TradFi & DeFi: is convergence inevitable? – Ledger Insights

This is a guest post from Jake Hartley, Business Development Director at Finality

Recent technological advances have made it possible to consider decentralized and distributed systems as meaningful alternatives to traditional solutions and institutions. ‘Decentralized finance’ (DeFi) is characterized by the use of new technologies – notably distributed ledger technology (DLT), or blockchain – to offer distributed and disintermediate solutions to the problems that established ‘traditional finance’ (TradFi) players have typically tackled i. through centralized and intermediate operations.

A wave of innovative products and approaches has captured the industry’s imagination and even trickled down to the general public, with reactions ranging from skepticism to enthusiasm. Institutional interest in cryptocurrencies is a particularly prominent example of DeFi ideas spurring TradFi actors to devote significant resources towards the understanding, productization and commercialization of a distributed, peer-to-peer product underpinned by DLT. But this is only a small part of a much bigger picture.

Many innovative FinTechs are now leveraging the ideas and ideals behind DeFi with the aim of challenging TradFi players on their own turf, potentially threatening the business models and revenue streams of incumbents. Perhaps due to the public fervor surrounding new assets such as cryptocurrencies, the relationship between TradFi and DeFi has often been characterized as adversarial, but this obscures the reality of the situation: a strong desire for integration on both sides, a common goal to make financial markets faster, cheaper and safer, and a willingness to use new technology to solve old problems more effectively. However, fully realizing these goals is not without challenges.

The challenges of DeFi and TradFi integration

Despite shared aspirations, a primary barrier to the integration of DeFi and TradFi is the marked difference between the two sectors in terms of agility, risk tolerance and willingness to embrace disruption. Clayton Christensen’s ‘Innovator’s Dilemma’ theory explains how incumbents can become vulnerable to disruption by doing the ‘right’ thing; they often focus more closely on the established end of the market, as that is where the highest revenues and their most loyal customers lie.

Innovators may struggle to compete in the established end of the market, but the unknown end of the market is relatively unprotected. In the world of finance, DeFi innovators have entered the financial markets by providing the on-ramp into cryptocurrency markets, but are beginning to expand into other areas, including tokenization of traditional assets, institutional lending, custody services, establishment of distributed financial market infrastructure (dFMI), and much more – grab increasingly into the domain of TradFi institutions in the process.

At the moment, the incumbents are still relatively unproblematic; their core markets remain profitable and unchallenged, and regulatory uncertainty surrounding the legal and prudential treatment of DLT and DeFi solutions remains high. But the aforementioned activities of insurgents are certainly attracting the attention of regulators, which – along with growing customer demand and the progress of others – could open the door to greater legitimacy and formal regulation. This can leave incumbents vulnerable and lagging behind innovators as they expand into their traditional markets.

Furthermore, TradFi – especially in the financial markets – has often been slow to adopt new technology. The risk associated with overhauling or integrating older systems with new solutions is a frightening prospect, and creates yet another barrier to convergence between the two spheres.

Is convergence between TradFi and DeFi in the wholesale space inevitable?

Despite the points of divergence outlined above, the growing readiness of regulatory bodies, growing demand from businesses and customers, and fundamentally shared goals to improve the speed, cost and security of wholesale financial markets mean that TradFi and DeFi convergence is a matter of when , not if. The benefits that each side can bring to the other are too compelling to deny.

DeFi seeks the legitimacy that can only be achieved through full compliance with applicable regulatory bodies and regimes. Full compliance facilitates the safe expansion of DeFi services and the technology that underpins them, promoting more widespread trust and use and access to a wider institutional consumer base.

On the other hand, TradFi is eager to leverage DeFi technologies such as blockchain in financial markets to compress settlement times to the same day (T+0). This limits the number of intermediaries required between the initiation of a transaction and final settlement, and leverages the risk reduction benefits that arise from the use of DLT. Large wholesale banks in particular can more accurately predict and manage their liquidity needs by taking advantage of the near-instant peer-to-peer settlement that technology enables.

Fnality – a consortium of leading global financial institutions – is already leveraging technology related to DeFi for applications on TradFi systems for these purposes, among others. Working with both TradFi and DeFi partners in preparation for the platform’s launch in late 2022, Fnality’s payment system can unlock intraday liquidity savings of up to 70% and enable near-instant settlement.

What are the requirements for DeFi and TradFi to develop together?

The successful convergence of DeFi and TradFi will result in the mutually beneficial use of innovative technology to streamline processes, reduce costs and ensure regulatory compliance while offering new products and accessing new markets. For this to happen, both sides need to be sure that this technology is secure, resilient and compatible, and that the legal framework around it is robust. What is really needed is a basic, regulated, technologically sound “layer of trust” to safely drive this convergence and ensure that both sides fully realize their shared goals.

As a TradFi-backed consortium with both significant DeFi pedigree and long-standing relationships with key central banks and regulators, Fnality is well positioned to sit at the intersection of these converging markets, strengthening both sides in the process.

Fnality is a consortium of global banks and FMIs building a regulated payments system to support the growing industry’s use of tokenized assets and marketplaces.