TradFi & DeFi convergence
From TradFi weakness to DeFi value proposition
INTRODUCTION
In recent years a combination of factors and events threw the global monetary system under discussion, forcing central banks worldwide to take action.
In the last 50 years, the financial sector didn’t experience substantial infrastructure change. Despite an astonishing growth of transaction volume since the 1950s and the advent of general-purpose payment cards, banking and capital market processes didn’t experience a substantial improvement.
Unprecedented events, macro-financial, economic, and geopolitical changes, and institutions entering the market are converging TradFi (traditional finance) into DeFi (decentralized finance).
DeFi is an open-source peer-to-peer finance, where transactions do not require a counterparty to process them. Avoiding 3rd parties mediation fees using smart contract automation business logic implies a change to the business model.
There is a lot going on in DeFi ecosystem and it is not always intuitive to wrap the head around concrete applications, and implications in the traditional world.
In this article, I wanted to contextualize DeFi changes in, infrastructure, business model, and user experience level, through some of the use cases, at the intersection of traditional financial TraDi and DeFi.
- TradFi pain points
- What is DeFi
- DeFi value proposition
1. TradiFi PAIN POINTS
Payment networks run on the same financial infrastructure built in the 1950s. Banking and capital market activities are affected by remittance, settlement & clearing, reconciliation, too slow, expensive, and subject to human failure.
Fintech introduced a better customer experience, easier access to financial services, better distribution, and cheaper services. Despite it improved the front end with a fresher and more appealing customer journey, didn’t address the hurdles coming from an obsolete technology infrastructure.
Meanwhile, customers have become more demanding, requiring a user experience at the same level as other digital services.
If on one side fintech is eroding market segments, especially the younger generations (Millennials, Gen Z), on the other, crypto and blockchain are frightening SWIFT (non-profit cooperation signed in 1977 by American and European banks to facilitate cross-border payments dispatching messages that credit or debit their account rather than actual payment its self) despite the new innovations this year, 2022, SWIFT network capabilities can’t compete with the order of magnitude of technological disruption brought by crypto and blockchain.
Covid triggered crypto adoption that had explosive growth in the summer of 2020, surging to 1B TVL (Total Locked Value) that kept growing up to 200B until May 2022 with total DeFI wallet users of 4.7M.
The loss of trust in the financial institutions, central and commercial banks, the war, the inflation in developed countries, the hyperinflation in developing countries, the surge of interest rates, and the recession, are adding uncertainties to a financial sector infrastructure already inappropriate for the market request.
Despite we live in a global economy the infrastructure didn’t change so much to fulfil higher demand, and more sophisticated customers, keeping the same type of services with the same low level of efficiency.
The majority of the Financial Systems still run on a mainframe, which implies:
- high complexity in a business-critical environment that can’t be interrupted and mistakes have critical economic and brand impact
- high operations cost to change and maintain. High rate of human errors due to manual processes, low fault tolerance for single points of failures due to centralized servers, services provided too slow for the customers
- legacy systems incompatible between different financial institutions (see OpenBanking), insufficient security level, struggle to keep up with compliance, changing regulations, and standards
Apart from Crypto and web3, there are also other less disruptive technologies, affecting the way retail and corporate consume finance: AI/ML, RPA, Chatbot, OpenAPI, Cloud, Mobile and Biometrics.
2. WHAT IS DeFi
Decentralized finance, DeFi, is disintermediated financial services backed by cryptocurrency and blockchain technology, where services, the exchange of value, takes place between peers, without 3rd parties such as banks, financial institutions, brokers, market makers, custodians, hedge funds or portfolio managers. It started with bitcoin in 2009 a censorship-resistant peer-to-peer payment network and store of value, and evolved to a volume of transactions equivalent to a market cap of $944,999,253,216.79, 9442 tokens, 272 exchanges, with around 40% is bitcoin (source Coinmarketcap as per October 2022).
Ethereum the second largest blockchain by market cap after bitcoin, introduced in 2013 smart contracts, a business logic that moves eth, its native currency token, and sets the foundation of decentralized applications. DeFi began by replicating TradiFi services such as payment, lending and borrowing, and exchanges, introducing new innovations due to the composable nature of its decentralized applications and stack of primitives: ledger, tokens, protocol, smart contract, dApps.
How does disintermediation work?
Smart Contracts: are computer programs that allow the disintermediated nature of DeFi services. The “contract” is an agreement that does not have legal validity unless intentionally stated by a legal authority. Smart contracts automate any process that involves interactions between two parties moving value in real time over the blockchain, rather than settling days as with traditional banking systems.
