High Five for the Digital Assets Road to HyFi

The digital transformation of the financial services industry has gained accelerated momentum over the past few years with the increased adoption of blockchain solutions and digital assets. However, with the development of the Finance 4.0 era, there is a growing demand to access and offer a full range of digital products and services alongside traditional products and services. This points to the need for some kind of dual approach. But how can this be achieved in practice when most of the financial participants are still off-chain and even if they are on-chain, there is fragmentation as a result of multi-blockchain and lack of integration in their traditional systems to ensure a coherent approach?

The issue of the “old” and the “new”

Many proponents of decentralization would make you believe that the current architecture of centralized financial services will become extinct before you know it because it stifles innovation and democracy through excessive control. This view is rather naive, however, despite the adoption of modern technologies and cloud-enabled over the past few years, the financial services industry still relies heavily on the complex legacy infrastructure that has been around for decades. It’s not easy to get rid of that and start over – like driving a car on the highway and trying to change the engine at the same time, constantly trying to maintain its speed.

Proponents of full decentralization also fail to appreciate that practical regulation and effective standards actually help protect investors and build trust. This increased credibility will create an environment in which more participants move from being off-chain to in-chain, creating more democracy and financial inclusion.

The “old” is not going away anytime soon, but one has to realize that the “new” has a lot to offer and, if harnessed effectively, the digital assets that power the blockchain will be transformative for financial markets. Even if it doesn’t “digitize everything”, it will “digitize many things”.

The process of technological progress is inevitable. In England during the Industrial Revolution, Bristol engineer Joseph Glass introduced the chimney sweeper. At first there was great resistance from realtors stating that one could do it better. But these people were young children working in precarious conditions. The result of technological progress was a law passed in 1840 that prohibited children from this profession. The technology led to a better way to do this despite the initial strong resistance. Nearly 200 years later, this is still true regardless of the technology or its purpose.

For the foreseeable future, the “old” and the “new” must coexist via hybrid solutions (traditional and digital) as lateral institutions, banks, brokers, exchanges, and other capital players increasingly embrace digital assets as part of their digital transformation agenda.

Peaceful coexistence or mass turmoil?

The need for coexistence should come as no surprise to anyone. The first email was sent in 1971, AOL arrived in 1992 and Hotmail arrived in 1996. Before email there was a paper publication and now there is instant messaging. However, all three of these forms still exist even though the volume of activity across them has changed over time. Bitcoin made its debut in 2009. Twelve years later, there have been major advances in crypto and digital assets, but even a decade from now centralized financial systems will still be around.

The main challenge is to improve how centralized finance (CeFi) and decentralized finance (DeFi) intersect within a regulated environment to support the convergence of traditional and digital asset activity.

As such, what kind of model could support such a symbiosis and how would this work in practice in the world of financial markets?

The convergence of CeFi and DeFi leads to HyFi

To support the coexistence of centralized and decentralized technology-enabled companies, the financial market and digital asset infrastructure must become interoperable.

Institutional players largely want exposure to digital assets in the same way as they do with other asset classes. However, interoperability and time to commercialization of digital assets remain a challenge for them, as the traditional and multiple types of digital asset infrastructure that support blockchain technology are heavily fragmented. Many now want exposure to digital assets without the difficulty of adopting the technology, and therefore want to stay off the chain.

Ease of integration into what they are already doing is essential. In order to overcome these hurdles and achieve greater efficiency in facilitating digital assets, financial players need to optimize their digital asset infrastructure in a secure and scalable manner through cloud-enabled microservices, via a distributed hybrid hub model.

Such a model would integrate private ledgers and public blockchains into the traditional market infrastructure to create a file
Hybrid Market Infrastructure Approach. This will enable digital assets to be mirrored in the traditional trading and post-trade systems of financial companies using the same interface standards used for traditional assets, and will connect them to a range of service providers that need them to trade and settle digital assets.

By using such hybrid solutions, capital market players such as banks, asset managers, brokers, exchanges, post-trade operators and service providers will seamlessly connect their ledgers to the digital asset markets.

One example of this would be centralized exchange and decentralized architecture that combine to create a type of hybrid exchange (HEX). For example, one that supports trading models such as a centralized exchange (CEX) such as a decentralized exchange (DEX) in a coherent way.

Other use cases that can be facilitated by the hybrid distributed axis model include:

  • Linking traditional and digital custody of assets by multiple custodians to a variety of digital trading options across brokers and exchanges, using familiar interfaces for simple integration;
  • development of new hybrid products, with the advantages of liquidity, financing and associated facilitation of new revenue streams;
  • Process digital asset trades in a very similar way to traditional assets in order to:
    • Enable a single view of all traditional and digital assets and positions (Net Asset Value – NAV) across different trading venues;
    • Perform asset management, through real-time netting and settlement, and reuse of traditional and digital assets;
    • Perform treasury management, such as intra-day financing, and collateral management by pledging assets from one or more custodians across multiple trading venues and brokers with dynamic, real-time updates; And
    • Manage credit limits – whether segmented or portfolio-wide across both traditional and digital assets, across all venues and custodians.

All of these will be part of the evolution of hybrid market infrastructure delivery
Hybrid Finance – HyFi!

Moreover, the hybrid distributed hub model itself is very energy efficient as less energy is used by the continuous movement of assets on public blockchains. It can be optimized so that this activity is used – in terms of public and private blockchains in the best possible way – which means that the company’s carbon footprint will improve over time.

The key will be how to apply regulation, which is designed for a centralized world, to an environment that will be increasingly hybrid (centralized and decentralized). As such, policy makers and regulators also need to adopt a hybrid approach to effectively regulating HyFi.

conclusion

Financial market infrastructure and digital asset infrastructure increasingly need to become interoperable, combine and evolve into a hybrid market infrastructure to enable Hybrid Finance (HyFi). The hybrid distributed hub model can facilitate such interconnection and is well suited to serving the trading, clearing, settlement and custody needs of institutional participants in a regulated environment.

We will increasingly see the development of such hybrid solutions and services that bridge the gap between traditional and digital capital markets, while effectively mapping evolving regulatory frameworks to enable mass adoption by institutional players.

Financial market players can use this hybrid approach to link their traditional systems with digital assets, globally, with almost any type of participant, anywhere in the world, across jurisdictions. It can also align with their ongoing digital transformation agenda to consume and provide services within the broader market in ways that also meet ESG’s broader goals.

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