When the U.S. Federal Reserve says it “might” raise interest rates, markets around the world react. So when it releases a white paper contemplating issuance of its own central bank digital currency (CBDC), the message should be clear: Digital finance is out of the shadows and on the cusp of mainstream. The Fed is not the leader here, but its weight will add considerable momentum to the digitization of money.
Of course, private digital money already exists in the form of cryptocurrencies — and a new generation of decentralized finance platforms are showing how blockchain-based smart contracts can create “programmable money.” That means that the flow of money is subject to protocols that govern the way a user invests, lends, borrows, protects against risks or even makes markets in derivatives. Crypto wallets and decentralized exchanges also allow people to pay or swap tokens with each other directly.
DeFi advocates claim that their form of programmable money will democratize finance, increasing access to products that were once restricted to institutional investors and reducing costs by eliminating intermediaries.
This is wishful thinking for now. Less than 5% of the global population is estimated to have used cryptocurrencies to date, making DeFi a tiny niche in the global financial system. If banks and fintech platforms can offer the same product choice across more units of value and bring it to their billions of customers, then it is the establishment that can lead the democratization of finance — not DeFi.
Yet this can only happen if established players are willing to embrace DeFi’s value proposition — and offer a wider range of digital products that can be tailored and adapted fast to meet changing consumer demand. And this in turn will depend on technology that allows any financial services provider to easily “program” money in the design of payments and other financial products. In other words, a product manager at a bank needs to be able to make changes — such as adding a “buy now, pay later” module to a payment product — in real time and without needing to write new lines of code.
If banks and fintechs can embrace this kind of flexibility, they will be better positioned for a future in which consumers will transact across more units of value and via platforms that are not owned by financial institutions but have payments and other products embedded in them. If they fail to adapt, US$250 billion of payments revenue could move to non-financial institutions by 2030, according to estimates by research firm IDC.
There is no question that incumbent players face a historic challenge in transforming their legacy technology in order to adapt to this new world order. But that doesn’t mean that the whole model of centralized finance will be overthrown by DeFi. For a start, the DeFi platforms themselves and the private cryptocurrencies that flow through them are still largely unregulated, which accounts for their small user base. And then there’s the emergence of CBDCs, which could be a potent alternative to private tokens and stablecoins.
We think it is more likely that private and public cryptocurrencies will eventually become part of the regulated financial mainstream, used for payments, investments, borrowing and other purposes alongside fiat currencies, loyalty program points and a good many other units of value. Indeed, IDC reckons that, by 2030, 60% of global consumers will have made a transaction using a unit of value other than fiat currency.
Legacy advantages
Banks and fintech platforms can still take important lessons from the explosion of DeFi platforms and the value that they process. People like choice in what they do with their money, are open to innovative products, and are comfortable with the principle of digital money.
If established players can integrate these principles into their offerings, they can capitalize on their huge advantages in terms of scale and customer trust. DeFi is fragmented, with hundreds of platforms offering distinct products and experiences. Any product development also involves writing code. But banks and large fintech platforms have the ability to bring together a range of products and make them accessible via user experiences that people already know.
So the challenge for incumbents becomes how to build these kinds of flexible, adaptable solutions. In simple terms, they will need technology that allows someone managing a retail bank’s software to easily configure and change that “buy now, pay later” process — or to add features for insurance or investment — to a payment process by using a drop-down menu.
Building technology that can deliver what customers want on the bank or non-bank platforms they already use has clear potential in the democratization of finance. Combined with the move toward regulated cryptocurrencies and the increasing use of CBDCs, it could also make today’s DeFi platforms increasingly irrelevant — but not without established players owing them a significant debt for demonstrating the power of programmable money.
