2021 has been a remarkable year for the entrepreneurs pioneering the growth of Decentralised Finance (DeFi). While traditional banks have exhibited the same kind of suspicion that they direct at cryptocurrency, DeFi-powered platforms like Maker, Compound and Aave have grown rapidly as investors pile onboard.
DeFi is often cited as a means of extending financial inclusion to the underbanked or hard-to-bank customers. But a year of rampant innovation in terms of products, protocols and platforms begs the question whether some mainstream customer segments might soon stand to benefit from continued maturity and increased liquidity in DeFi’s ecosystem.
A case in point is SMEs, which have come out of the current pandemic battered and bruised. With many firms unable to access traditional forms of finance (even those that are ostensibly targeted in their direction), is it possible that the fast growing DeFi market could unlock new lending and finance opportunities for smaller firms? At the same time, are there other core components of the disruptive DeFi model that might prove advantageous to beleaguered SMEs?
While there are clearly some intriguing options available to SMEs within the DeFi universe, there are also some potential risks. Below, to my mind are the key pros and cons of going down this route.
Reduced barriers to speed and efficiency: SMEs can benefit from the core attributes that have driven DeFi’s hypergrowth in the last year. Harnessing the capabilities of blockchain means reduced costs and greater speed/efficiency. For businesses that operate across more than one territory, lower cross-border fees are a particular benefit of DeFi. This has clearly been a consideration for ASEAN-based ShuttleOne, which sees scope to reduce transaction costs by 80%.
Ample liquidity to support SME funding: TVL (total value locked) in the DeFi sector has risen from $3 billion in mid-2020 to $179 billion at the time of writing. This figure confirms traders' hopes for a prolonged rally and suggests that a growing number of investors are switching on to the competitive advantages that DeFi offers. The rapid rise of TVL in the DeFi ecosystem means there is money to support the provision of sizeable loans to SMEs.
Open source innovation driving new offers: In the jargon of the internet, DeFi is very composable, which essentially means that developers can easily build additional layers onto existing protocols. The benefit to SMEs is that new applications and platforms are being developed all the time that can provide them with bespoke solutions. The following protocols are just two examples of how DeFi is helping to address SME challenges: Goldfinch Finance is seeking to transform access to capital by offering loans without collateral. Compound allows users to earn interest on their cryptocurrency deposits and has no borrowing fees and a low liquidation threshold.
Capacity for lenders to spread risk: Unlike individual banks, which take on all the risk of lending to an SME, DeFi makes it possible for would-be lenders to share the risk with other players in the ecosystem. This distributed risk model arguably makes lending to SMEs less unattractive, while simultaneously making it easier for SMEs to achieve their financing targets.
Ongoing issues around cyber security: Depending on your perspective, it is possible to claim enhanced security as a DeFi-related advantage. Traditional banks fail, they lose client money and their systems are targets for identity fraud. Identity fraud can't happen in De-Fi, because there is no identity. That said, the rapid growth of DeFi has left it open to serious cyber security issues including the recent $611 million hack of cross chain protocol Poly Network. One security expert anticipates a continued growth in DeFi hacks in the coming period, with the market not stabilising for 2-5 years.
Inherent risk of working with SMEs: The availability of new financing options via DeFi doesn't change the fact SMEs are often risky partners. Even in this emerging market, there will be question marks over businesses that can’t raise finance through traditional channels. Even if they do get the greenlight, it’s important to keep in mind that DeFi loans are currently heavily over-collateralised - meaning borrowers have to post a lot more money to secure the loan than in Fiat currency.
Regulation, exchange, interoperability: Another big issue for SMEs looking to DeFi for their banking needs is the lack of integration with existing structures and support systems. As a global network that transcends borders, which regulatory regime is going to step in and support SMEs that are victims of fraud in the DeFi universe? And what about interaction with traditional currencies? Although there are some moves towards integration, it remains challenging to move money backwards and forwards between digital and Fiat currency. There are also issues around interoperability between different DeFi protocols. Until this is resolved, scalability remains an issue.
On balance, DeFi-powered banking for SMEs remains an interesting thesis rather than a proven proposition in Q4 2021. But the speed it is growing and innovating could alter that perspective quite rapidly. It's worth noting that this sector is likely to see the most short-term growth in regions where SMEs are underbanked or where the overall financial system is weak or corrupt. Expect some of the key DeFi banking breakthroughs to come out of Asia-Pacific, India and Africa.