The traditional financial system has been a dependable and robust foundation for the world economy for generations. However, as time has advanced, it has become apparent that this system is not free from weaknesses. The 2008 financial crisis served as a significant wake-up call, revealing serious flaws in the established financial structure, particularly its reliance on major and interconnected institutions. It served as a clear reminder that the existing system is not flawless and needs adjustments to address the changing needs of consumers.
In the aftermath of the 2008 crisis, a wave of innovation in the form of fintech startups and other disruptors surged onto the financial scene. These newcomers offered digital business models aimed at streamlining financial processes for everyone. They were more agile than banks, cheaper, and offered easier access to financial services, especially for the unbanked. While these innovations undoubtedly represented a step forward, they did not fundamentally reshape the underlying structure.
Enter DeFi or Decentralized Finance, a revolutionary model that has provided an alternative to the centralized financial system. DeFi promises to empower individuals to take control of their financial destinies, offering a vision of an open and borderless ecosystem that is accessible to anyone with an internet connection. Like its predecessor, however, DeFi also has its unique set of challenges, which we will explore shortly.
Is it DeFi or TradFi, black or white? Do we need to limit ourselves to an all-or-nothing decision? While the two models appear contradictory at first glance, the future may lie in embracing a hybrid approach that leverages the strengths of both systems. In this article, we will explore the convergence of traditional and decentralized finance, seeking to understand whether a hybrid model could pave the way for the financial system of the future.
Limitations of Traditional Finance (TradFi)
The conventional financial system, as we know it, has been around for quite some time. And while there have been breakthroughs like the transition to digital finance, the involvement of tech giants’ in payments, and the rise of fintechs as disruptors, its foundation has remained largely unchanged. Payment networks continue to operate on the same infrastructure designed in the 1950s.
Trust in traditional financial services relies on intermediaries who maintain records across various isolated ledgers that are disconnected from each other. Due to each participant having distinct roles in the system, reconciling these separate ledgers and finalizing transactions can be time-consuming. On average, global cross-border payments take between three to five days to settle. In light of the fast-paced nature of the modern world, traditional financial payments are falling behind in terms of speed and efficiency. It’s also worth noting that these cross-border payments incur significant costs in the form of transaction fees.
The concentration of power is another pressing concern within traditional finance, with the largest financial institutions possessing influence over the broader economy. As we’ve seen during the 2008 crisis, the downfall of major banks triggered a severe global recession, underscoring their sway over the financial system. The rise of fintechs seemed promising in terms of disrupting this power imbalance, but many fintechs have since been acquired by these very same institutions. Their shared foundation exposes new entrants to the legacy and influence of existing industry players.
Furthermore, a significant portion of the global population lacks access to the traditional financial system. Roughly 1.4 billion individuals are considered unbanked, meaning that they are deprived of essential financial services. This ongoing issue stems from multiple factors, including banks restricting loan accessibility, the prohibitive expenses linked to maintaining a bank account, and challenges related to physical accessibility.
Finally, traditional financial institutions ask users to comply with strict know-your-customer (KYC) requirements to authenticate their identities. While these measures are designed to prevent fraud and money laundering, they entail a multitude of paperwork and verification steps, making the process time-consuming and sometimes inefficient. Furthermore, due to the independent operations of financial institutions, customers are compelled to repeat this process when transitioning from one bank to another. KYC processes also trigger privacy concerns among customers who prioritize anonymity, as they entail the gathering of sensitive personal data.
The rise of DeFi
DeFi leverages blockchain technology to establish decentralized applications (dApps), streamlining peer-to-peer lending, borrowing, insurance, and digital asset trading without the involvement of traditional financial intermediaries. Blockchain upholds integrity within the DeFi environment by dispersing trust across a network rather than relying on a single entity. It guarantees immutability through the use of consensus algorithms and cryptography, eliminating the potential for manipulation. In a transparent setting where every action is visible, any attempts at manipulation must be transparent to all participants, and the network automatically rejects any unauthorized actions.
In contrast to TradFi, which depends on central authorities, the foundation of the DeFi ecosystem lies in smart contracts, which autonomously encode the terms of agreements between buyers and sellers. These contracts automate any interaction between two parties, transferring value directly onto the blockchain.
For a better understanding of where and how DeFi solves the current challenges of centralized finance, let’s take a look at two of the major protocol categories.
Borrowing and Lending protocols
Borrowing and lending play a pivotal role in the realm of finance. In traditional finance, these transactions occur within traditional financial institutions, where users entrust their assets to the platform, which manages loans and sets interest rates. Such platforms typically necessitate users to place their faith in a central authority to safeguard their funds.
