How financial institutions can embrace decentralised finance

Finan­cial ser­vice com­pa­nies in the Mid­dle East, includ­ing banks, insur­ance com­pa­nies, and fin­techs, have a grow­ing inter­est in the oppor­tu­ni­ties and risks posed by decen­tralised finance (DeFi). Jorge Cama­rate, Antoine Khadi­ge and Vishal Gup­ta from Strategy& out­line how insti­tu­tions can start embrac­ing decen­tralised finance.

As its name sug­gests, decen­tralised finance refers to peer-to-peer finan­cial ser­vices with no cen­tral author­i­ty or inter­me­di­ary involved in trad­ing, lend­ing, invest­ing, and oth­er activities.

Among the advan­tages of DeFi are low­er fees, due to the lack of inter­me­di­aries; increased trans­paren­cy, since all activ­i­ty is read­i­ly acces­si­ble and view­able to every­one; increased secu­ri­ty and valid­i­ty, since trans­ac­tions can­not be altered once they are stored; and easy exchanges among accounts and companies.

Although only a tiny frac­tion of finan­cial ser­vices trans­ac­tions today are offered through cryp­tocur­ren­cies com­pared to gov­ern­ment-issued cur­ren­cies, the cryp­to ecosys­tem is expand­ing at a blis­ter­ing pace, fueled by keen inter­est from the invest­ment community.

Mean­while, exam­ples abound of extreme volatil­i­ty, plat­form fail­ures, crim­i­nal­i­ty, and envi­ron­men­tal risk. In this envi­ron­ment, finan­cial ser­vices exec­u­tives must care­ful­ly con­sid­er their approach­es to DeFi – includ­ing how, where, and when to invest – while simul­ta­ne­ous­ly acknowl­edg­ing and mit­i­gat­ing the risks and avoid­ing cost­ly missteps.

Stay­ing on the side­lines is not a viable option giv­en the learn­ing curve, oppor­tu­ni­ties to exert influ­ence as the ecosys­tem devel­ops, and the poten­tial to estab­lish a role that gen­er­ates sub­stan­tial returns and staves off competition.

Glob­al cryp­to com­pa­nies with an inter­est in DeFi have begun to expand into the Mid­dle East. Binance, the largest cryp­to exchange glob­al­ly, announced plans to set up its Mid­dle East head­quar­ters in the Unit­ed Arab Emi­rates (UAE).

Like­wise, local com­pa­nies have begun to par­tic­i­pate. Rain Finan­cial, a Bahrain-based cryp­to exchange, recent­ly raised $110 mil­lion in fund­ing, pri­mar­i­ly from for­eign investors includ­ing Coin­base Ventures.

Joining the ranks

Banks and oth­er tra­di­tion­al finan­cial insti­tu­tions can con­sid­er par­tic­i­pat­ing in the DeFi mar­ket in a vari­ety of ways.

First, they could oper­ate as a trust­ed dis­tri­b­u­tion chan­nel. Banks already have a cap­tive cus­tomer base and have invest­ed con­sid­er­able resources in the dig­i­tal cus­tomer expe­ri­ence, which the DeFi ecosys­tem is sore­ly lacking.

Sec­ond, banks can offer safe cus­tody ser­vices – akin to safe deposit box­es – for cryp­tocur­ren­cy and oth­er dig­i­tal assets such as non-fun­gi­ble tokens (NFTs). Already, US Ban­corp, the fifth-largest bank in the Unit­ed States, has begun pro­vid­ing cus­tody ser­vices to fund man­agers to store pri­vate keys for bit­coin and oth­er cryptocurrencies.

Third, banks and oth­er finan­cial insti­tu­tions can devel­op cred­i­ble and trust­wor­thy path­ways between the cen­tralised finan­cial ser­vices ecosys­tem and DeFi. For exam­ple, Gold­man Sachs recent­ly announced it will facil­i­tate client invest­ment in dig­i­tal assets includ­ing bitcoin.

Fourth, banks can use DeFi to stream­line tra­di­tion­al­ly cum­ber­some trans­ac­tions. For exam­ple, the typ­i­cal cross-bor­der pay­ment goes through six insti­tu­tions – two cen­tral banks, two cor­re­spon­dents, an orig­i­na­tor bank, and a receiv­er bank – before it is set­tled. Alter­na­tive­ly, a bank could set­tle the pay­ment with­in min­utes using sta­ble­coin (any cryp­tocur­ren­cy with a sta­bilised price).

GCC gov­ern­ments are sig­nal­ing their intent to active­ly reg­u­late the region’s nascent cryp­tocur­ren­cy (cryp­to) ecosys­tem, includ­ing DeFi, with a wave of new ini­tia­tives. In late 2021, the Unit­ed Arab Emi­rates (UAE) issued a new stored-val­ue facil­i­ties reg­u­la­tion cov­er­ing cryp­to assets.

The Cen­tral Bank of Bahrain now allows cryp­tocur­ren­cies as an offi­cial method of pay­ment (not legal ten­der), and per­mits estab­lished banks to inter­op­er­ate with cryp­to exchanges so that cus­tomers can eas­i­ly with­draw and deposit their money.

How­ev­er, the DeFi ecosys­tem still lacks the reg­u­la­to­ry frame­works – for exam­ple, for anti-mon­ey laun­der­ing – that are well-estab­lished in tra­di­tion­al finance. Giv­en the com­plex­i­ty of DeFi, reg­u­la­tors will need time to clar­i­fy their role and pro­vide the over­sight need­ed to boost con­fi­dence in the system.

Sim­i­lar­ly, the decen­tralised com­mu­ni­ty that gov­erns DeFi is still in its incep­tion stage and will evolve as the indus­try matures. Banks and oth­er finan­cial ser­vices com­pa­nies should devote them­selves to par­tic­i­pat­ing in dis­cus­sions about these and oth­er issues that are pre­req­ui­sites for a viable DeFi indus­try segment.

The DeFi ecosys­tem has reached its ear­ly-adopter stage, yet it is pre­ma­ture to say with any cer­tain­ty that it will become mainstream.

For the near future, finan­cial exec­u­tives can expect sub­stan­tial ambi­gu­i­ty sur­round­ing all things DeFi, which they can best con­front with an open mind, a lev­el head, and a will­ing­ness to roll up their sleeves and get involved – before it grows from yet anoth­er unwel­come dis­rup­tion into an exis­ten­tial threat.

About the authors: Jorge Cama­rate is a Part­ner at Strategy& in the Mid­dle East, where Antoine Khadi­ge is a Prin­ci­pal and Vishal Gup­ta a Senior Associate.