Opportunities and Risks for Traditional Insurance Companies and Banks with DeFi Business Models#
Industry Perspective
Disclaimer: The views and opinions expressed in this article are solely those of the author
Key Insights
Legacy banks and financial institutions face internal and external challenges in integrating cryptocurrencies into their existing business framework for generating new revenue streams.
The internal perspective involves leveraging distributed ledger technology for enhanced management, while the external perspective centres on handling crypto customers with an emphasis on regulatory compliance and environmental sustainability
Legacy banks often miss out on business opportunities due to constraints related to regulation, organisation, processes, delivery, and employee biases.
Offering tailored financial products, such as crypto mining equipment insurance and crypto hedging insurance, can enhance profitability and help diversify the revenue streams of Legacy Banks and financial institutions.
Talent acquisition and skill development are crucial to improve crypto risk management within legacy banks.
Introduction#
The decentralised finance (DeFi) ecosystem, with its innovative models and frameworks, has introduced disruptive business models that challenge the traditional financial landscape. This article aims to analyse this challenge in detail, exploring how traditional players in finance can leverage the hidden and visible value within DeFi business models. To enhance your understanding of this topic and to provide you with a better understanding of this article, I recommend reviewing the following articles “Short Survey on Business Models of Decentralized Finance” by Jiahua Xu and Teng Andrea Xu and “DeFi vs TradFi: Valuation Using Multiples and Discounted Cash Flow” by Teng Andrea Xu, Jiahua Xu, Kristof Lommers.
Business Ideas#
Let’s begin with a foundational overview, drawing insights from the aforementioned articles.
Within the context of Decentralised Finance (DeFi) Business Models among the prominent DeFi business models are Protocols for Loanable Funds (PLFs), Decentralised Exchanges (DEXs), and Yield Aggregators. This section will delve into these DeFi models and discuss their potential adoption by traditional insurance companies and banks. Any additional details not covered in this article can be further explored in the aforementioned articles.
a) Protocols for Loanable Funds (PLFs):
PLFs have revolutionised lending and borrowing within the financial sector. These protocols facilitate access to loans and cryptocurrency lending without intermediaries. Revenues are generated through interest rates, shared between the protocols and lenders.
b) Decentralised Exchanges (DEXs):
DEXs enable peer-to-peer cryptocurrency trading, eliminating the need for intermediaries. These platforms earn revenue by charging trading fees, contributing to the protocol’s treasury.
c) Yield Aggregators:
Yield Aggregators merge strategies to optimise investor returns. Investors deposit funds into “Vaults,” implementing diverse strategies for profitability. Yield Aggregators levy commission fees on strategy profits.
Resolving the Paradox#
The question arises: Is it paradoxical for traditional insurance companies and banks, champions of centralised finance, to embrace DeFi models to extract additional value while upholding their established positions? However, as the financial landscape evolves, exploring innovative opportunities becomes essential to maintain profitability and stay ahead in the highly competitive and regulated financial sector. To be noted that profits in the financial industry are significantly influenced by Central Bank decisions, particularly interest rate fluctuations. By adopting decentralised finance business models, though seemingly paradoxical at first glance, financial institutions can stabilise revenues and partially free themselves from Central Bank decisions. With this context in mind, let’s explore potential business opportunities and risks for traditional banks and insurance companies in adopting each DeFi business model.
a) PLFs：
Business Opportunities for Traditional Banks：
Penetrating a New Market: Through PLFs, banks can tap into the burgeoning cryptocurrency lending market, attracting a fresh customer base. The emphasis, in reality, must be on cross-selling and upselling commercial opportunities, rather than immediate profits.
Diversified Revenues: PLFs provide an additional revenue stream, complementing traditional lending practices.
Technological Innovation: Legacy IT systems in banks are challenging to overhaul. PLFs, with their innovative technology, could serve as pilot systems, gradually expanding across the organisation.
Risks for Traditional Banks：
Regulatory Uncertainty: DeFi lacks comprehensive regulations, exposing banks to potential legal and regulatory complexities.
Smart Contract Vulnerabilities: Relying on smart contracts exposes banks to cybersecurity risks and financial losses.
