July 2022 another vote operated by the MakerDAO governance accepted HV Bank as a new RWA vault to conduct loans. As tradition, all the governance decisions on MakerDAO are public and can be consulted freely, here is the vote relative to the new RWA:

Essentially the deal between HVB and MakerDAO will enable HVB to leverage a 100 million DAI loan from Maker to support its growth and new investments. In return, MakerDAO will profit from the possibility to diversify its counterparty risk and generate interesting returns from the DAI loaned out via the HVB’s bond managers. As described by the informative twitter thread by MakerDAO. “HVB will have access to DAI liquidity in exchange for the sale of participation interests in the underlying whole loans originated by HVB. HVB will originate loans to customers and then submit eligible ones for participation, once validated the RWA trust will acquire a maximum 50% interest in the underlying loan emitted by HVB by executing a certificate of participation in exchange for cash (DAI). Every month, HVB will then remit to the trust the pro-rata portion of all interests received by HVB in respect to the loan participations. “ (Twitter, 2022)[i].

---

[i] Twitter (2022). MakerDAO. Link

Following the opening of the RWA and the ratification of the agreement MakerDAO can now be a partner in the loans originated by HVB, it is in fact the very first noticeable partnership between a TradFi institution and a DeFi protocol.

TJ Ragsdale, the manager of the RWA vaults at MakerDAO stated that “As demand for crypto leverage is decreasing, rates in the real world are rising, so there’s an opportunity where Maker can mint DAI at a low cost of capital and lend it against really good, robust real-world assets at a higher rate.” (Blockworks, 2022)[i].

If this partnership is a success, it may bring legitimacy to the MakerDAO protocol within the TradFi world and may pave the way to other similar deals, with MakerDAO or with other DeFi partners.

---

[i] Blockworks (2022). MakerDAO Adopts real-world assets as crypto leverage demand wanes. Bessie Liu. Link

Latest news regarding MakerDAO are fresh, beginning of October 2022. Earlier this year, in June, the protocol voted to deploy excess funds from the treasury of the protocol into traditional assets as an investment. The vote enables MakerDAO to invest USD 500 million from the treasury into external assets, short term US treasury bonds, IG corporate bonds and ETFs. The goal for Maker was to diversify its assets, generate yield on its treasury and strengthen its balance sheet.

To lead this diversification efforts MakerDAO had to find a reliable partner, a bank, an asset manager to facilitate and lead. This is a done deal, as Maker has selected the Swiss crypto bank Sygnum for this task this month. Sygnum was selected due to its status as a “bridge” between the traditional financial system and the crypto space as well as its experience within regulated banking. To support Sygnum, BlackRock Switzerland was also selected as a partner.

Rajiv Sainani who leads the business development for MakerDAO in Europe stated that Maker needed “a counterparty with a banking license who could acquire the ETFs and also provide institutional-grade custody” (Sygnum, 2022)[i] for the digital assets, crypto and traditional financial assets. Sygnum indeed appears to be a prime candidate to fill in the role of the ideal partner as it holds a banking license in Switzerland and has been operating under the umbrella of being one of the first “Crypto Banks” on the planet. The director of customers at Sygnum, Martin Burgherr congratulated the establishment of this partnership by saying: “Maker’s vote confirmed Sygnum as a “crypto-native” bank, working hand-in-glove with the DeFi community. It is proof that traditional-crypto finance industry investments can flow both ways, and that the future has heritage, especially when shaping next-generation finance.” (Sygnum, 2022)[ii].

The first phase of the project will aim at allocating and investing USD 250m into a portfolio of BlackRock iShares ETFs. But to go one step further, this project will show case a two-way regulated bridge between a DeFi protocol and a TradFi institution and will start a flow of funds from the crypto space to traditional assets.

The USD 500 million diversification effort kick started by MakerDAO is the tip of the iceberg, as numerous other DeFi protocols and DAOs could benefit from better treasury management and diversification. Those funds are only waiting to be captured by professional asset managers.

---

[i] Sygnum (2022). Sygnum lead partner in Maker half-billion treasury diversification. Link

[ii] Sygnum (2022). Sygnum lead partner in Maker half-billion treasury diversification. Link

DeFi was born in 2020, it has seen a tremendous increase in popularity over 2020 and 2021 and since then has started to also be an interesting market for traditional players. We have listed in the previous section cases were DeFi and TradFi collide, we firmly believe that the list will expend drastically in the future as both world melt and borders become blurry.

