Whether DeFi Survives or Not, Web3 Tech is Here to Stay with TradFi
This year has been highly erratic for DeFi, with the market going into crypto winter, and a number of high profile CeFi exchanges and projects collapsing. This has brought significant questions about the future of certain cryptocurrencies, and DeFi as a whole.
However, TradFi seems to be unfazed in its faith in the underlying technologies that Web3 has brought to bear, and is actively investing in those tech capabilities to its own advantage.
The three primary components that are working their way into TradFi in a meaningful way are:
Figure 1: TradFi is using blockchain technology, asset tokenization, and smart contracts to significantly enhance a number of current systems, process and asset classes
Blockchain technology: using Distributed Ledger Technology (DLT) to significantly improve the automation, operational efficiency, of existing TradFi systems and processes
Asset tokenization: tokenizing assets by creating, issuing and managing them on a blockchain platform to increase liquidity, enhanced functionality (e.g. fractionalization), tokenization refers to a process where a digital representation of an asset is created on a blockchain, authenticating its transaction and ownership history. The range of asset classes and potential use cases in TradFi is near limitless to include both digitized assets of existing financial instruments (e.g. stocks, bonds, real estate) as well as real-world assets (e.g. real estate)
Smart contracts: leveraging the concept of “programmable money” by establishing agreements in code, partially or fully automating any financial instrument or contract and enabling “trustless” agreements that minimize trust in an institution or human action for a contract to execute based on specified parameters. This has the potential to bring significant automation and impartiality in peer to peer agreements, whether that be individuals or institutions
… we will go deeper into each of these technologies, and how TradFi is integrating them into incumbent environments with traditional financial products, assets and technology. First, let’s look at what the leaders in TradFi are saying about the future and its possibilities.
How are TradFi leaders currently viewing and leveraging the best Tech from Web3 and Digital Assets?
“Blockchain Is Much More Than Crypto. Regulated financial institutions are well positioned to harness the revolutionary technology.”
David Solomon, CEO of Goldman Sachs, penned an opinion piece suggesting that blockchain is much more than crypto, and that regulated financial institutions are well positioned to harness the revolutionary technology (Wall Street Journal).
He noted that as a longtime participant in financial markets, he still sees blockchain as a promising technology if allowed to innovate under the right conditions. Under the guidance of a regulated financial institution like Goldman Sachs and other TradFi’s, blockchain innovations can flourish.
If you are going to upend the industry that moves capital around the world and face scrutiny from dozens of regulators, it isn’t enough to invent a popular app or raise tons of venture-capital money. You need to know how to mitigate risk and build proper controls.
Recently, using its new tokenization platform, Goldman Sachs arranged a €100 million two-year digital bond for the European Investment Bank with two other banks, all based on a private blockchain. Typically, a bond sale like this takes about five days to settle. Goldman’s settled in 60 seconds. By reducing settlement times, Goldman is lowering costs for issuers, investors and regulators. Using blockchain, TradFi can extend these benefits more broadly in fixed-income markets and across other asset classes.
“The next generation for markets, the next generation for securities, will be tokenization of securities”
Larry Fink, CEO of BlackRock (a $10 trillion asset management firm), stated "the next generation for markets, the next generation for securities, will be tokenization of securities," and will provide “instantaneous settlement” and “reduced fees” all while not disrupting BlackRock’s business model. At the same time, he mentioned that most crypto firms will not be around in the future, but that blockchain technology and associated capabilities will be very important for TradFi.
BlackRock has also partnered with Coinbase and announced a spot Bitcoin private trust, both as means to give its clients direct exposure to crypto assets which shows an embrace of DeFi as well as leveraging its underlying technology.
JP Morgan also notes in its recent whitepaper (Institutional DeFi: The Next Generation of Finance?), tokenization could potentially enable financial services to be delivered “in a more open manner.”
Boston Consulting Group and other industry leaders also see a very attractive value proposition for asset tokenization of real world assets that are generally highly illiquid. They estimate that by 2030, tokenization of global illiquid assets will be a $16 trillion business opportunity, and the total tokenized market to be 10% of global GDP in the same timeframe.
Figure 2: BCG estimates that by 2030, tokenization of global illiquid assets will be a $16 trillion business
What is TradFi actually doing in this space, and what are some real world, commercially viable use cases?
There are an incredible number of examples of TradFi both leveraging Web3 and DeFi tech for private and custom use, as well as TradFi building on DeFi. A few examples include:
DBS executed intraday repo transaction using JP Morgan’s Onyx Digital Assets network powered by blockchain. Banks use repurchase agreements (repos) for short term funding by selling securities such as U.S. Treasuries, and agreeing to repurchase them later.
