Navigating disruption within financial services

DeFi: A crash course

DeFi is a collective term for financial services built upon the decentralized foundations of blockchain technology and cryptocurrency,¹ with the goal of enabling financial services without reliance on central financial intermediaries and traditional financial services institutions. Instead, DeFi crypto replicates some financial services in a potentially more open and transparent way, with no central authority.

Blockchain in financial services

DeFi and digital assets represent a rapidly growing market—as of December 2021, the DeFi market has crossed $130 billion in market capitalization.² As the market evolves, organizations should consider the opportunities and risks presented by DeFi technology as they position themselves in the digital asset economy.

Opportunities

As the financial industry continues to adopt DeFi-related solutions, organizations can harness DeFi’s various unique attributes to create opportunities that include:

• Process simplification: DeFi may reduce reliance on intermediaries, currently required to maintain the trust between participants in a financial transaction, and may enable transactions to be directly settled between participants.
• Process automation: Smart contracts³ allow organizations to automate processes and services through a self-executing protocol layer. Benefits include the ability to scale certain services previously dependent on human execution while simultaneously creating a greater ability to tailor customer needs via the flexibility of the source code.
• Reduced transaction costs: DeFi’s simplified interaction model between transaction participants, managed by the underlying protocols embedded in smart contracts, may reduce transaction costs for the participants. This may help financial institutions lower the cost of service, offering a competitive advantage to acquiring customers.
• Increased control and security: Assets are stored in accounts (i.e., wallets) that are unhosted or self-hosted, allowing users greater autonomy, the ability to control their own assets, and direct interaction with a digital currency system instead of an intermediary. While DeFi increases organizational security mechanisms, cyberthreats remain as a material risk.
• Transparency: DeFi’s decentralized autonomous structure (DAO)⁴ may enhance transparency by ensuring that the underlying blockchain remains public, while private wallets provide users with more control over their money. Increased transparency may allow financial institutions to enhance their user experience and offer a more tailored suite of information and products to its customers.
• Faster settlements: Blockchain technology provides for “instant” real-time settlement. In many traditional forms, settlement can take up to three days, despite the actual clearing transaction requiring only seconds.
• Liquidity: Although DeFi applications introduce a level of complexity that may act as a barrier to entry, DeFi also has potential financial inclusion benefits through its extensive reach to the underbanked or unbanked population through permissionless and borderless access to services. This increased global connectivity, coupled with the ability to tailor services to anyone with an internet connection, could also allow institutions to access liquidity pools not previously available.
• Innovation enablement: DeFi’s open, programmable, and permissionless architecture provides participants with an ability to view and verify protocols and “fork code” (i.e., take source code and develop an independent use over the top), providing an opportunity to create alternative and derivative services and products.

Risks and challenges

While DeFi provides numerous potential advantages for its customers, it is also important to understand its various accompanying risks, including:

