The creation of Ethereum (ETH -2.53%) in 2013 laid the foundation for cryptocurrency to take the largest step in its evolution since the creation of Bitcoin. With Ethereum’s programmable blockchain, developers could build self-executing code that would be triggered based on set conditions. Subsequently, this gave rise to an entire sector of blockchain that is known today as decentralized finance or DeFi.
With DeFi, many traditional financial operations, such as lending, were revolutionized and gave way to entirely new methods of crypto-based finance like yield farming. Unlike traditional finance, DeFi was open to anyone with sufficient funds and an internet connection. Users didn’t need a credit score, they didn’t have to show proof of identity, and they didn’t need to rely on an intermediary like a bank. For these reasons, many view DeFi as a direct competitor to traditional financial institutions.
However, that might have all changed this week with an announcement by one of the world’s largest banks.
Banks embrace blockchains
For the last year, banking giant JPMorgan Chase (JPM 0.16%) and its partners in Singapore and Japan have been experimenting with ways to blend DeFi and traditional finance. In a world first, the banks were able to utilize blockchains and cryptocurrencies to facilitate some of their most common transactions. To do this, they “tokenized” Japanese yen, Singaporean dollars, and bonds from both countries. All this means is that they were able to create blockchain versions of these traditional financial products.
The experiment achieved two notable accomplishments. First, they simulated a deposit of the Singaporean dollar token in exchange for the Japanese yen token. This type of transaction is done all the time between banks. Because the value of national currencies changes every hour of the day, in order to maintain a well-structured balance sheet, banks trade currencies depending on price fluctuations. With currencies now in a tokenized form on the blockchain, banks can make these trades instantaneously, automatically if certain conditions are met (like a price drop or increase in the currency), and cheaper since there is no need to settle the trade with a middleman.
The second part of this experiment was built on the tokenizing of national currencies, but in the form of bonds. Like the currency market, bonds are heavily traded and have a wide range of players such as corporations, banks, and even governments. Similar to the accomplishments made by tokenizing currencies, the creation of a blockchain bond mitigates costs, streamlines processes, and allows transactions to be conducted in real-time.
After the success of the experiment, the chief fintech officer of the Monetary Authority of Singapore (one of JPMorgan’s partners in the experiment) asserted that “digital assets and decentralized finance have the potential to transform capital markets.”
How they did it
To make all of this happen, a few blockchains were used. The trades were technically settled on Polygon (MATIC -10.70%) but also involved Ethereum and the DeFi specalist Aave (AAVE -12.33%). Ethereum has become the standard blockchain for DeFi due to its programmable smart contracts, decentralization, and security. However, costly fees and slow transaction speeds can plague the blockchain when traffic is high. Polygon remedies this by processing transactions on its own blockchain and then adding them to Ethereum as a bundle instead of individual transactions. This makes Polygon faster and cheaper to use than Ethereum but still maintains that desired compatibility.
To set certain parameters like foreign exchange rates and interest rates, Aave was used. You could think of Aave as the actual bank where conditions can be put in place by executives. In addition, Aave’s functionality allowed JPMorgan to set up credential-based access so that only certain participants could make trades.
DeFi meets TradFi
This experiment proves that long-established processes carried out by banks can move to a blockchain-based solution and benefit all participants. Since the creation of cryptocurrencies and DeFi, banks and other traditional financial giants have written off its potential. Now, that’s all changed.
Ethereum, Polygon, and Aave are at the forefront of DeFi integration with traditional finance. The potential these cryptocurrencies possess is just starting to be realized, and collectively, they possess the ability to revolutionize the nearly $7 trillion international banking industry. With all three of these cryptocurrencies at historically low prices, an investment today could provide promising returns as traditional finance begins to tap into DeFi’s true power.
JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. RJ Fulton has positions in Ethereum and Polygon. The Motley Fool has positions in and recommends Aave, Ethereum, JPMorgan Chase, and Polygon. The Motley Fool has a disclosure policy.