JP Morgan has also leveraged Polygon, the Ethereum Layer 2 scaling technology, to trade tokenized cash deposits in a Singapore-based trial via Onyx Digital Assets, a private blockchain created by the bank.
Goldman Sachs is trying to make blockchain based bonds happen, using Ethereum technology to issue €100 million ($121 million) in two-year digital notes for the first time
BlackRock selected Coinbase to provide Aladdin clients access to crypto trading and custody via Coinbase Prime, creating new access points for institutional crypto adoption.
Credit Suisse, in partnership with a group of Swiss banks, tested securities tokenization on the Ethereum public blockchain and settled transactions with fiat currency. The tokenized securities were traded on BX Swiss, the FINMA-regulated Swiss securities exchange and subsidiary of Börse Stuttgart.
This sounds great, but what exactly from Web3 tech will be persistent, and what are the benefits?
Let’s break down the concept and benefits of each component:
Component 1 - Blockchain technology.
Concept: using Distributed Ledger Technology (DLT) to significantly improve the automation, operational efficiency, of existing TradFi systems and processes.
Benefits:
Blockchain core benefits for existing TradFi systems and processes: TradFi can build on the blockchain to transform existing systems and processes to harness the benefits of democratization, decentralization, and reduced friction to value transfer
Trusted shareable data: multiple TradFi parties can participate as member nodes on the blockchain and have identical, immutable and constantly synchronized copies of a shared ledger (for data that should be shared cross party). This would effectively eliminate the need for each TradFi party to maintain its own data silo for certain components of a product, transaction or ecosystem. This would also significantly increase end-to-end transparency for audit purposes
Compliance: TradFi can build on the blockchain while also integrating the necessary controls for compliance, such as permissioning, in order to satisfy AML / KYC and other necessary items
TradFi can take blockchain technology either to (1) develop private blockchain solutions underpinning existing products, processes and services to leverage its benefits, or (2) build new or existing products, processes and services on public blockchain environments or the same. As evidenced above, TradFi’s are doing both.
Component 2 - Asset tokenization.
Concept: Tokenization of assets refers to creating, issuing and managing them on a blockchain platform to increase liquidity, enhanced functionality (e.g. fractionalization), tokenization refers to a process where a digital representation of an asset is created on a blockchain, authenticating its transaction and ownership history.
The range of asset classes and potential use cases in TradFi is near limitless to include both digitized assets of existing financial instruments (e.g. stocks, bonds, carbon credits, Treasurys) as well as real-world assets (e.g. real estate)
Benefits:
Instantaneous settlements and reduced fees: tokenization can provide instantaneous settlement of transactions and reduced fees, significantly faster and cheaper than current systems and methods.
Fractionalized assets: traditional financial assets are fractionalized to a degree today; however, the process is extremely manual and inefficient, whereas tokenization can automate the process and bring end-to-end lifecycle transparency, while also matching capital to investment opportunities in a more ubiquitous way “on-chain”
TradFi is significantly opening up the aperture of what can be tokenized, far beyond cryptocurrencies and focusing more on existing financial instruments and their underlying assets.
Read more here by Blockworks in its multi-part series on asset tokenization: Stabilize Money, Stabilize the World; What It Takes To Tokenize the World.
Component 3 - Smart contracts.
Concept: leveraging the concept of “programmable money” by establishing agreements in code, partially or fully automating any financial instrument or contract and enabling “trustless” agreements that minimize trust in an institution or human action for a contract to execute based on specified parameters. This has the potential to bring significant automation and impartiality in peer to peer agreements, whether that be individuals or institutions
Benefits:
Automated, fast and highly reliable, significantly reduced manual intervention enabling “zero touch” processing of contracts
Significantly reduced cost and risk in servicing of assets, execution of transactions and settlements
Significantly enhanced functionality, with the ability to define market rules, security, business processes, and other configuration parameters
TradFi is experimenting now with smart contracts to take advantage of these benefits, but while maintaining the right human-oriented controls for aspects it believes should not be completely automated end-to-end.
What is most likely to happen from here?
If you refer to the future of finance and hybrid hypothesis where both TradFi and DeFi coexist, with a number of mechanisms bridging the two, there may be a future where pure play DeFi thrives and TradFi is a fast follower with rapid adoption of the tech and capabilities discussed.
Alternatively, there is potentially a world where TradFi consumes the majority of the tech and projects. For example, Goldman Sachs has made it known that it is keeping dry powder in anticipation of attractive opportunities for Web3 players in the current crypto winter and broader macro level environment. Goldman is clearly planning to capitalize on this bear market by acquiring crypto firms at rock-bottom prices, showing that they also clearly value the tech, potentially more than other aspects of the firms.
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