The Smart Contract execution is triggered by a specific event that “if … than” the condition occurs, the execution takes place. Smart Contracts get data from Oracles, which are external sources that feed smart contract programs that run on the blockchain. Oracle are usually third-party data source provided by centralized entities. The program is immutable, the code can’t be changed once deployed on the blockchain. It is deterministic, they either happen in full, exactly as described, or they don’t run at all, the only way to modify a Smart Contract is to deploy a new instance. The program is immutable, the code can’t be changed once deployed on
the blockchain. It is deterministic, they either happen in full, exactly as described, or they don’t run at all, the only way to modify a Smart Contract is to deploy a new instance.
Smart Contracts get data from Oracles, which are external sources provided by centralized entities that feed smart contract programs translating real world events (non-deterministic data) to digital values (deterministic data) like for example software oracles or inbound oracles that retrieve online data from external programs and web APIs — such as market prices, flight status, and weather data. Outbound Oracles make possible for smart contracts to communicate with non-blockchain sources transmitting smart contracts data to external systems.
Hardware Oracles: provide real-world data for smart contracts through physical systems. For instance, hardware oracles can communicate with RFID sensors used in various industries (automobile, pharmaceutical, supply chain, etc.).
dApps, decentralized applications, are the implementation of the business logic coded into the Smart Contracts. The federation of different dApps, combined, creates new financial services offered to customers.
Once dApps are deployed can’t be taken down and have several capabilities: are composable/plug and play, payment is built in, backed by cryptography which preserves data integrity, user privacy, and can’t be censored.
On the contrary, the fact that dApps run on open-source smart contracts makes them an easy target for hackers along with others flaws like scalability, poor user experience, and difficulty to make changes to the code.
DeFi financial services can be provided by non-custodial, or DeX exchanges, or custodial exchanges, CeFi.
DEX — decentralised exchanges — are peer-to-peer marketplaces where traders can exchange crypto for other cryptocurrency tokens owning the private key used to sign each transaction.
DEX are non-custodian DeFi platforms, where crypto-to-crypto transactions take place without banks, brokers, or any other intermediary. Users are the owners of their funds (or crypto) since they own the private key that is stored on their own devices. Your key your coin!
CeFi are centralized exchanges that allow “on-ramp” fiat to crypto exchanges. Rather than DeX, which doesn’t have access to customers' funds since they do not have their private key, CeFi takes ownership of customers’ private key, storing them on their private servers. CeFi have access to customers' funds, thus same as banks, can do whatever they want: inhibit access, block withdrawals, freeze your account, at best, without counting frauds, direct, or from 3rd parties granted to access your account. Not your key not your coin!
3. DeFi VALUE PROPOSITION
Open, permissionless
Everyone with a mobile phone can access it. KYC, know your customer, and AML, anti-money laundry, is managed based on the exchange-specific jurisdiction regulations. This potentially opens the doors, to 1.7 billion unbanked, or people excluded by the international financial system, worldwide.
DEX capabilities
Self-sovereign — no external authority, government, institutions, or banks, can’t freeze your assets, can’t close or size your account, and can’t refuse to provide any services since the transactions are direct peer-to-peer.
Ownership — asynchronous cryptography (the pair private/public key) allows self-custody of your own assets without the need for 3rd parties. Not your key not your coin, means that if you don’t have the private key, you don’t own your funds. If stored in a bank, or bank-like centralized exchange custodial wallet, where your keys are held by a 3rd party service.
Privacy — transactions are pseudo-anonymous by design– transactions are linked to addresses that correspond to public keys derived from user-held private keys, not by username or password. Transactions are encrypted and stored on nodes around the globe.
Transparency, public— assets can be traced where they are within the blockchain along with their provenance. For this reason, despite conventional thoughts, cryptocurrencies (bitcoin) are the worst medium to use for illicit activities that are best founded with cash.
Mobility — in a digital wallet you can potentially carry on all your assets and move them worldwide.
Cheaper & faster — it is the first financial network where remittance and settlement occur within the same network in almost real-time. Remit money and settle payments are cheaper and faster.
Superior Operations — this translates in terms of operations management in a huge decrease of complexity, streamline processes, reduce costs, increase of efficiencies, and instantaneous go-to-market reach.
More secure — due to the combination of capabilities like asynchronous cryptographic functions, digital signature that sign, time stamps the transactions, the immutability of the ledger, consensus mechanism that randomizes the block of transactions executed, and distributed system with no single point of failure.
CONCLUSION
I help HNWI and Family Offices to understand how sustainable data centers can can preserve their wealth investing in geographically distributed alternative assets, to builds the decentralized infrastructure necessary for energy transition, offsetting Co2 emissions rather than buying carbon credit. This can be achieved by leveraging new fixed-income products that captivate new generations and unite families with a sense of purpose and philanthropy.
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