To Close the Gap Between Traditional Finance and Crypto

Cryptocurrencies have made great strides in breaking into the mainstream, prompting banks to make strategic moves in hopes of putting traditional finance (TradFi) and blockchain products under one roof. Such successful integration could lead to mutual benefits, as traditional financial institutions could generate added revenues, and the crypto sector could widen its user base and capitalize on established regulatory frameworks of TradFi, thereby boosting security.

The question is: how much work will need to be done to streamline the convergence of cryptocurrencies and traditional finance? And what will be left of it: an entirely new infrastructure that hosts a bridge where the two worlds can communicate with each other effectively, or one has to play by the rules of the other in a zero-sum game, or ‘this-will-never-work’ kind of a situation?

Uniting Worlds: When TradFi and Crypto Collide

The ‘Cryptonized' Motion has been Set For a Long Time

Indeed, both markets have witnessed how TradFi attempts to seize the opportunity to offer related products and custodial services within their wealth management offerings since 2018. Examples include Citibank's investment in blockchain enterprise SETL, Morgan Stanley's crypto fund options via Bitcoin fintech firm NYDIG, BNY Mellon's stake in crypto custodian Fireblocks, and UBS's faster interbank transactions through the USC project.

The development and use of fiat-backed stablecoins like USDC, USDT, BUSD, and TUSD is also another pivotal stepping stone in bridging the gap between traditional finance and cryptocurrency. These are digital tokens tethered to fiat currencies, typically the USD, and held by a central issuer mirroring the circulating stablecoins. Transparency, accountability, and regulation vary across issuers, with some providing third-party audit reports to substantiate their 1:1 peg (1). As the name suggests, these coins provide stability (although depegging does happen from time to time), thus suitable to facilitate day-to-day transactions with less risk of sudden value fluctuations.

Little do many know this widely embraced stablecoin is actually derived from a concept that we have come to know as Tokenization of Real-World Assets (RWA). This process allows for the transfer of ownership or rights to real-world assets using digital tokens on a blockchain or distributed ledger. Think about it: when you buy 01 USDC, your $1 is deposited in a bank and subsequently represented as 01 USDC on a blockchain.

Besides stablecoin issuers, platforms like Tangible Store also incorporate the idea into making tangible assets — wine, gold, watches, real estate, and more — purchasable through TNFTs (Tangible Non-Fungible Tokens) on their marketplaces.

The RWA playground does not stop at consumer goods and lands, either, as several institutional-grade protocols have joined the market(2):

• Goldfinch: Allows undercollateralized crypto loans with RWA instead of crypto collateral.
• TrueFi: Allows uncollateralized lending for both RWA and crypto-native assets.
• Maple Finance: Focuses on institutional lenders and corporate borrowers.
• Swarm Markets: Tokenizes traditional financial assets like stocks and bonds.
• Ondo Finance: Offers institutional-grade finance on-chain.

Given its recent significance, the integration of traditional finance (TradFi) with cryptocurrency solutions will indeed be a focal point of discussions at KBW 2023.

What will Need to be Done

Decades of banking experience have offered valuable lessons for the crypto industry to learn from, enabling it to adopt proven methods and avoid repeating past mistakes. As we've seen, crypto risks like rug pulls and protocol collapses can lead to some individuals gaining fortunes while others losing life savings.

The key to mitigating these risks lies in establishing regulation and transparency standards, all while preserving cryptocurrency's core principles of decentralization.

An example is the discussion on crypto asset Exchange-Traded Funds (ETFs). Through ETFs, investors gain access to crypto assets via regulated institutions, with institutional support and potential fund recovery. This approach, requiring KYC compliance, adds a layer of regulation and transparency that safeguards retail investors.

Companies like BlackRock are exploring legalizing Bitcoin ETFs, but the SEC's hesitation, citing a lack of ‘surveillance-sharing’ agreements (3), seems to slow the progress in the West. However, in Asia, HSBC Hong Kong customers are now offered the trading option using Bitcoin and Ethereum futures ETF (4).

Another concern is although blockchain technology can bring transparency and accountability to TradFi transactions, reducing potential fraud, current banking practices have not yet recognized encrypted transaction history as proof of legitimate crypto asset acquisition.

In the case of centralized exchanges, this issue can be addressed with the implementation of proof-of-reserve (PoR), an auditing practice providing unbiased reports on crypto company reserve assets. By employing PoR, investors and banks can gain confidence in the integrity and legitimacy of the platform's operations, ensuring a higher level of trust in the cryptocurrency ecosystem.

Yet, maintaining user anonymity with TradFi products while validating lawful asset acquisition still remains a challenge, which should be the next steps of development in the near future.

Bottom Line

The integration of traditional finance and crypto holds a promising future, as highlighted by a survey conducted by the Financial Times Group. The survey revealed that investors are more inclined to participate in the crypto market if traditional finance institutions offer relevant services (53 percent). This highlights the importance of TradFi serving as an entry point, offering users a familiar infrastructure and facilitating a smooth transition.

Figure 1. Top five trends increasing investor appetite for digital assets. Source: Financial Times

To sum up, for traditional finance, this integration would mean attracting more investors while for the crypto industry, it implies expanding the adoption. Investors, on the other hand, gain more investment options and a heightened sense of security. The successful merging will pave the way for a symbiotic relationship that enhances the financial landscape for all parties involved and a whole new ecosystem of solutions built specifically for this relationship to thrive.

Reference

1. Cryptopedia Staff on Gemini, The Global Stablecoin Ecosystem, March 9, 2022
2. Andrea Dal Mas on LinkedIn, Real World Assets: The Bridge Between Traditional and Crypto Finance, April 5, 2023
3. Tanaya Macheel on CNBC, Bitcoin briefly falls after SEC reportedly calls ETF filings inadequate, but posts a winning month, June 30 2023
4. André Beganski on Decrypt, HSBC Hong Kong Launches Support for Bitcoin and Ethereum ETFs, June 27, 2023

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