Business Opportunities for Insurance Companies：
Smart Contract Insurance: Insurance firms can offer coverage against smart contract vulnerabilities in PLFs, safeguarding users and generating premiums.
Risk Assessment Services: Insurance companies can develop risk assessment services for PLF participants, aiding informed decision-making.
Risks for Insurance Companies：
Limited Historical Data: Insufficient data on DeFi transactions could hinder accurate risk assessment and policy pricing.
Market Volatility: Cryptocurrency’s volatile nature could pose challenges in pricing insurance products, necessitating reinsurance policies. In the article “DeFi vs TradFi: Valuation Using Multiples and Discounted Cash Flow” we can learn how to value digital assets. Furthermore, it is paramount to note that, so far, this value is extremely volatile, and traditional players need to surf on this volatility, need to learn how to govern this volatility.
Risk Management Practices：
Tech Collaboration: Insurers can partner with tech experts to bolster smart contract security and mitigate risks.
Robust Risk Models: Creating advanced risk models for DeFi-related insurance products can enhance underwriting precision.
b) DEXs:
Business Opportunities for Traditional Banks：
Liquidity Provision: Banks can serve as liquidity providers on DEX platforms, earning fees and interest on deposited assets.
Market Expansion: DEX partnerships enable banks to broaden their market reach beyond conventional borders.
Emerging Risks for Traditional Banks:
Counterparty Risks: Engaging with anonymous DEX users exposes banks to counterparty risks and potential fraud, although modern risk management practices mitigate these concerns.
Reputation Risks: Involvement in unregulated DEX spaces could tarnish a bank’s reputation if associated with illicit activities.
Business Opportunities for Insurance Companies：
Secure Custody Solutions: Insurance firms can offer secure custody solutions for DEX users, reducing asset loss risk.
Smart Contract Risk Coverage: Insurance products can be designed to cover smart contract vulnerabilities on DEXs.
Risks for Insurance Companies：
DEX Risk Understanding: Insurance firms might lack comprehensive knowledge of DEX-specific risks, impacting policy underwriting.
Pricing Data Limitation: The absence of pricing data for DEX-related risks could hinder accurate insurance product pricing.
Risk Management Practices：
Security Audits: Insurers can conduct security audits of DEX platforms to ensure adherence to high-security standards.
Blockchain Expert Collaboration: Collaboration with blockchain experts aids insurers in comprehending and assessing DEX-related risks.
c) Yield Aggregators:
Business Opportunities for Traditional Banks：
Investment Ventures: Banks can partner with Yield Aggregators to offer innovative investment opportunities to clients, potentially yielding higher returns.
Fee-Based Income: Banks can receive fees for directing client funds toward specific Yield Aggregator strategies, reducing reliance on central bank interest rate changes.
Risks for Traditional Banks：
Investment Volatility: Involvement with Yield Aggregators exposes banks to market volatility and possible investment losses.
Reputation Risks: Poor strategy performance may harm a bank’s reputation.
Business Opportunities for Insurance Companies：
Tailored Investments: Insurance firms can craft investment products incorporating Yield Aggregator strategies.
Risk Mitigation Services: Insurance companies can provide risk mitigation services to Yield Aggregator users, reducing potential losses.
Risks for Insurance Companies：
Complex Risk Evaluation: Grasping and evaluating diverse Yield Aggregator strategies might pose challenges for insurers.
Strategy Performance Uncertainty: Insurers face uncertainty in predicting the performance of selected Yield Aggregator strategies.
Risk Management Practices:
Diversification: Encouraging investors to diversify across different Yield Aggregators can mitigate risks tied to individual strategies.
Transparent Reporting: Insurers can demand transparent reporting from Yield Aggregators, ensuring clients comprehend their investments.
Conclusion#
Although the adoption of DeFi business models by traditional insurance companies and banks may seem paradoxical, exploring these opportunities is essential to thrive in a competitive financial landscape. Understanding unique business opportunities and potential risks associated with each DeFi model is crucial for informed decision-making. By implementing robust risk management practices and collaborating with blockchain experts, traditional financial institutions can harness DeFi’s potential while mitigating inherent risks. This shift is strategic, enabling institutions to capitalise on emerging opportunities and ensure long-term sustainability within the financial industry mitigating existing and emerging risks.