TradFi will keep its distance until DeFi becomes a manageable risk

Opinion by: Roy Mayer, founder and CEO of Vixichain

When traditional finance (TradFi) institutions shifted from skepticism to interest in crypto and its technological and financial solutions, hope emerged that its involvement in the industry could drive growth and widespread adoption. As crypto and decentralized finance (DeFi) propel an economic evolution, competing realities must inevitably coexist. 

An affordable alternative

Following countless bankruptcies, individuals no longer blindly trust the banking system, and the financial freedom DeFi and crypto promote provides a more efficient, affordable alternative. As the engine of our economic system, however, TradFi helps keep the financial environment safe by designing regulations that protect both businesses and individuals. Even if digital assets and blockchain become the premier payment rail and value movements, TradFi will remain a part of the equation.

As DeFi and tokenized real-world assets (RWAs) continue to pique the interest of banks and asset managers, it’s hard not to notice that TradFi’s role remains minimal. Onboarding more institutions requires DeFi to pursue strategic partnerships, prioritize compliance and integrate innovative tools to ensure adherence to legal frameworks. 

Can DeFi and TradFi coexist?

While many crypto enthusiasts and decentralization purists won’t love the idea of TradFi’s involvement in their domain, it’s widely understood that institutions provide regulatory and risk management experience, credibility, liquidity and more. With DeFi’s maturation, its understanding of its strengths and weaknesses enables it to reach across ideological divides and lean on TradFi’s experience to fortify its position within an evolving financial landscape. 

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While some major institutions issue tokenized treasuries and bonds, TradFi’s involvement in crypto developments comes primarily from digital-first banks or experimental blockchain pilot programs such as SWIFT. Of course, there are numerous spot Bitcoin (BTC) and Ether (ETH) exchange-traded funds, but these developments tend to parallel crypto’s ecosystem instead of actively participating.

What’s holding institutions back?

The decentralized nature of blockchain-based platforms, with their transparency and opt-in compliance, keeps institutions at arm’s length. Unclear regulations that can drastically vary from region to region, alongside privacy concerns, widen the gap between DeFi and TradFi.

Despite regulatory processes like Know Your Customer (KYC) becoming more common among DeFi platforms, interacting with public blockchains where the vast majority of liquidity lies presents rigidly compliant institutions with too many uncertainties. 

Banks can and do work with risk because it can be quantified and acted upon. Uncertainty in finance, however, deals with unknown future outcomes. For institutions known for risk mitigation, the inherent volatility in crypto and DeFi means they lack sufficient data to take calculated risks. Since both sides stand to benefit from cooperating and engaging with one another, bridging this gap between these similar yet vastly different ecosystems requires DeFi to clean house first.

Finding common ground between DeFi and TradFi

With centuries of experience managing assets and navigating shifting regulatory landscapes, TradFi can’t be expected to accommodate the decentralized nature of DeFi, which operates in a regulatory gray area. Considering its legal obligations, financial institutions have little to no flexibility in dealing with decentralized ecosystems’ Wild West regulatory status. 

To be fair, DeFi platforms have made modest strides in compliance and risk management, with many protocols and exchanges boosting investor confidence by undergoing voluntary audits. Still, they have much to learn from their centralized counterparts, but signs indicate a willingness to adhere to regulatory demands. 

Generally speaking, TradFi knows it can benefit from blockchain efficiency and that growing interest from retail and institutional investors in this emerging asset class means a potential new revenue stream. If banks and asset managers felt DeFi platforms were secure enough, they could leverage TradFi’s credibility to offer retail and institutional clients crypto custody and asset management services. More prominent players could also leverage their vast liquidity reserves to serve as liquidity providers, offering convenient access to lending and borrowing and tokenized RWA solutions for non-crypto native investors. 

Prominent asset managers — including BlackRock, WisdomTree and Franklin Templeton — have already tokenized private equity or mutual funds. Earlier this year, Citigroup announced its plans to use the Avalanche blockchain to test the tokenization of some of its private equity funds. These developments demonstrate just how badly financial institutions want to participate.

Until mainstream finance sees DeFi as a manageable risk instead of a liability, expect its role to remain on the periphery of the blockchain ecosystem. DeFi must continue prioritizing KYC and Anti-Money Laundering enforcement, pushing for a minimum compliance threshold to serve as an industry standard and a starting point for discussing sensible regulations.

Enhancing regulatory measures encourages more proactive and lucrative TradFi involvement by reducing some of that uncertainty. For most DeFi projects, however, this creates frustrating burdens. However, many services, like Chainalysis, can help resource-challenged startups enhance their regulatory standing.

DeFi can showcase its maturation by adopting innovative compliance tools such as decentralized identity solutions like zero-knowledge proofs and risk-based approaches that mitigate the privacy and security issues with public blockchains. It can further boost its legitimacy in the eyes of institutions and potential investors by leveraging emerging interoperability protocols and integrating insurance layers, providing institutions with better growth opportunities and a more potent risk buffer.

DeFi has achieved a lot from a technological standpoint, and TradFi’s interest validates this. For the sector to take the necessary next step, it must embrace regulations like institutions do. By leveraging the latest innovations and institutional-grade privacy and security standards, DeFi can forge meaningful partnerships with TradFi that don’t undermine the sector’s key principles, thus breaking down the frontier between the two 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.