The DeFi lending and borrowing market has seen remarkable growth in recent years, with a Total Value Locked (TVL) exceeding $120 billion, establishing it as the largest protocol category. In DeFi, loan origination takes place through liquidity pools, connecting buyers and sellers with liquidity providers. Because lenders cannot assess borrower risk due to anonymity, loan agreements are defined within smart contracts, while risk mitigation is achieved through over-collateralization, a strategy that also protects against the volatility associated with crypto assets. DeFi excels in providing almost instantaneous transfers during the disbursement phase. Whereas in the servicing stage, it automates payment processing, interest rate adjustments, and amortization schedules through smart contracts, minimizing the requirement for manual intervention. DeFi's ultimate collection phase ensures automated and punctual repayments.
Decentralized exchanges (DEXes) rank as the second largest category, boasting a TVL of $19.749 billion. In DEXes, digital assets are traded directly without intermediaries, leveraging liquidity pools or AMMs to adjust prices in response to supply and demand, all while removing the necessity for trust in operators. In contrast to centralized exchanges, which may solely handle fiat, enable fiat/crypto transactions, or exclusively focus on crypto assets, DEX users can offer liquidity, earn yields, and engage in trades against liquidity pools instead of conventional order books. Curve, Uniswap, and Sushiswap are some of the well-known DEXs. Uniswap, for example, uses the AMM protocol on the ETH blockchain and relies on liquidity pools. These pools are created and maintained by users who deposit equal amounts of two different tokens.
While DeFi offers a promising array of benefits, it is crucial to recognize and address the challenges that come hand-in-hand with this rapidly evolving financial ecosystem.
First, there are inherent risks tied to oracle dependencies within the realm of decentralized finance. Oracles play a crucial role in furnishing the data that underpins DeFi protocols, typically sourced from third-party providers. However, this reliance on external sources exposes DeFi systems to potential risks, including oracle failures and attempts by malicious actors to tamper with the provided data. The accuracy and integrity of the information delivered by oracles become pivotal, as DeFi protocols heavily hinge on it for decision-making and functionality.
Smart contracts, pivotal to DeFi transactions, are susceptible to malicious attacks, especially given the open-source nature of DeFi, making them more vulnerable to cyber threats. Common vulnerabilities include flash loan attacks, unauthorized access, and reentrancy attacks. Up to May 2023, there had been 148 documented DeFi exploits, primarily attributed to smart contract weaknesses. One notable incident was the Curve hack in August 2023, where the attacker deployed a malicious smart contract on the ETH blockchain, interacting with Curve's smart contract. While Curve managed to recover most of the funds post-attack, the event underscored the growing need for enhanced security measures.
Market manipulation remains a persistent challenge in the DeFi industry. Recently, Solidus Labs released a report revealing that liquidity providers engaging in wash-trading have accounted for a minimum of $2 billion worth of cryptocurrency on Ethereum-based decentralized exchanges since 2020. Wash trading is also prevalent in traditional markets, where it is typically addressed through surveillance and self-trade prevention mechanisms. Similarly, it can be prevented on DEXs, and they don't have to be magnets for manipulation. However, the question of who is responsible for tracking on-chain wash trading remains ambiguous.
Lastly, scalability remains a concern in DeFi. Due to its anonymous and automated nature, borrowing, and lending transactions in DeFi often must be overcollateralized due to a lack of qualitative metrics that incentivize honest actions (such as the credit score system present in traditional finance). Overcollateralization requirements restrict peak capital efficiency in DeFi ecosystems. Furthermore, escalating demand for DeFi services implies that protocols must handle a higher transaction load. Currently, the Ethereum network, where the majority of DeFi transactions occur, is limited to processing 30 transactions per second, in stark contrast to Visa's capacity of 65,000 transactions per second in traditional finance. The introduction of the proof-of-stake model was a partial response to this demand surge, however, transaction volumes continue to rise, requiring further solutions to ensure a seamless and cost-effective user experience. The upcoming Ethereum upgrade, ETH 2.0, planned for launch this year, aims to address this pressing issue by boosting the transaction capability to 100,000 per second.
A hybrid approach: Best of two worlds?
Both TradFi and DeFi have their own unique set of advantages and challenges. Traditional financial institutions possess established risk management and security measures to safeguard assets, yet they face challenges such as limited accessibility, concentration of power, and inefficiency. On the other hand, DeFi protocols effectively address these challenges by providing easier, faster, and automated access to capital. However, at times, they lack equivalent security measures and encounter scalability issues.
Though seemingly contradictory, a strategic integration that leverages each other's strengths to offset weaknesses is a possibility. DeFi brings innovation, accessibility, and transparency to the table, while TradFi offers enhanced security and a well-established functional system. By merging their strengths, a hybrid approach could potentially unlock further innovation, instill investor confidence in asset security, and pave the way for commercially scalable financial solutions.
The convergence of these two ecosystems may initially seem like a distant or overly optimistic possibility for many. However, recent examples of DeFi and TradFi convergence serve as compelling demonstrations that collaboration is indeed achievable.
