How Can TradFi and DeFi Work Together?

When decentralized finance (DeFi) instruments were first emerging, a lot of people were speculating about whether they could potentially replace traditional finance (TradFi) institutions, which have not undergone any significant changes for quite a while. As time went on, because of progressively increasing blockchain technology adoption, the paradigm shifted, and now many experts are pointing out that the two spheres should actually evolve together and merge.

This concept is known as hybrid finance (HyFi). It combines the advantages of both centralized and decentralized systems, using blockchain technology to create a more efficient and transparent financial ecosystem. This approach allows for greater accessibility, scalability, and security in financial transactions.

In this article, we are going to see how TradFi coexists with DeFi at the moment and how they can work together in the future.

TradFi and DeFi in their current state

While traditional finance has been around for many centuries, the processes and systems have been refined over the years to ensure stability. Even though this system still has the potential to fail as we have seen with things like the housing bubble which lead to the crisis in 2007-2008, the regulatory norms and practices still make it more reliable compared to DeFi. 

What is more, TradFi continues to be more accessible to a wide range of people, including those who may not have access to the Internet and knowledge about blockchain technology.

On the other hand, the traditional financial industry has been slow to adopt new technologies and innovations, which has led to a lack of diversity in products and services. What is more, TradFi institutions often charge high fees. This sphere is also notorious for being controlled by a small number of large institutions, which can lead to a concentration of power and limited competition.

In order to compensate for the drawbacks, DeFi elements can be used in conjunction with more traditional instruments. In fact, this is already the case: some banks, hedge funds, and other financial institutions have started to invest in DeFi protocols or set up their own DeFi platforms. For example, in 2020, Onyx launched by J.P. Morgan became the first bank-led blockchain platform. And in 2022, The Bank of New York (BNY) Mellon launched a custody service together with a crypto firm Fireblocks that offers to store clients' private keys and provide bookkeeping on their BTC and ETH. Additionally, stablecoins have been often regarded as the bridge between the two Fi’s.

HyFi potential use cases

Hybrid Finance can be used in a lot of ways. Let us consider a few examples.

1. Insurance. DeFi protocols can be used to make insurance solutions transparent, efficient, and accessible to all. In this case, traditional finance would provide risk management, while DeFi would automate the claims and payout process. In a limited form, such projects already exist, e.g. InsurAce Protocol which protects users’ investment funds, and Nexus Mutual provides insurance to crypto projects in case of hacks or bugs.
2. Payment Solutions. DeFi has been gaining popularity in the area of cross-border payments, which are traditionally slow and expensive. Stablecoins like USDT or USDC can facilitate fast and low-cost transactions, while traditional finance is used to provide liquidity and fiat currency support.
3. Lending and Borrowing. Decentralized lending platforms could offer loans to individuals and businesses without the need for intermediaries. Traditional finance would be used in order to provide the necessary credit scoring and risk assessment.
4. Renewable Energy. DeFi has the potential to create new financing models for renewable energy projects, enabling investors to fund projects directly and earn returns on their investments. Traditional finance would be used to provide underwriting, insurance, and other related services.

Conclusion

Hybrid finance presents a promising solution to the limitations of both DeFi and TradFi systems. The integration of DeFi elements with more traditional instruments could lead to greater innovation, accessibility, and security in financial transactions. As blockchain technology continues to evolve, it is likely that we will see more collaboration between DeFi and TradFi, leading to a more efficient financial ecosystem for everyone.