Crypto Assets have grown over 100x in total market cap, making it the best performing asset class of the last decade.
Unfortunately, most financial institutions haven’t been able to capture significant value from crypto assets due to liquidity, regulatory, and risk issues.
But as governments pass crypto-friendly regulations, Decentralised Finance can provide an ROI on crypto assets that banks already hold on their balance sheets.
In fact, there’s more than one reason why banks should get involved in DeFi. But first, let’s look at what DeFi actually is.
What is DeFi?
Decentralised finance refers to a new form of financial services hosted on public blockchains.
But rather than transactions happening through a third party (like in traditional banking), they happen between the parties involved and a smart contract, which is an automated program stored on a blockchain.
Smart contracts are designed to automatically execute when predetermined conditions are met. Let’s take a look at an example in DeFi lending.
Alice wants to earn some interest on her bitcoin savings instead of letting them sit in her wallet. She connects to a DeFi protocol and deposits liquidity in a lending pool.
Lucia lives in Latin America. She needs liquidity for urgent reasons but has been rejected by traditional lenders. Lucia also owns some crypto assets, but doesn’t want to sell them and lose out on any future gains. She finds out about a popular DeFi lending platform and realises she has enough assets to post as collateral.
DeFi lending is designed to be trustless, borderless, and in many cases, quicker, cheaper and more lucrative than traditional finance (TradFi). However, it’s still an emerging market that lacks the fail-safes of TradFi.
Some of the current issues with DeFi include:
- Lack of liquidity;
- High crypto volatility;
- Excessive overcollateralization;
- Lack of standardization / interoperability between blockchains.
Banks regularly act as liquidity providers and shock absorbers in traditional finance, and they can eventually play a similar role in the DeFi world. But aside from the wider societal benefits of financial institutions participating in DeFi, there are real revenue opportunities to be considered.
Let’s dive into the benefits of providing cryptocurrency liquidity.
1. Liquidity Providers Are Reaping High Returns
As banks diversify into crypto assets, providing liquidity is a way to maximise returns.
Liquidity providers are currently receiving double and even triple-digit returns on assets they hold.
On the other hand, traditional savings accounts in the EU offer up to 1.5% per annum at the most. This gap, combined with inflation, means individuals could decide to hold their assets in DeFi protocols.
However, banks can capitalise on DeFi yields by becoming liquidity providers themselves (or offering unique financial products — which we’ll cover later).
Let’s look at the numbers for a microinvestment on the Tropykus protocol.
Tropykus is designed for emerging markets, offering microloans and microsavings products. Depositing a maximum of 0.1 rBTC (around €3900) with the microsavings option provides 4.09% APY. On the other side, the user is paying 8.34% interest on the loan, which is lower than the benchmark in many Latin American countries but high enough to pay for the provider’s yield and the transaction fees.
Rates in DeFi are calculated automatically and depend on a variety of factors, such as transactions in the protocol and supply & demand. Yields can in fact reach much higher levels. For example, let’s take a look at this $4,000 investment between two popular Uniswap pools using Metacrypt:
A provider could potentially earn 55% APY, which far exceeds anything we see in traditional finance today.
On top of high APYs, certain platforms let providers stake LP (Liquidity Pool) tokens to earn extra rewards. For example, xSUSHI holders can stake their tokens (on top of the original liquidity provided) and receive 0.05% from all liquidity pools.
2. Institutions Can Offer Unique Blockchain Banking Products
To the average consumer, blockchains, cryptocurrencies and finance in general are unclear concepts. Mix all three, and it’s a recipe for confusion.
Instead, banks can make DeFi more accessible by building on DeFi infrastructure and acting as a secure gateway for crypto investments.
This infrastructure can help banks offer:
- High-yield products like crypto savings accounts;
- Competitive loan rates while still profiting from interest spreads;
- Greater accessibility for the unbanked without the need for verification.
By enabling their own customers to provide crypto liquidity, banks can offer a secure and familiar gateway into DeFi, attract new market segments, and increase their overall profits in the process.
3. Some Liquidity Pool Tokens Give Holders Governance Rights
LP tokens function similarly to stock shares, meaning holders can vote on decisions and propose new developments.
So as banks look to build on existing DeFi infrastructure, governance rights provide crucial control over the development of DeFi protocols.
For example, Sushi’s MISO (Minimal Initial SushiSwap Offering) protocol results from a governance proposal. Through this governance proposal, LP token holders created a token launchpad platform tailored to the SUSHI community.
So, how can banks provide crypto liquidity?
Providers must choose a DeFi protocol. But not all protocols are made the same. Which protocol a bank chooses will largely depend on which crypto assets it holds as well as its overall objectives in DeFi.
A few known protocols include:
After assessing each protocol and choosing the most appropriate, banks can begin depositing their crypto and earning interest. But some institutions will want to go a step further and immediately offer high-yield savings products to their customers to maximise their returns.
In this case, they require the appropriate infrastructure to start experimenting with DeFi banking apps and solutions. That’s feasible, but it doesn’t have to be the first step.
Keep in mind that “great things are not done by impulse, but by a series of small things brought together.”
Becoming a liquidity provider may be a simple way to get involved in DeFi, but it allows institutions to take that first step whilst enjoying attractive returns.