• Technology risk: The technological complexity and immaturity of DeFi increases its vulnerabilities. Its blockchain foundation makes DeFi susceptible to failures or attacks on the underlying network, which become magnified as these networks scale at a rapid pace without the commensurate technological safeguards and redundancies in place.
• Security risk: While security risk may be mitigated through preemptive audits of smart contract models (including independent third parties) and multiple layers of coding review, there still remains a general lack of regulatory oversight and time-tested control mechanisms to provide sufficient safeguards.
• Operational and governance risk: The lack of a single point of failure and an identifiable actor means that there is no clear point of accountability or redress related to problems that arise via DeFi applications. In fact, the lack of the centralized management, typically present within TradFi institutions, limits corresponding governance mechanisms, imbuing DeFi services and products with an inherent degree of riskiness and lack of accountability.
• Compliance and legal risk: The regulatory environment, which is built around the existence of single organizations, intermediaries, and jurisdictions, is ill-equipped to oversee a disintermediated, globalized market structure. Not only does the decentralized nature of DeFi make it difficult to regulate any single entity, but it also makes it difficult to identify responsible parties or enforce regulatory actions. As such, DeFi may be used to bypass legal or regulatory obligations and de facto increase the possibility of nefarious activity.
• Financial risk: As DeFi continues to grow, the risks presented could potentially pose threats that could destabilize the financial system as a whole. The key financial risks driving such undesired outcomes are credit risk, liquidity risk, market risk, and tax risk.
  • Credit risk: A lack of traditional underwriting protocols generally infuses DeFi with a high-credit-risk profile. The anonymity of a DeFi network makes it difficult to adequately assess risk, conduct due diligence, determine creditworthiness, and calibrate appropriate interest rates of borrowers as well as pursue recourse beyond the collateral provided.
  • Liquidity risk: With no centralized exchange or counterparty in place, DeFi services often rely on incentivizing market-makers to liquidate undercollateralized loans. While these mechanisms are often baked into the structure of the DeFi program, reliance on predetermined governance logic and programmatic design limits the ability of DeFi applications to respond to unanticipated market conditions or consumer behavior.
  • Market risk: DeFi’s inherent structure increases the possibility of various market abuses. The speculative nature of crypto has subjected DeFi to greater volatility, as sudden drops in digital asset values may have an asymmetrical impact on DeFi applications. Additionally, the pseudonymity of trade and smart contract owners makes it difficult to identify sources of market manipulation or incorrect pricing.⁵
  • Tax risk: There remains little guidance on the taxation of digital assets. This requires users to analyze each leg of the transaction to determine which may be a recognition (taxable) event for tax purposes.

Conclusion

While organizations may not yet be prepared to reckon with the notion of DeFi and blockchain in financial services, it is nevertheless critical that they bring the concept into their strategic purview as they consider the future of financial services and their own positioning within the industry. As a market leader in digital assets, blockchain technology, business model optimization, and regulatory strategy, Deloitte is uniquely positioned to assist organizations in navigating the complexities of this rapidly-evolving space.

About Deloitte’s Business and Entity Transformation (BET) practice

Deloitte’s Business and Entity Transformation practice exists at the forefront of an evolving market. Disruptive forces, such as digitalization, technological innovation, and regulatory expectations, are fundamentally shifting the paradigm under which financial services operate and challenging organizations to adapt their business models and strategies to capture these evolving opportunities. Whether it is through the lens of creative product development, response to new regulatory requirements, emerging technologies, the acquisition of innovative capabilities, or enhancement of existing operations, the BET practice leverages its cross-industry expertise and global footprint to help guide businesses through their strategic objectives. We combine our breadth of knowledge and experience, as well as a suite of industry-tested tools and accelerators, into a broad approach to business model strategy to help organizations navigate this future-defining process.

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At Deloitte, our people work globally with clients, regulators, and policymakers to understand how blockchain and digital assets are changing the face of business and government today. New ecosystems are developing blockchain-based infrastructure and solutions to create innovative business models and disrupt traditional ones. This is occurring in every industry and in most jurisdictions globally. Our deep business acumen and global industry-leading audit, consulting, tax, risk, and financial advisory services help organizations across industries achieve their blockchain and digital asset aspirations. Reach out to our leaders to discuss harnessing the momentum of blockchain and digital assets, prioritizing initiatives, and managing the opportunities and challenges associated with blockchain adoption efforts.

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Endnotes

¹ CoinGecko, “Top 100 DeFi coins by market capitalization,” accessed April 4, 2022.
² Ibid.
³ Smart contracts are agreements on blockchain that are self-executing and programmable. Using predefined rules, smart contracts carry out transactions, potentially eliminating third parties, making processes more cost efficient and with shorter settlement times.
⁴ Decentralized autonomous organization (DAO) is the organization that controls the protocols of most of the DeFi applications. It is not single-handedly run by a centralized entity or company but consists of programmers, owners of applications, and its users, which ensures that control over the DeFi application is decentralized.
⁵ Caroline A. Crenshaw, “Statement on DeFi Risks, Regulations, and Opportunities,” US Securities and Exchange Commission (SEC), November 9, 2021.