For banks we believe that the catalyst for DeFi adoption and increase in experimentation will come from regulation. Currently DeFi is a black box in terms of regulation, as such it is extremely risky for a big financial institution to invest, commit and onboard DeFi protocols as clients or partners. If a clear regulatory framework is not provided, at least in the US and in Europe, we expect banking players to experiment from the sidelines and not get involved too much.

Initially we thought about doing two sections, one for banks and one for DeFi regarding concrete opportunities, but we quickly noticed that those are double ended, and synergies are profitable to the two sides of the coin.

When the regulatory, compliance and legal hurdles will be tackled, then banks will probably be bolder in their explorations and start to interact more with DeFi protocols. We believe that the main opportunities lay in the following areas:

Treasury Management and Corporate Finance: DeFi protocols and DAOs hold respectable treasuries and war chests, those assets are currently laying on blockchains, yielding small interests and suffering from high risk, as all crypto assets are highly correlated, diversification is difficult. Eventually the protocols will grow their headcount, will probably have to incorporate themselves to comply with future regulations and as such will have to also respect more drastic rules in terms of reporting and audits. We believe that Banks will become prime partners for DeFi protocols, those will become clients and will leverage centuries of experience in treasury management, investment banking, risk management as well as credit lines and classic services offered to corporate clients by banks.

Integration of DeFi protocols into banking user interfaces: DeFi suffers from poor user experience, it suffers from the inherent stress to sign transactions yourself, it suffers from a very high barrier of entry in terms of education and trust. It must be overwhelming for a new user to search for the right protocols, to get the right information and to avoid any mistakes that could put in jeopardy their whole portfolio. Banks offer this level of comfort, through their UIs and integrated dashboards and e-banking platforms bank could start to offer attractive ways for clients to participate in the DeFi space. Banks could offer clear buttons, comprehensible educational content and abstract away from clients all the hurdles and difficulties. No more installing wallets, buying crypto on exchanges, sending the crypto to your own wallets, connecting to protocols and signing complex transactions. Banks could offer all that with a single click. Liquid Staking would be a prime vehicle for that. Interested customers could instruct the bank to buy a set of Ethereum tokens and stake them in one click, the bank would pay the interest rate to the client at the frequency chosen by the customer and manage all the technical operations in the background. Banks could even craft new strategies around the basic DeFi offering such as options and forward contracts that would hedge the customer from the volatility of the native crypto assets.

According to blockchain research firm Blockdata, institutional access to DeFi could unlock a trillion-dollar opportunity (Blockdata, 2022)[i] over the next half decade. It is no secret that DeFi protocols would benefit immensely from additional capital deployed in the space, it would boost liquidity, it would bring legitimacy and would of course bring new customers and users.

Banks as the regulatory highway: DeFi protocols have troublesome waters ahead. The regulation is coming and is going to come hard. DeFi protocols will need to adapt fast and onboard in a record time compliance staff that will understand the business and will be able to steer the protocols towards regulatory compliance. Banks have been doing this for ages, banks already have fully trained, and battle tested staffs. Staff that know extremely well the requirements, staff that sometimes even participated in the elaboration of the regulation. To swim and survive, the DeFi protocols could leverage partnerships with banks, joint ventures, and collaborations to profit from the structure and gained experience in that domain, in turn banks would benefit from understanding better this new financial Lego brick, a brick that is particularly appealing to younger generation and tech savvy millionaires.

Efficiency & new open markets: Blockchain infrastructure is running 24/7 and DeFi protocols are by nature accessible, public, and always available. There are no closing hours and there are no intermediaries or mandatory operators to conduct and execute trades. The astounding automation level permits high synergies within banks. Banks could leverage this “free” infrastructure to progressively shift some of their daily activities from their internal silos, crippled with technical debt, high degrees of customization and complex interfaces to DeFi protocols. Such activities could be FX trades, cross border payments and transfers, internal transactions between accounts. Those could be achieved by leveraging decentralized exchanges, lending, and borrowing, part of asset management and investment services. As we have seen in previous sections, DeFi protocols are starting to upon up to the possibility of customizing their offerings to appeal to TradFi institutions, we believe that this trend will incentivize banks to progressively shift some of their activities to DeFi protocols, this is already the case today with fintech’s.

