Baloise Group are generally well ahead of the innovation curve so when you see Sibylle Fischer from Baloise writing on DEFI and smarty contracts it strengthens the view that all carriers, reinsures and brokers should be planning how to anticipate both opportunities and potential disruption.

Fischer says: "DeFi makes its financial products available to anyone, with banks and brokers no longer essential to facilitate a transaction. These DeFi products may also include other financial service activities, like insurance underwriting. Now, as innovations in blockchain continue and global demand for transparent and automated insurance products are also on the rise, smart contract technology is helping accelerate experimentation (and generate some real world use cases) within DeFi.........

While the technology to execute smart contracts already exists, industry incumbents, insurtechs, start ups and other venture-backed companies are still in the early stages of creating blockchain-powered insurance products. Right now there are very few products available, and smart contracts remain fairly limited in the types of events and contingencies they can address. With sizable challenges ahead (particularly around data protection, regulation, privacy, and legacy infrastructure), there’s much work to be done for smart contracts to truly scale. However as blockchain technology continues to evolve and DeFi matures, there is a general understanding within the insurance industry around the massive potential for adoption, growth and expansion in the smart contract space. "

Blockchain and DeFi in minutes by Maarten Ectors

If you are already aware what Blockchain and DeFi are, then please skip this part. Blockchain is a distributed ledger which allows many parties to always know what is happening. It is a single source of truth. The ledger makes it impossible to double spend a crypto coin like Bitcoin or more generally called a token. Some ledgers not only support tokens and the accounting of how they move from one wallet to the next but also smart contracts. A smart contract can create a token, destroy a token, transfer a token and basically do anything else a normal computer programme can do.

Think about smart contracts as the place where a business can “code” the business logic, e.g. who to give a loan, and afterwards ask the contract to autonomously run the business. This capability is used by a new class of companies called DeFi which create decentralised finance solutions. The tokens and smart contracts they use allow them to create loans, investments, insurances, even distributed stock exchanges. A token can be used as the substitute for a coin just like a payment, e.g. think Bitcoin; but can represent ownership, e.g. a diamond, a house, art; an activity, e.g. a vote; or anything you want, e.g. a risk.

DeFi companies have been able to set up distributed token exchanges which are fully automated. They have created innovative financial products, e.g. a flash loan is a loan given to people you do not trust by wrapping the loan inside one transaction which takes seconds before the loan is paid back and either the loan is paid back or not given. DeFi companies are just getting started.

The Digital Blockbuster

Every time a new disruptive technology comes along it takes years before the real power is understood. 

Google, Amazon and Facebook were looked down upon for years. Many said they were never going to make any serious money, let alone be profitable.

Once established players realise they underestimated a disruptive technology or company, they tend to rush and copy & apply the technology to their existing business. This often leads to a “digital blockbuster” in which the new technology is being used to automate the existing business but not to transform it. A Blockbuster in 2021 would use a mobile app for customer orders, AI to predict demand, Bitcoin to pay and drones to deliver but everything would still be about the DVD business and not about how to be Netflix.

Companies can learn a lot from launching a Digital Blockbuster and that is fine as long as they know they do and it is used as a way to give them time to launch a Netflix afterwards. Unfortunately too few companies do not realise they are not on a path to be the next Netflix.

Is Blockchain ready for the enterprise?

Bitcoin is definitely not ready to be used as a payment mechanism because it can only handle 5 transactions per second and because of the high volatility of the price of a Bitcoin as well as the transaction fee which is extremely expensive. For reference Visa does several thousands per second.

Ethereum, on top of which many DeFi companies have built, is equally slow (15 transactions per second) and equally expensive. Ethereum 2.0 is being rolled out at an accelerated pace and is estimated to be able to do 100,000 transactions per second once fully available. Also the price per transaction will become a lot cheaper because a new model to validate transactions is being rolled out [see proof of stake if you are interested].

Several newer distributed ledger technologies are being rolled out as we speak, e.g. Cosmos, Polkadot, Flow, Near, Casper, … [Since I am an advisor to Casper, I suggest you do your own research if you are interested in any of them]. They already support many of the features enterprises are looking for, e.g. easy upgradability, better performance, lower transaction cost, choice of programming language,…

When to use a Distributed Ledger?

Having multiple computers do the same calculation will be slower than having one computer do the calculation. So if speed is your only criteria, then blockchain will never be your technology of choice.

