Blockchain technology and digital currencies are not yet part of the average person’s day-to-day financial life. However, as consumer interest grows, so does their potential to disrupt the global banking ecosystem in significant and lasting ways. Not unlike the transformation catalyzed by the introduction of online and mobile banking, decentralized finance (DeFi) and digital currencies enable people to bank differently — and as with digital banking, financial institutions need to adapt in order to remain competitive in the long term.

Decentralized finance is, put simply, a system that enables financial activities — from lending to investing — to occur on a blockchain, without the need for a traditional banking intermediary.

Potential benefits include faster decisioning time for loans, less human intervention, and more equitable access to financial services. What has the potential to disintermediate traditional banking institutions can also create opportunities and enhanced efficiencies. However, the path to decentralized finance won’t be an easy one, and those interested will have their work cut out for them.

On the surface, DeFi offers individuals the ability to access, exchange and grow capital outside of a traditional banking relationship or environment. But rather than resist this disruption for fear of obsolescence, banks can find ways to engage with and serve customers who are exploring this space. Peer-to-peer lending, cross-border payments and trade finance are three obvious use cases worthy of consideration, where DeFi could bring about major change to the status quo. These are areas where financial institutions should begin thinking about the potential value of DeFi, while keeping in mind the tremendous hurdles that need to be overcome before these will become a reality.

Efficient, automated peer-to-peer lending

Online peer-to-peer lending has existed for years; however, the DeFi version is still in its infancy. The difference between traditional peer-to-peer lending platforms and DeFi is that the blockchain eliminates the middleman. Anyone who has a digital wallet can lend money or take out a loan and make interest payments. Borrowers and lenders connect their digital wallets to one of the many available DeFi lending apps, select their preferred interest rate, currency and liquidity, and the app creates a smart contract for their loan. Neither the borrower nor the lender needs to trust — or even know — the party on the other end of the loan. The DeFi app (dApp) tracks the loan and extracts payments automatically via the blockchain, which prevents default.

As with traditional peer-to-peer lending, DeFi peer-to-peer lending circumvents traditional banks. However, the market for this service is growing quickly, and there is opportunity for banks to serve customers who are interested in the space by providing access to digital wallets and cryptocurrency exchanges that link to their existing bank accounts.

Cross-border payments and currency exchange

Blockchain technology and digital currencies could also disintermediate banks from the process of foreign exchange and cross-border payments. Traditionally, a bank customer travelling from New York to Singapore would need to exchange U.S. dollars for Singapore dollars at a bank or other currency exchange. How many Singapore dollars their U.S. dollars are worth depends on the exchange rate at the time of the transaction. But a traveler with a digital wallet and access to a cryptocurrency exchange app can use the app to exchange their Bitcoin or Ethereum for DAI, a stablecoin linked to the value of the U.S. dollar, and buy Singapore dollars with that digital currency. This can be done completely online, and avoids fees associated with traditional foreign exchange.

Banks still have a role in this use case, because the stablecoins created by central banks can be used to facilitate currency exchange. Again, the process is in its infancy, but banks that make cryptocurrency wallets and exchange apps available to their customers stand a better chance of keeping those customers engaged even if they bypass the bank’s foreign exchange services in favor of using digital currency.

Trade financing administered via smart contract

On the commercial banking side, DeFi has the potential to disrupt banks’ role in trade finance. Where banks currently serve as third parties between importers and exporters, reducing risk and facilitating global trade through lending, lines of credit, letters of credit, and other financial instruments, smart contracts on the blockchain could eliminate the need for banks to perform these functions.

Rather than arranging financing and managing risk through their banks, importers and exporters can use decentralized apps to establish smart contracts that issue payment automatically upon delivery of the goods. The “dApps” use APIs to validate workflows. While not actively in use yet, DeFi applications for trade finance will reduce costs and extend access to smaller players who may not have the banking relationships to support traditional trade financing arrangements. Creating a digital wallet and downloading an app is much faster and simpler than opening a bank account and applying for financing. Again, banks that enable customers to explore DeFi solutions in this area can engage with clientele who might otherwise bypass their services.

A new and challenging paradigm

By its nature, decentralized finance disrupts the traditional banking model and removes the need for human intervention. This can be a frightening prospect for financial institutions where personal service has always served as a driver for relationship building and customer loyalty.

Beyond that, and more importantly, financial institutions need to consider the complexity that would be required of such code. If we consider the lending scenario, smart contracts are executed within milliseconds, and the traditional means to establish collateral and meet know-your-customer (KYC) requirements are out the door. The algorithms need to be extremely sophisticated to factor all this in. High risk requires high levels of protection.

A good analogy for DeFi is the autonomous car. The potential benefits of self-driving vehicles are tremendous, but the required technology is complex and multilayered, extending beyond the vehicle to include a flawless GPS infrastructure and an ability to react to unexpected and unplanned obstacles. The promise of decentralized finance is also worthy of exploration, but with no best practices in place, pioneers must be prepared for heavy lifting.

Decentralized finance and digital currencies belong to an emerging and rapidly evolving area of the financial services landscape. Rather than view DeFi with suspicion or steer away from its potential for disruption, traditional banks and financial institutions should educate themselves on the space and determine how to engage in ways that support their current and future customers’ needs and preferences. Peer-to-peer lending, cross-border payments and trade financing are three examples of areas where banks would benefit from understanding digital currencies and DeFi use cases and expanding their offerings accordingly.

Shuki Licht is the senior vice president and chief innovation officer at Finastra. He has more than 20 years’ experience delivering innovation-led products and has led global innovation agendas, process, technology and teams from ideation to production, and has implemented artificial intelligence, machine learning, deep learning, computer vision, smart edge devices (IoT), blockchain, platforms, marketplaces and open application programmable interfaces to drive product differentiation, revenue growth, and address emerging markets.