Tokenization of real-world assets
An example of how DeFi and TradFi can come together to create more value is through the tokenization of real-world assets (RWAs), which involves representing the ownership of tangible assets such as real estate, precious metals, and collectibles on-chain in the form of digital tokens. Traditionally illiquid and large-scale items, like houses, can be traded or fractionalized for multiple buyers. Keeping the ownership of the real-world assets on-chain lowers costs by eliminating middlemen, increases trading efficiency, and creates more liquidity in the market.
The sector has experienced rapid growth in recent years, with DeFi projects and companies aiming to bring financial assets on-chain. According to a 2022 Celent survey, 88% of global institutional investors are comfortable with digital representations of cash using blockchain technology, while 91% of institutional investors are interested in investing in tokenized assets. Traditional financial companies are eager to tokenize assets such as gold, stocks, and commodities.
A significant development is that Franklin Templeton, a global asset management giant, recently expanded its on-chain fund to Polygon, becoming the first U.S. registered mutual fund to use a public blockchain to process transactions and record share ownership. According to a report by Boston Consulting Group, the global market for tokenizing RWAs has the potential to reach $4–16 trillion by 2030, signaling that the tokenization of RWAs is more than just a technological trend and that further collaboration between TradFi and DeFi is likely to emerge on this front.
Visa expands stablecoin crypto settlement to Solana
Another recent example that has garnered attention in the payments ecosystem is Visa's announcement to expand its stablecoin settlement capabilities to support Solana. This expansion allows Visa merchants to accept USDC payments on the Solana blockchain. Stablecoins play a crucial role in the DeFi space, providing investors with the opportunity to generate yield from their crypto assets without being exposed to market volatility. Investors seeking higher yields than traditional investments can tap into the DeFi market with relatively low risk. This partnership shows the potential to introduce a traditional financial company’s user base to cryptocurrencies and DeFi, while also illustrating that stablecoins can serve as a robust interbank settlement solution.
The convergence of two inherently contrasting ecosystems presents its own set of challenges. Firstly, to facilitate this convergence, financial regulators must prioritize efforts to mitigate regulatory uncertainties linked to DeFi. Additionally, DeFi protocols should intensify their scrutiny of illicit activities. Meanwhile, both parties involved need to collaborate to enhance technical compatibility, ensuring a seamless user experience.
Can CEXs contribute to a hybrid future?
Right in between TradFi and DeFi, there is CeFi (Centralized Finance), describing a financial system that leverages the existing security measures of the former and adopts a regulated approach, while providing financial services using cryptocurrencies and blockchain technology. As a subset of CeFi, centralized exchanges (CEXs) facilitate the trading and exchange of digital assets within a centralized framework.
Serving as the middle ground between these worlds, can CEXs contribute to the transformation of financial services? Believing it can play a pivotal role in what’s coming next, Phemex is leading the change within CEXs and is in the process of partial decentralization to meet users’ demands for greater transparency and participation without compromising on security and privacy. At the core of this transformation lies Phemex Soul Pass, a soulbound token that cannot be traded and is used to verify the unique identity of its holder. By leveraging soulbound token technology, which uniquely ties each token to an individual, Phemex utilizes the blockchain to establish on-chain reputation and credit scores. This approach can potentially pave the way for undercollateralized loans, even within DeFi protocols, addressing the overcollateralization constraints often linked with DeFi.
A notable difference between a DeFi and a CeFi ecosystem is that DEX users have full control over their private keys. Phemex Soul Pass (PSP) bridges this gap, empowering them with complete ownership of their online identities in the growing Web 3.0 ecosystem. Furthermore, Phemex is getting ready to launch its native Phemex Token, which can be staked to obtain vePT for participation in the Phemex DAO. By encouraging community engagement, Phemex is looking to create a decentralized society within an exchange.
Hybrid cryptocurrency exchanges possess the potential to emerge as future epicenters for both crypto trading and community development. Striving to strike a balance between centralized and decentralized platforms, they provide users with cutting-edge APIs, operational efficiency, and autonomy while ensuring robust security measures are not compromised.
DeFi has been recognized as a disruptive force challenging traditional financial systems, offering a fundamental pledge to enhance financial accessibility and openness. This appeal is not limited to the unbanked; it extends to millions of users keen on embracing the forthcoming era of finance and gaining control over their assets. The potential of DeFi is rooted in its traits of immutability, transparency, and efficiency. Yet, like any nascent technology, it confronts vulnerabilities and hurdles.
Collaborative efforts between TradFi and DeFi hold immense promise for shaping a more inclusive financial system for everyone while ensuring the sustainable growth of new technologies. Centralized exchanges, naturally positioned between these two realms, have the potential to act as catalysts for a hybrid approach, leveraging the strengths of both domains and bridging what initially appear to be disparate worlds.