If on the other hand many parties are or can be involved, if trust is an issue, if data needs to be reliably modified by many, … then distributed ledger technology can be interesting.

What new products are DeFi companies launching?

DeFi companies are reimagining how a world without intermediaries or centralised entities can work. Some even are pushing the model further and are trying to understand how financial services companies can be successful without needing people in any operational capacity. A great example are distributed insurers like NexusMutual.io and BridgeMutual.io who both allow capital provisioning, claim handling, risk assessment and general governance to be done by third-parties.

How hard is it to be a distributed bank or insurer?

At this moment anybody can download a crypto wallet app, go through some KYC questions, transfer money in and buy crypto currencies. Given a crypto wallet is like a bank account, the easiest first step in a distributed bank is to offer a crypto bank account. Neobanks like Revolut are doing this.

Some crypto is linked to real currencies, e.g. 1 USDT is worth $1 USD, and are called stable coins. If somebody is able to create a stable coin and wallet solution which allows for more than 10K transactions per second and costs $0.01 or less per transaction, then this will substantially disrupt the global payment industry. We are between some months to some years away from this being possible.

The next issue to be a distributed bank is KYC or know your customer.

In order to avoid money laundering and other forms of fraud, most financial regulators want to know exactly who is involved in a financial transaction. Currently this is solved via often manual processing of official documentation. Fintechs have come up with digital approaches, e.g. Onfido can read a photo of your passport. The real solution however is to be able to prove it is you, without sharing any personal data with others. Many decentralised identity solutions are being worked on to do exactly this. Most will use concepts like Zero Knowledge Proof in which a person can proof something about them without giving away any information, e.g. I can prove I am over 18 if the UK DVLA confirms I have a driving license, I can prove I earn more than the minimum wage if my employer or the tax authority confirm I am paid more than the minimum wage,… Distributed identity solutions are available as we speak and improving every day.

Fraud-detection and money laundry solutions are probably one of the harder problems to fix in a fully decentralised bank. 

Using the decentralised technology for private distributed payment networks in which all parties are trusted could be a first step in the right direction. Other regulatory compliance however can be done often better with decentralised ledgers given that all transactions are stored on the ledger, it is hard “to steal” funds or to deny a transaction took place. Regulatory reporting as such is one of the key areas where distributed ledger technology makes enormous sense. Distributed ledgers can also use the concept of Oracles, i.e. a trusted party which often provides data to smart contracts. A good example of an Oracle is any mechanism which provides information about the Gold price. As long as there is trust that the Oracle is right, smart contracts can automatically take action. The mechanism of Oracles could be used to prove by a trusted party that funds which are introduced on a distributed ledger did not come from a criminal operation. This area is ripe for new product innovations by established players working with innovators.

Many financial products have rules around available capital, e.g. a bank needs to hold a certain percentage of deposits and can not use them for loans, similar for insurance. This capital provisioning can be fully automated via smart contracts.

Lots of financial instruments are derivatives, linked to others [e.g. index-based] and other automated financial products. All of these can be fully automated via smart contracts.

Risk management is a major function for both banks and insurers. Given the transparency of the distributed ledger, again automation of risk management and regulatory reporting related to it is a great use case.

In investment management, insurance and pensions, often third-parties hold the actual invested assets, i.e. custodianship, while professional traders and investors make the decision where to invest. Again this is a prime use case for a distributed ledger.

Intermediaries are a major part of the current financial system. In a distributed finance world this group is likely to be cut-out, given that smart contracts will take over their job.

Financial advice is often needed before a customer is willing, and in some cases is allowed, to perform a transaction. Most of this regulation is focused on protecting the customer from themselves or from experts who do not share a win-win with them. In a fully automated distributed world, it would be easier to get price transparency and as such lots of this regulation could be simplified and is obsolete. For other parts the distributed ledger can be a great place to store the advice/consent that was given, and as such lots of “misunderstandings” can be avoided.

What should existing financial institutions focus on?

Existing financial institutions are at risk of applying blockchain technology to try to automate a broken process. At the same time they have an existing business, brand, trust and revenues to protect. If existing teams are asked to apply blockchain then the likelihood of a revolutionary product coming out of such teams will be low.