---

[i] Blockdata (2021). Could a Trillion dollars be waiting to flood into DeFi from institutions over the next 5 years. Jonathan Knegtel. Link

The value creation in the scenario where traditional financial players would adopt, integrate, or partner with DeFi protocols will be articulated around the following themes:

New business models: combining traditional products with decentralized options will permit to create new operating models and synergies that will in turn generate new business models.

New exotic products: the composability qualities of DeFi, the volatility of the market and the frenetic creation of new types of assets will incentivize banks to create new types of exotic assets, one example could be an asset that would combine a hedge against the volatility of Ether and permit to stake the asset efficiently to generate stable interest for the customers.

Exposure to new products for clients: Integrating offerings from DeFi protocols will permit to expend the portfolio of products and services that banks will be able to provide to their customers. New ways to swap security tokens at any time of the day, new financing options will create value for the customers.

Holistic advice to clients: By integrating DeFi and blockchain products into the product portfolio, banks will be able to bring new assets in their assets under management and offer a wider scope of peripheric services to the clients, whether it is more accurate wealth planning, reporting or tax operations. Customers will be delighted to benefit from better service and advice.

Composability and global reach: DeFi is global and cross boarder by definition, by plugging into this wide network, banks will be able to accelerate operations and benefit from atomic and t+0 settlement. Swapping currencies, sending funds will be nearly instantaneous. Launching new products will be as fast as plugging a new protocol, a matter of days.

New customers for corporate services: DeFi protocols are immature finance wise and will be prime new corporate customers, for treasury management, for partnership or for asset management and regulatory advisory. This will in turn generate value for the bank, who will benefit from additional corporate customers and for the DeFi protocols that will get access to services that they desperately need.

New collateral and liquidity options: Banks will bring new funds into their coffers, funds that will fuel new expansion plans for the banks themselves and their customers.

Free and speedy innovation: the innovation is lightning fast in the DeFi space, in a matter of 2 years a $200 Billion industry was born. The innovation is also open source and completely free in terms of accesses. Any actor plugging into this thriving eco system will benefit and create value

As was the case for the value creation, in terms of value capture, we will solely focus on the banks. Banks will capture value through three different channels:

Customers: Most banks that do not offer crypto services to their clients will probably miss out on revenues and assets, potentially even resulting in clients moving their accounts to other competitors that do offer a wider portfolio of services. Retaining and acquiring new clients that are tech savvy and looking to diversify their portfolio and integrate crypto and defi products is important. By being at the forefront of innovation, a DeFi curious bank will be able to gain back the lost customers and even acquire new ones from slower competitors. By retaining and gaining new customers the bank will capture value in the form of higher assets under management, but also through new fees and commissions. All transactions, all transfers, while being very much automated will be subject to new revenue streams for the banks. New revenues represent an important stream of the value capture. Finally, through holistic advice to their customers, banks will be able to know more about them and about their financial habits or consume patterns. The blockchain is public, once a customer links their private wallet to the bank, the bank has full vision about all the transactions there.

Corporate: Partnering with DeFi protocols will provide banks with new liquidity options and new funds. DeFi treasuries are big, and they are under-utilized, banks will put these funds to work, generate yield, diversify, and ultimately permit banks to capture new markets and generate new revenues by scaling faster. DeFi protocols are also in dire need of advisory and corporate services, banks will be able to expend their corporate customers base and by this mean generate new revenues.

Efficiency: Finally, banks will be able to capture value on the infrastructure level. Leveraging public infrastructure, a common good, to process transaction will permit to cut costs in terms of internal resources and IT effort. The bank will be able to eventually transform into a platform, an open marketplace where clients will be able to pick and choose products. Leveraging a common, global, open infrastructure would be a logical first step into that direction.

Integrating DeFi protocols into TradFi offerings or simply serving DeFi protocols with classic banking services will eventually happen soon, the opportunity is simply too big. But pulling together both worlds will not be easy.

