How decentralized finance will transform business financial services – especially for SMEs

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Rebecca Liao, Co-Founder, SKUChain

• Decentralized finance (DeFi) is emerging as a tool for smaller businesses in developing markets, particularly for remittances and small loans;
• The transaction banking industry is beginning to see DeFi’s potential to overhaul the inflexibility of present processes;
• Uptake of DeFi in transaction banking could open up new capital opportunities for larger companies and increase liquidity for SMEs.

Decentralized finance had a resurgence last summer. Cryptocurrencies like bitcoin and ether are now becoming more widely accepted for payments and USD Coin (USDC) has made significant progress towards being an asset that will maintain its value without future depreciation.

At the same time, the blockchain technology that underlies cryptocurrency and its supporting financial infrastructure are on their way to offering a system of financial rails in parallel to – and connected with – traditional financial infrastructure.

Both Coinbase and Compound Treasury have released USDC-based loans that guarantee at least a 4% yield (far higher than traditional products of a similar risk), and smaller platforms are offering cross-border access to capital with rates that are far more variable but would be unavailable otherwise. So far, this growth in loan products has come from the retail sector: individuals holding and trading crypto-assets for personal use. Banks such as Morgan Stanley and US Bank now offer crypto-products for their wealth management clients. But what about businesses?

Since its inception, DeFi – literally decentralized finance or blockchain-based forms of finance that do not rely on centralized intermediaries such as banks – has been adopted to some extent by smaller businesses in developing markets whose needs are unmet by the traditional banking system. For example, some businesses use payment companies like BitPesa in Africa, Tranglo in ASEAN and the major DeFi exchanges to either make direct payments or convert payment amounts to USD-backed stablecoin for cross-border remittance. https://www.youtube.com/embed/6WG7D47tGb0?enablejsapi=1&wmode=transparent What Is Blockchain?

The greater transaction banking industry now sees DeFi as a potentially significant growth engine and disruptive force. Transaction banking addresses the operational needs and day-to-day transactions of businesses and financial institutions. Usually, only companies who are top customers of banks are able to have ready access to these services, which focus on managing the liquidity of a company, cash flows, trade and supply chain finance and other instruments needed to facilitate domestic and international corporate transactions. In 2020, industry-wide transaction banking revenue reached $1 trillion.

According to Samantha Pelosi, SVP of Payments and Innovation at BAFT, the largest trade association for transaction banking: “The potential efficiency gains and democratization of finance associated with DeFi are attractive to traditional financial institutions. However, DeFi negates the need for relationships with trusted intermediaries, which makes the model disruptive and somewhat alien to these banks.”

Virtually all major international commercial banks have at least piloted the use of blockchain for transaction banking services – which remain slow and cumbersome – but none of these pilots have involved DeFi. Rather, they focus on making bank processes more efficient and replacing traditional financial instruments with standardized digital assets. That means the approval and execution of transactions still ultimately go through the framework of traditional banking or more established fintechs. For example, a business’ credit risk is assessed based on financial statements and only applies to that specific business, without the ability to distribute risk across its system. The infrastructure around client support is also quite extensive, which means clients cannot be serviced without a high threshold cost. These practices hamper capital opportunities for larger enterprises and freeze out SMEs.

DeFi platforms provide an alternative system, not simply a plug-in to existing banks. Their decentralized nature means transaction onboarding and market-based risk assessments are much easier to scale across a business’ wider system because access to relevant information is not dependent on centralized processing or a prior relationship. Prior to DeFi, a business would have to complete anti-money laundering and “know your customer” checks for every source of capital and convince their counterparts to onboard to the same transaction banking programmes. They also would not be able to present evidence of performance on their debt or payables outside of financial statements.

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

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

What is the World Economic Forum doing about blockchain?

Blockchain is an early-stage technology that enables the decentralized and secure storage and transfer of information. It has the potential to be a powerful tool for tracking goods, data, documentation and transactions. In this way, it can cut out intermediaries, reduce corruption, increase trust and empower users.

The potential uses of blockchain technology are essentially limitless, as every transaction is recorded and distributed on a ledger that is almost impossible to hack. Though the most well-known use case is cryptocurrencies, blockchain is being positioned to become a global decentralized source of trust that could be used to collect taxes, reduce financial fraud, improve healthcare privacy and even ensure voting security.

Blockchain has the potential to upend entire systems – but it also faces challenges. Read more about the work we have launched on blockchain and distributed ledger technologies – to ensure the technology is deployed responsibly and for the benefit of all. We’re working on accelerating the most impactful blockchain use cases, ranging from making supply chains more inclusive to making governments more transparent, as well as supporting central banks in exploring digital currencies.

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

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

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

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

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

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