Ideally “challenger brands” and separate automated ventures are set up in a way that funding, operations, risk management and other aspects are separated from the mothership. Potentially a separate legal entity with its own processes is required. This is the only way to avoid internal teams, which are at the losing end of the new technology or do not understand it, from delaying or even sabotaging success.

Blockchain is ideal for multi-party solutions so new ventures could focus on creating industry efficiencies for customers, partners or even between competitors. An example could be automation of a letter of authority [LoA]. The LoA is a concept whereby a customer looking for advice needs to authorise the independent advisor before they can gain access to their account balance, pension, insurance,… A digital blockbuster would be to just automate this process. A more innovative approach would be to think about an Uberization of advisors and how this could be automated for complex financial services products.

Another example in the pension space are the pension dashboard and transfers. A pension ledger can hold all pensions and allow for simple transfer processes. Why would you want to create a simple way of pension transfers? If you would offer an automated pension that is exponentially cheaper than the “semi-automated” products currently available, wouldn’t you want all customers to be able to easily transfer? A similar mechanism can work for bank accounts as well. Many established companies have legacy systems and legacy products. Instead of migrating the existing product and data which is expensive, why not offer a better digital fully-automated product instead and offer the customer an automated product migration. If you can easily migrate your legacy book, then you are likely able to do the same for competitors ;-)

Given the enormous efficiencies that can be obtained through automation, products whose price have a tendency to go towards zero, could be revolutionised by putting the price to zero and changing the way to make money. Blockbuster kept its $3/movie rental while Netflix went to less than $10/month for unlimited access while telecom providers were charging exponentially more. Robinhood put the price for retail investors to buy stocks to zero because the trading data could be sold to hedge funds to front-run the market. Any incumbent with a volume business should consider this strategy for non-core business.

Automation brings the potential for new products. Why not let each customer define their own investment fund? In a world of smart contracts and AI, expensive traders could be substituted. Investors require investments to be having a great ESG score. Why not tokenise ecological, social and governance solutions? Often institutional investors also want to balance long term liabilities with asset investment gain. Smart contracts are great at enforcing the right investment strategies, especially if they were hidden in hundreds of pages of paper contracts until recently.

Multi-party ecosystem-based marketplaces is another example where incumbents can quickly make a difference. Incumbents are often slower than challengers to launch a new product and cannot take as much risk of failure. Why not create automated marketplaces for challengers to offer their different products to existing customers and both get a commission. You can afterwards invest in, buy or copy the successful challengers.

What should challengers focus on?

Challengers have little to lose and much to gain. So product innovation based on new customer needs should be in their core DNA.

Too often incumbents follow unwritten rules which are no longer true. We are not supposed to share financial information with others, is such a rule. eToro proved by combining investing with a social network, that the best investors want to be followed by others. Why are bank accounts, investments and payments so restricted? Shouldn’t a grandparent be able to automatically put money into an investment product for grandchildren without needing the parents to be involved? Family and friends as well as line manager/colleague type of financial products can use a lot of innovation. Social networks and financial products were hard to do, until distributed smart contracts became available, that is.

If a start-up creates a new market, e.g. electric scooter rental, then this comes with new types of risks, e.g. the risk of a mortal accident. Traditional actuarial risk management requires historical data and lots of it before insurance, loans, … can be priced and underwritten. What if risk can be tokenised and sold/invested in? Why not have others co-invest in loans? The wisdom of the crowd might be a great helper.

Most DeFi companies are solving problems they found in other DeFi companies. Potentially now is the time to broaden the customer base and look at problems other start-ups have. Start-up's never have enough funding and customers. Automation to help fund or sell products as such should be high on the list.

Incumbents are slow to move but have two things startups do not have, i.e. lots of money and lots of customers. Any solution which allows incumbents to quickly launch innovative products to their customers can be a win-win.

The future of finance = blockchain

The alpha-male Wall Street trader made room for the quant in a high-frequency trader. The actively managed special purpose investment vehicle for the passive index-fund. Blockchain and related distributed ledger technologies are going to bring even bigger changes to the financial services industry. An industry where handwritten paper, call centres, faxes and billion-dollar spreadsheets still exist, is an industry ripe for a blockchain revolution. Regulatory hurdles might actually become regulatory catalysts in a world of super distributed automation. The token economy is here…

To make sure DeFi, Smart Contracts and DeFi are factored into your strategic planning please contact Marteen Ectors or me via LinkedIn.