The main challenge today is of course the lack of proper regulation. DeFi protocols can be, for the most part, accessible with anonymous/pseudonymous wallets, without any KYC, AML or CTF checks, the protocols are not properly audited and do not have to report much. As such it is very tricky for banks to get engaged into the space. As long as the regulators of the biggest economies will not publish clear guidelines and a comprehensive global framework to follow, banks will only dip their toes in the DeFi liquidity pools, carefully, without committing. Some will, such as the HVB, but those will be mostly exceptions. In Europe, the DeFi regulation will start to get drafted in the next 2 years, it will be probably the same for the US. The new framework will either kill DeFi by imposing stringent and inefficient rules or regulate moderately and permit DeFi to thrive with an increasing involvement from traditional players. The establishment of true, long lasting, and bold partnerships between DeFi and TradFi will only be possible with strong and clear regulation. Taxation and Jurisdiction clarity will also have to be sorted out. DeFi is decentralized by nature, the ownership and governance are quite opaque, it is difficult to put real identities in front of protocols and it is extremely complex to identify who is accountable and who is liable. As such, determining the jurisdiction and leadership of global and decentralized protocols will be one of the challenges to be solved if banks would want to create business relationships with them. Registering a new supplier or a new partner at a global bank requires efforts in term of onboarding, due diligence, compliance, and paperwork. The very nature of a DeFi protocol is a serious barrier for these processes and will need to change if DeFi and TradFi are meant to work together in the future.

Integration, operational oversight, and central risk management will have to evolve, banks are used to be in complete control of their proprietary or licensed software and infrastructure. SLA (service level agreements) are in place, hotlines can be called, and human support is expected to be available. Blockchain infrastructure and DeFi protocols are the complete opposite. There is nobody to call, nobody that is paid to assist you, the infrastructure is public, the apps are called “dapps”, and as such operational staff at banks will need first to get comfortable with this new paradigm. Some of the blockchains on which DeFi protocols operate have stability hiccups, but the main ones, such as Ethereum, have simply never gone down. Banks will have to loosen up their expectations of what is in their hands and what is not, learn how to plug into a decentralized network and be simply part of it. Central risk management will have to also adapt itself and learn how to deal with new types or risks and how to assess it properly. To complement the rest, complete and efficient monitoring and compliance tools will have to be developed as well, tools that are today being developed by companies such as TRM Labs or Chainalysis.

By interacting with decentralized protocols, banks will need to put in place new ways to protect their customers, new services that will include custody of digital assets, mature and well-designed infrastructure to interact with DeFi and various blockchains. Rigorous audits must be conducted prior to onboarding new DeFi products, audits that will have to be done frequently. Customers will need to be shielded by the banks from bots, algorithmic traders, flash loans, front runners, and various other exploits.

DeFi being an immature technical space, security and best practices will absolutely have to evolve and get better. If DeFi continues to be plagued with exploits and hacks as it is the case today, then involvement from traditional risk averse players will be only sporadic. Smart contracts are great tools for efficiency and automation, but those have only been around for a couple of years and as such are still in their infancy. Bugs, coding errors and technology risk will have to be studied, researched, and enhanced by academics, by security professionals and by blockchain experts. Protocols will have to be properly audited (security wise) before being integrated into bank’s offerings. To go one step further, the human aspect will also need to be addressed, as some of the DeFi protocols have “admin keys” that permit to bootstrap accesses and control the funds locked there. Usually, the admin keys are sharded and divided among a set of key users operating a protocol, to avoid the risk of having one or two members going rogue. But collusion cases have already been witnessed in the past. Selecting carefully the “admin key” guardians will be important; a potential solution would be to eventually include banks as guardians to cement a meaningful partnership.

Finally, it all comes to education. DeFi was feared, was deemed dangerous and most importantly, it was not understood well. Regulators, TradFi professionals, government officials need to have access to information, to well-crafted educational content. Within banks, innovation teams need to have staffs that are enabled to experiment and use DeFi technology, to understand it deeply, not only from reports and slide decks. Bootcamps, workshops, seminars need to be organized, where questions should be asked in an open manner, even the most difficult ones (KYC, security issues, consumer protection, regulation…). The key is to demystify the technology and make it concrete. One of the best ways to do so is to conduct hands on demos, where a limited number of attendants would install a wallet on their smartphones, receive some test tokens and then operate a few trades among themselves. Once the users have a fair understanding of a wallet and see that it is quite like other apps they might have used in the past, it is quite easy to transition to DeFi and show how to use the wallet in order to access services and products. For the leaders of those workshops, the goal would not be to convince the attendees that blockchain and DeFi are here to replace the whole banking system, but rather to spark some curiosity and open the minds of the participants. So that next time they stumble on a DeFi headline, they might read more and start their journey down the rabbit hole. Protocols and blockchain foundations need to publish documentation, developer SDKs, API, and interfaces to make it easy for newcomers to be onboarded.

