Is decentralised finance the future for SMEs?

Is decentralised finance the future for SMEs?

According to the latest TechNation report, the decentralised finance market is exploding, with both small and medium-sized enterprises (SMEs) waking up to its benefits. While still in its infancy, the trend towards finance conducted outside traditional banking sectors could transform the way smaller companies operate.

Decentralised finance (DeFi) cuts out intermediaries by allowing people and businesses to conduct transactions through technology-based formats such as peer-to-peer networks. This removes the control banks and other financial institutions have on services and the movement of money. Potential benefits for smaller firms include faster transactions, reduced costs and more accessibility to financial products such as loans.

Jeremy Cheah, associate professor at Nottingham Business School, said: “DeFi is the future. The benefits are immense – for example, reducing friction and cost of transacting; customised products; and more privacy and reliability from DeFi’s use of blockchain technology. By removing intermediaries, the cost of borrowing and lending will fall, and loans can come from anywhere. However, challenges remain. Adoption is not widespread due to low awareness; difficulty of use; and lack of legal protection and enforcement.”

Extreme volatility in the values of decentralised currencies such as bitcoin is another outstanding concern.

Stellar expansion

DeFi’s growth has been extraordinary. In the two years to June 2022, DeFi users grew from under 300,000 to 4.8 million, according to Dune Analytics. However, this is still minuscule compared to centralised finance.

One growth driver has been the wider acceptance of decentralised digital currencies, known as cryptocurrencies. Another is that so-called stablecoins, such as USD Coin (USDC), have gained trust through being pegged to traditional currencies such as the US dollar.

The World Economic Forum (WEF) has said these developments could transform the way SMEs access and use financial products and services such as loans, cross-border payments and currency management.

UK firms could be at the forefront of this trend. The Global Alternative Finance Benchmarking Report 2020 found that the UK market for alternative finance, such as peer-to-peer lending, was worth $10 billion – the third largest behind the US and China.

Meanwhile, a 2021 report by Responsible Finance identified a critical funding gap of £22 billion for UK small enterprises, and low trust between businesses and banks. DeFi could help fill the gap.

Faster, cheaper, more transparent?

One potential benefit of DeFi for SMEs is the ability to make international payments with no intermediary slowing transactions and levelling charges. Payments could be instantaneous, rather than taking several days to pass through clearing.

Cryptocurrencies are popular with younger people, so using them could attract younger customers. Also, blockchain helps protect from fraudsters and stops customers with insufficient funds making payments.

A huge potential market is cross-border loans. For example, Centrifuge is an SME financing platform that allows investors to connect with firms needing capital, cutting out intermediaries such as banks. Centrifuge claims the model is radically faster, cheaper, and more transparent than traditional finance, and anyone can use it to raise capital.

WEF has said that traditional banking infrastructures obstruct SMEs because of their high cost thresholds, and centralised approval and execution frameworks. DeFi could solve these problems by cutting out intermediaries. It could also address smaller businesses’ operational needs via services that only banks’ top corporate customers can usually access. These include liquidity management, such as cash flow, trade and supply chain finance.

DeFi also allows for the exchange of trustable data across a system, speeding up onboarding, said WEF.

Cheah adds that DeFi is easily accessible, everywhere – all you need is a phone with internet. If based on blockchain, the system is trustless, which means the record cannot be tampered with and disputes between parties do not arise.

Another advantage for SMEs is that DeFi apps (dApps) are like Lego blocks, enabling you to stack financial products flexibly to better tailor and target your products.

Outstanding challenges but serious potential

Cryptocurrency rates are still vulnerable to large swings in investor sentiment. This has led to extreme volatility, even in established currencies such as bitcoin, and the recent collapse of Terra Luna, which has eroded trust in stablecoins.

Cheah says that some SMEs are pursuing DeFi innovations, but not enough for widespread adoption, which is so far limiting economies of scale. Customer awareness is also a challenge, as SMEs are still not up to speed on the latest DeFi products.

One risk is that the DeFi space remains largely unregulated, with no legal protection of customer rights, adds Cheah. Fraud can go unpoliced, while technical bugs in smart contracts can still exist, causing significant losses to customers.

WEF said DeFi frameworks had also suffered from a lack of interoperability between different blockchains. But recently, cryptocurrency exchanges have become more robust, allowing for easier conversion between stablecoins. This change has given SMEs more options to conduct DeFi business, and to improve their liquidity.

Cheah adds: “Technical and technological challenges such as around interoperability, smart contract bugs, and difficult to use dApp interfaces have all deterred SMEs from using DeFi. But research into DeFi products and technical and technological breakthroughs continue unabated. As innovations continue, DeFi products will become more attractive, and the long-term potential for UK SMEs is massive.”