Opinion by: Roy Mayer, founder and CEO of Vixichain
When traditional finance (TradFi) institutions transitioned from skepticism to interest in cryptocurrencies and their associated technological and financial innovations, there was hope that their involvement might spur growth and widespread acceptance. As crypto and decentralized finance (DeFi) drive an economic transformation, the coexistence of competing realities becomes inevitable.
An Affordable Alternative
Amid numerous financial collapses, a growing number of individuals have lost faith in conventional banking systems. The financial freedom that DeFi and crypto offer represents a more efficient and cost-effective alternative. Nevertheless, as the cornerstone of our economic system, TradFi plays a crucial role in safeguarding the financial environment by crafting regulations that protect businesses and individuals alike. Even if digital assets and blockchain technology evolve into the primary channels for payment and value transfer, TradFi will remain integral to the broader financial landscape.
As DeFi and tokenized real-world assets (RWAs) increasingly capture the attention of banks and asset managers, it is evident that TradFi’s current role is limited. For DeFi to onboard more institutions, it must pursue strategic partnerships, prioritize compliance, and incorporate innovative tools to ensure alignment with legal standards.
Can DeFi and TradFi Coexist?
While many crypto advocates and decentralization purists may resist the idea of TradFi encroaching on their territory, it is widely recognized that institutions contribute regulatory and risk management expertise, credibility, liquidity, and more. As DeFi matures, its understanding of its strengths and weaknesses allows it to bridge ideological divides, leveraging TradFi’s experience to strengthen its position in an evolving financial landscape.
Recent initiatives, such as tokenized treasuries and bonds issued by major institutions, underscore TradFi’s interest in crypto developments. However, this involvement is often spearheaded by digital-first banks or experimental blockchain pilot programs like SWIFT. While numerous Bitcoin (BTC) and Ether (ETH) exchange-traded funds exist, these developments usually parallel rather than directly engage with the crypto ecosystem.
What’s Holding Institutions Back?
The decentralized nature of blockchain platforms, characterized by transparency and voluntary compliance, keeps institutions at a distance. Unclear regulations, which can vary significantly by region, coupled with privacy concerns, widen the gap between DeFi and TradFi.
Despite the increasing adoption of regulatory processes such as Know Your Customer (KYC) among DeFi platforms, interacting with public blockchains—where most liquidity resides—presents highly compliant institutions with numerous uncertainties. Banks are adept at managing risk because it can be quantified and mitigated. However, the uncertainty inherent in finance, dealing with unknown future outcomes, poses a significant challenge.
For institutions known for their risk mitigation capabilities, the volatility associated with crypto and DeFi means they lack sufficient data to make informed decisions. Although both ecosystems stand to benefit from collaboration, bridging the gap requires DeFi to address internal issues first.
Finding Common Ground Between DeFi and TradFi
With centuries of experience in asset management and navigating regulatory changes, TradFi finds it challenging to accommodate the decentralized nature of DeFi, which often occupies a regulatory gray area. Financial institutions, bound by legal obligations, have little flexibility in engaging with decentralized ecosystems that operate in a “Wild West” regulatory environment.
To their credit, DeFi platforms have made incremental progress in compliance and risk management. Many protocols and exchanges have bolstered investor confidence by undergoing voluntary audits. However, they still have much to learn from their centralized counterparts, though indications suggest a willingness to meet regulatory expectations.
TradFi recognizes the potential benefits of blockchain efficiency and the increasing interest from retail and institutional investors in this emerging asset class as a potential revenue stream. If banks and asset managers perceived DeFi platforms as secure, they could leverage TradFi’s credibility to offer crypto custody and asset management services to retail and institutional clients. Prominent players could also leverage their substantial liquidity reserves to act as liquidity providers, facilitating lending and borrowing and offering tokenized RWA solutions for non-crypto-native investors.
Notable asset managers, including BlackRock, WisdomTree, and Franklin Templeton, have already embarked on tokenizing private equity or mutual funds. Earlier this year, Citigroup announced plans to utilize the Avalanche blockchain to test the tokenization of some private equity funds. These developments highlight financial institutions’ eagerness to participate in the crypto space.
Until mainstream finance perceives DeFi as a manageable risk rather than a liability, its role will likely remain on the periphery of the blockchain ecosystem. DeFi must continue to prioritize KYC and Anti-Money Laundering enforcement, establishing a baseline compliance threshold as an industry standard and a starting point for discussing sensible regulations.
Enhancing regulatory measures encourages more proactive and lucrative TradFi involvement by reducing uncertainty. For most DeFi projects, however, this creates significant challenges. Services like Chainalysis can assist resource-limited startups in strengthening their regulatory standing.
DeFi can demonstrate its maturation by adopting innovative compliance tools such as decentralized identity solutions like zero-knowledge proofs and risk-based approaches that address privacy and security concerns associated with public blockchains. By leveraging emerging interoperability protocols and integrating insurance layers, DeFi can enhance its legitimacy in the eyes of institutions and potential investors, providing them with better growth opportunities and a more robust risk buffer.
DeFi has achieved remarkable progress from a technological standpoint, and TradFi’s interest validates these accomplishments. For the sector to take the necessary next step, it must embrace regulations akin to those of traditional institutions. By adopting cutting-edge innovations and adhering to institutional-grade privacy and security standards, DeFi can forge meaningful partnerships with TradFi without compromising its core principles, ultimately bridging the gap between these once disparate ecosystems.
Opinion by: Roy Mayer, founder and CEO of Vixichain.
This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts, and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Source: Cointelegraph