Cryptocurrencies, blockchain and DeFi are polarizing, some people are still considering the whole space as a gigantic Ponzi scheme while others are already calling it the future of finance. What is certain is that the whole ecosystem has evolved dramatically in the last two years. It grew from a $ 500 million industry in January 2020 to $ 170 Billion in January 2022 (DefiLlama, 2022)[i].

The rise has forced incumbent traditional financial institutions and the regulators to start to investigate the space, learn and start to reflect on regulation and potential opportunities.

---

[i] DefiLlama (2022). Total TVL. Link

Our initial question was whether DeFi represents a threat or an opportunity for banks. Some voices are advocating that DeFi will completely replace our current financial system and that as such DeFi will redefine how we transact. This is most likely a utopian way to look at things. All things considered, DeFi is still a very small market, an unregulated niche that is moving extremely fast but that suffers from its lack of maturity, high level of uncertainty and extreme volatility. DeFi is not a threat for traditional finance and will not replace it, we will always need banks in our daily lives.

But DeFi is providing interesting contributions to the financial sector, it brings disintermediation, efficiency, privacy, resilience. It permits individuals without access to the banking sector to still leverage financial tools, it redefines how we as humans can collaborate around a shared goal with new governance models.It brings transparency to the financial world, it redefines what open finance means, it carries important values such as privacy and common good infrastructure. The field carries tons of opportunities, it is therefore no surprise that we have witnessed in the past year an increasing number of experiments and real partnerships such as the initiatives proposed, voted, and implemented by the MakerDAO community. In our opinion, banks will interact more and more with the DeFi space, whether it is on the product angle, by integrating and creating new offerings, or the corporate one, providing services and advisory to unexperienced DeFi teams. Our point of view is supported by the conclusion of a survey conducted by Deloitte at the AFR Banking Summit in 2022 that states that “banks are eager to play a prominent role in the DeFi ecosystem” (Deloitte, 2022), indeed, the majority of the responding banks consider DeFi as an opportunity and consider offering new products, get involved on the regulatory side or provide services to DeFi protocols.

For DeFi protocols, more interactions with the traditional world are unavoidable, it is bound to happen, both worlds will eventually melt and blur. But this is not necessarily a bad thing, the new influx of capital and the access to finance professionals will bring legitimacy and growth to the sector, it will professionalize it and make it better in the end. User experience will improve, trust will be guaranteed by the banks and new kind of use cases will be available for digital assets.

However, this cannot come without profound changes on the regulatory topic, clarity and a global framework are mandatory prerequisites for incumbent traditional players to get involved. Regulations will have to be carefully crafted by regulators, in partnership with DeFi protocols and partners from traditional finance. Education efforts will have to be sustained to bring all stakeholders up to speed, from a technical and operational perspective. International standards will have to be set and tools will have to be deployed around compliance and AML topics to pave integration opportunities. The space will have to sort out its security and exploit problem eventually as well. This is a high mountain to climb, but absolutely feasible. Banking and tech executives are joining crypto native firms, big tech is integrating crypto capabilities, cross pollination in terms of talents will develop solutions to current barriers.

Banks will integrate DeFi products, or position themselves as corporate partners, however our long-term vision does not end here. From a retail perspective bank will slowly lose their current monopolistic position, customers will be looking for products and offers rather than for a banking partner for life, they will be ready to switch from one provider to another in a blink of an eye, they will get accustomed to a vast portfolio of financial apps and partners, tailor made for their needs. In our opinion, banking as a platform will be the future, banks will be product dealers, a regulated gateway to financial products, curated and offered through banks. Similarly, to what we see today in the DeFi world, where users access different protocols by plugging their wallets, banking customers will be able to leverage a generic personal account, not linked to any specific bank, in their full control, and access banking products on marketplaces. KYC process and the user validation would also be done on the generic account level, the customers would be able to access the banking products without disclosing their full identity, the banks providing the services would only be able to see that the customer has been validated and is entitled to access their services. Self-sovereign identity (SSI) would be a solution in that regard, as it offers a blockchain approach to digital identity that gives individuals full control over their information that they use to prove who they are.

The DeFi space is evolving quickly, and as it grows, it professionalizes itself. 2022 has been the year of partnerships between DeFi and TradFi, we expect the trend to accelerate in 2023 and to explode in 2025 when a proper regulatory framework will be available. Banks and DeFi have much to gain by partnering as both options are very complementary.