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What exactly is TradFi & DeFi?

Date
18/09/2023
Written by
Lykke
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Confused by the abbreviations TradFi and DeFi, and wondering what their actual differences are? Let us walk you through the latest financial jargon used by many and understood by few. 

What is TradFi?

Traditional finance (TradFi), as its name suggests, is the conventional financial system that has been around for decades. It is composed of banks, insurers, stock exchanges, custodians and other financial institutions regulated by national and international authorities. They enable the trading of stocks, bonds, derivatives and commodities, as well as carrying out payment services, nationally or internationally. 

These financial institutions and the assets they offer are heavily regulated. Clients can thus easily contact their bank and sue them in the event of a problem. 

There is no official figure of the size of TradFi, given it includes so many different segments. The US stock markets – New York Stock Exchange, Nasdaq and the over-the-counter (OTC) markets – were on their own valued at more than 46 trillion US dollars at the end of June, data from Siblis Research shows. The OTC markets are those exchanging securities that are not listed on the two main exchanges just mentioned. To this figure you have to add all the other stock, commodity, forex exchange and bond markets… 

High costs, slow processing times & more issues linked to TradFi

One of TradFi’s disadvantages is its dependency on intermediaries to carry out financial transactions. This is not only costly for its users but also creates high entry barriers to access financial products. The slow processing of transactions, especially when it comes to international payments that typically take two to five banking days to settle and clear, is another weakness. 

Yet another issue related to TradFi is its adherence to analog processes. The lack of liquidity witnessed on the financial markets in the aftermath of the financial crisis of 2007-2008 can be traced back to these inefficient processes. Manual processing of orders slows down the execution and increases the risk of human errors, which in turn can negatively impact both trading and settlement and reduce liquidity. This is one of the reasons why central banks around the world used quantitative easing policies, injecting more than 10 trillion dollars into the markets to ensure liquidity. 

The reliance on physical branches is another disadvantage linked to TradFi, a reality in remote regions and developing countries where access to financial institutions is limited. Lastly, the lack of transparency linked to the financial services offered is another problem which should not be underestimated. Which client is aware of the exact costs of life insurance policies they hold or what their funds are being used for by their banks? 

These disadvantages boosted the demand for decentralized finance (DeFi) platforms, once blockchain technology emerged in 2008.

What is DeFi?

The technological advances made in cryptocurrency and blockchain over the past 15 years are staggering. The DeFi market has witnessed a fast uptake by users and grown exponentially since 2009 when the first Bitcoin transaction took place. Its market capitalization reached 12 billion dollars by the end of 2021. The global DeFi market is forecast to reach 232 billion US dollars by 2030, signifying a 43 percent annual growth between now and 2030, according to a report released by Zion Market Research

But what is DeFi? As previously hinted, it is a decentralized financial system built on blockchain platforms. Such technology eliminates all the costly intermediaries involved in TradFi in one fell swoop, connecting people directly with one another for transactions. The transactions made on the blockchain are also secure, transparent and immutable. 

The transaction times are also much faster than in TradFi. We’re talking about seconds on blockchain networks such as Solana and Avalanche, and minutes when it comes to Binance Smart Chain, Polygon and Ethereum. 

The blockchain on which Bitcoin operates can only process seven transactions per seconds (TPS), so it is unable to handle high volumes of transactions. Bitcoin is therefore not considered to operate on a DeFi platform. Bitcoin is nevertheless the world’s largest cryptocurrency with a market cap representing almost half of that of the total crypto universe, making it an essential part of the DeFi market.

Risks related to DeFi

DeFi does not come without risks though, given that the players are decentralized. It can be very difficult for a client affected by fraud, hackers or rug pulls to hold someone liable as there is no central person or entity responsible for running the blockchain. 

Regulators around the world are well aware of this issue and are trying to close these loopholes. In the US, the Securities and Exchange Commission (SEC) earlier in September started a probe into the DeFi exchange Uniswap Labs. The US regulator may in the worst case make all DeFi transactions illegal.

Will we settle on something in the middle? 

TradFi is slowly but surely recognizing the benefits of integrating aspects of DeFi into its own back-office infrastructure. Two such elements are smart contracts and atomic swaps. 

The use of smart contracts – self-executing (smart) contracts that autonomously carry out the terms of contracts on a blockchain without the involvement of any intermediaries – could automate the processing of numerous types of transactions. One area where smart contracts are already used by TradFi is in the issuance and management of (smart or tokenized) bonds, with the European Investment Bank, Siemens, the City of Lugano and the Dutch bank ABN Amro among those who have taken the step. Smart contracts could considerably cut costs and settlement times, as well as increasing transparency and accuracy while reducing fraud. 

The use of atomic swaps – cryptocurrency exchanges taking place on blockchain networks with immediate effect through smart contracts – could on its side revolutionize both cross-border and cross-asset transactions. Such swaps enable instant transfers, thus also cutting costs and settlement times. It’s of particular interest regarding remittances, international trade and forex transactions.

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