TradFi & DeFi deep dive 1(a): TradFi Infrastructure
Remember when The Next Block discussed how there is a hybrid hypothesis for the future, of TradFi (Traditional Finance) and DeFi (Decentralized Finance), suggesting that each are on a path of convergence as they tackle similar challenges to modernize the financial services experience?
As a refresher, we made the following hypotheses that suggest a hybrid TradFi and DeFi future of finance:
Hypothesis #1: The future of finance is hybrid & distributed across TradFi and DeFi.
Hypothesis #2: The future of DeFi is multi-chain & distributed.
Hypothesis #3: The future of underlying infrastructure is multi-cloud and distributed.
Hypothesis #4: The future of finance governance is hybrid & distributed.
Here’s a refresher on the landscape that we see playing out, and where we will focus today on TradFi Infrastructure (1a):
Bottom Line Up Front.
TradFi infrastructure represents the conventional, foundational building blocks of incumbent banks, capital markets institutions and other financial services providers. This can include data center facilities, enterprise and business IT infrastructure, and legacy technologies such as IBM mainframes where many core systems of record and real time transaction processing still lives today. This infrastructure is generally shifting to digital and cloud-native to accommodate the movements toward digital banking and maintain competitive parity or advantage with FinTech’s and other challengers.
Additionally, this includes a set of private, permissioned and TradFi owned technologies for incumbents that are seeking to move the ball forward on innovation, in-house enablement of Distributed Ledger Technology (DLT) as a platform, and other new paradigm shifts in this space without having to operate on open, permissionless, and otherwise DeFi-native constructs. Some great examples noted above include a possible future with Central Bank Digital Currencies (CBDCs) and other forms of digital cash, perhaps proprietary stablecoins (e.g. JP Morgan’s JPM Coin), as well as tokenized deposits where consortiums like the USDF are trying to solve for. There are also emerging private enterprise blockchain platforms such as R3 and Hyperledger.
Figure 2: The key projects and vendors that comprise the Future of Finance landscape
… there are many other representations on the Internet that cover core components and the ecosystem of crypto and DeFi. For another great view, check out The Digital Finance Stack from Bankless, a leading newsletter, podcast and resource on DeFi.
History and context.
Before we dive into each TradFi infrastructure component, we should un Web 3.0, which is enabling a new Internet backbone and core components for payments and money movement. Traditional infrastructure has built the web and core financial technology as we know it today, from the establishment of the World Wide Web and networking / telecommunications protocols that are still used today, to conventional IT infrastructure like mainframe for mission critical core financial systems and physical or virtualized server technology
Web 1.0 and 2.0 concepts of initially static HTML web pages with centralized data sources, and eventually shifting towards more digital-native and interactive applications and websites, have enabled the current era of e-commerce, online banking, and electronic methods of payments and money movement. The shift towards Web 3.0 intends to enable openness, decentralization, repatriation of power and privacy to the user, and self-governance… all of which are making way for a new kind of infrastructure and foundational constructs for the next wave of finance to include cloud-native infrastructure, blockchain technologies, and digital currencies.
Web 3.0 is a concept that suggests the current model of the Web is in need of change, which is highly dynamic and interactive but significantly concentrated and dominated by the Big Tech and hyperscale players, and also features a high degree of data capture and limited privacy features. The current demand for the next evolution of the Web is trending towards things like openness, decentralization, repatriation of power and privacy to the user, and self-governance.
According to Gemini, Web 3.0 refers to a vision of the third generation of computing, which anticipates that technologies like blockchain will decentralize the internet and disintermediate web 2.0 companies like Facebook, Amazon, LinkedIn, and Apple to enable the online exchange of value, and allow users to own their data. Web 3.0 carries the unique, new characteristics of being open, trustless, and permissionless in design. This macro level shift of the next generation Web is driving behaviors for how all industries operate and are architected, to include Financial Services Institutions.
Read here and here, as well as watch here to see more from Tim Berners-Lee, known as the inventor of the World Wide Web, on the next Web of open, linked data. A good example of a modern browser that meets the vision of Web 3.0 and user privacy is the Brave browser.
TradFi Infrastructure component 1: Digital assets (e.g. CBDCs)
Digital assets are modern, digital-native assets that are being established by TradFi institutions to include:
Central Bank Digital Currencies (CBDCs), primarily by central banking authorities like the Federal Reserve and in collaboration with TradFi’s. Additionally, a number of TradFi consortiums have been established like the USDF Consortium, a Bank-Minted Tokenized Deposit Referencing Fiat Currency on Blockchain. Read more here from Consensys on all things CBDCs.
Also, stablecoins and digital assets that are similar to DeFi assets, but TradFi-minted; a great example being the JPM Coin from JP Morgan. Stablecoins, a type of cryptocurrency, are a new digital asset that is effectively a cryptocurrency with a value that is pegged to a stable asset as well as fully backed with reserve assets, such as the US dollar. Some of the most notable examples of these “digital dollars” include Circle’s digital dollar (USDC), the Gemini Dollar (GUSD), and DAI, although each of these sit on the DeFi side of the hybrid landscape and we are generally still waiting to see major TradFi activity on proprietary stablecoins or tokenized deposits, or even embracing and providing custody of these DeFi-native digital assets.
There are an incredible amount of benefits to stablecoins, including not having to fully exit the crypto markets when trading in and out of other assets, strong integration between traditional and modern financial environments, and a digital asset that is increasingly able to traverse both environment types as well. Read more about how Circle is accomplishing this with the USDC and is even pursuing to become a national digital currency bank. Additionally, while payments integration with traditional and modern is a great step forward, the traditional payments space is desperately in need of modernization. For example, over 65% of non-cash payments are used via ACH, which is a technology invented in the 1970s and can take multiple days to clear a transaction.
Other good concepts to look at include how governments are researching Central Banking Digital Currencies (CBDCs), and how institutions like Maker, AAVE and Compound are more broadly completely rethinking the need for centralized, administrative entities for governance on a variety of financial services.
TradFi Infrastructure component 2: Permissioned and private enterprise blockchains.
There are a number of vendors here establishing private blockchain platforms by which TradFi’s can build upon to the extent that they are, common vendors include Hyperledger Foundation and R3. Rather than leveraging open, permissionless and truly democratized blockchains such as Ethereum, many enterprise organizations are evaluating and deploying private blockchains where the enterprise is the single authority and has control over the environment, which can be critical for some use cases such as a business’s supply chain and logistics. Private blockchains are also permissioned, where only certain individuals or entities are authenticated and authorized participate in the blockchain as member nodes, and staying with the use case of supply chains, this could include only enterprise employees, suppliers, and other external permissioned stakeholders. Private blockchains have their place in the enterprise landscape where the organization may see value in the efficiences, end-to-end transparency and immutable record of blockchain as an underlying platform, but not necessarily the open, permissionless and truly democratized aspects of a public blockchain environment.
Read more here at 101 Blockchains to better understand private blockchains and why enterprise organizations are considering them.
TradFi Infrastructure component 3: Data center, enterprise IT, & traditional finance infrastructure.
Historically, TradFi has built its own enterprise data centers to host IT infrastructure and serve well known core banking platforms (e.g. FIS), mainframe technology for legacy , and custom built platforms and applications as well. For example, IBM Z mainframe technology is used by 44 of the top 50 banks still to this day.
Over the past decade-plus, many TradFi’s have migrated from their enterprise data centers to co-location providers such as Equinix, Digital Realty, and NTT. Cloud Service Providers (CSP) have also started to build Local Zones to serve cloud capability for ultra low latency (ULL) requirements in areas of proximity to financial infrastructure, such as Chicago and New York City.
Additionally, most TradFi’s have modernized their legacy IT infrastructure in favor of on-premise, data center hosted private clouds out of reticence to put mission critical workloads and data on public cloud, while still going cloud-native… a trend which is shifting more and more in favor of public cloud. The bedrock of modern infrastructure includes the big 3 Cloud Service Providers (CSPs), which host elastic, on-demand computing infrastructure for all industry workloads to include financial services. Cloud is becoming the center of gravity for the vast majority of innovation in this space:
Traditional financial services institutions are moving to public cloud infrastructure
83% of financial services institutions report they are deploying cloud technology
Core banking software vendors are offering a glide path to hosted cloud solutions as its underlying infrastructure
On the DeFi side, More than 60% of Ethereum nodes run in the cloud, mostly on Amazon Web Services
The well known story of CapitalOne as the flagship legacy financial institution to fully exit the data center and host the majority of its workloads in public cloud is one of the few outliers of traditional financial institutions that has undergone a complete digital and cloud-native transformation. This case study aside, Financial Services Institutions are generally on a very deliberate path to cloud adoption, with a set of unique hurdles to adoption across business, technology and regulatory imperatives.
We will discuss cloud-native infrastructure further in section 1b, Hybrid and shared infrastructure, where CSP’s are serving both TradFi and DeFi.
If you liked this post, check out our TradFi and DeFi Hybrid Hypothesis map for additional double clicks into every aspect of the landscape for the future of finance technology.
