High Five for the Digital Assets Road to HyFi

The digital transformation of the financial services industry has gained accelerated traction over the last few years with the increasing adoption of blockchain solutions and digital assets. Nonetheless, as the era of Finance 4.0 evolves, there is a growing demand to access and offer a full range of digital products and services alongside traditional ones. This suggests the need for some kind of dual approach. But how can this be achieved in practice when most financial participants are still off-chain and even if they are on-chain there is fragmentation as a result of multiple blockchains and lack of integration into their traditional systems to ensure a cohesive approach?

The case for the ’old’ and the ‘new’

Many proponents of decentralization would have you believe that the current construct of centralized of financial services will be extinct before you know it as it stifles innovation and democratisation through excessive control. This view is somewhat naïve, however, as despite the adoption of newer technologies and cloud enablement over the last few years the financial services industry is still heavily reliant on complex legacy infrastructure that has been in existence for decades. It is not so easy to rip this out and start afresh - akin to driving a car on the highway and trying to change the engine at the same time, whilst continually trying to keep it moving at speed.

Supporters of complete decentralization also fail to appreciate that pragmatic regulation and effective standards actually help protect investors and build trust and confidence. This increased credibility will create an environment whereby more participants transfer from being off-chain to on-chain, creating more democratisation and financial inclusion.

The ‘old’ is not going away any time soon, but one has to acknowledge that the ‘new’ has much to offer and if harnessed effectively, blockchain enabled digital assets will be transformational for financial markets. Even if this does not lead to the ‘digitization of everything’, it will lead to the ‘digitization of many things.’

The march of technological progress is inevitable. In England during the Industrial Revolution, Bristol engineer Joseph Glass introduced the chimney sweeping machine. Initially there was much resistance from estate owners citing that a person could do it better. But such people were young children working under precarious conditions. The result of technological progress was an Act passed in 1840 banning children from this profession. Technology had led to a better way of doing this despite initial strong resistance. Nearly 200 years on, this still holds true no matter what the technology or its purpose.

For the foreseeable future, the ‘old’ and the ‘new’ must coexist via hybrid solutions (traditional and digital) as buy side institutions, banks, brokers, exchanges and other capital players increasingly adopt digital assets as part of their digital transformation agenda.  

Peaceful coexistence or all-out disruption?

The need for coexistence should not be surprising to anyone. The first email was sent in 1971, AOL arrived in 1992 and Hotmail in 1996. Before email there was paper post and now there is instant messaging. However, all 3 of these forms are still in existence even though the volume of activity across them has changed over time. Bitcoin first came into existence in 2009. 12 years on there has been much progress in the crypto and digital assets space, but even a decade from now centralised financial systems will still be out there.

The key challenge is to optimise how Centralized Finance (CeFi) and Decentralized Finance (DeFi) will intersect within a regulated environment to support the convergence of traditional and digital asset activity.

As such, what type of model can support such coexistence and how will this work in practice within the financial markets realm?

CeFi and DeFi convergence leads to HyFi

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

Institutional players largely want exposure to digital assets in the same way as they do for other asset classes. However, digital asset interoperability and time to market remain a challenge for them, with traditional and multiple types of blockchain-enabled digital asset infrastructure being severely fragmented. Many currently want exposure to digital assets without the headache of adopting the technology and therefore want to remain off-chain.

Ease of integration into what they already do is essential. In order to surmount these obstacles and achieve greater efficiency in digital asset facilitation, financial players need to optimise digital asset infrastructure in a secure and scalable fashion through cloud enabled microservices, by way of a hybrid distributed hub model.

Such a model will integrate private ledgers and public blockchains into traditional market infrastructure to create a hybrid market infrastructure approach. This will enable digital assets to be reflected within financial firms’ traditional trading and post trade systems using the same interface standards used for traditional assets, and will connect them to the range of service providers they need to trade and settle digital assets.

Using such hybrid solutions, capital markets players such as a banks, asset managers, brokers, exchanges, post trade operators and service providers will seamlessly connect their private ledgers to digital asset markets.

One such example will be the centralized exchange and decentralized construct combining to create a type of Hybrid Exchange (HEX). For example, one which supports trading models that are Centralized Exchange (CEX) like and Decentralized Exchange (DEX) like in a cohesive fashion.

Other use cases which can be facilitated by a hybrid distributed hub model include:

• Linking traditional and digital custody of assets by multiple custodians to a diverse range of digital trading options across brokers and exchanges, using familiar interfaces for simple integration;
• Developing new hybrid products, with liquidity and funding benefits and associated facilitation of new revenue streams;
• Processing of digital asset trades in a fashion very similar to traditional assets to:
  • Enable a single view of all traditional and digital assets and positions (net asset value - NAV) across different trading venues;
  • Perform asset management, with real-time netting and settlement, and re-use of traditional and digital assets;
  • Undertake treasury management, such as intra-day funding, and collateral management by pledging assets from one or more custodians across multiple trading venues and brokers with real-time dynamic updates; and
  • Manage credit limits – either segmented or at a portfolio level across both traditional and digital assets, across all venues and custodians.

These will all be part of the evolution of hybrid market infrastructure delivering Hybrid Finance - HyFi!

Moreover, a hybrid distributed hub model itself is highly energy efficient as less energy is utilised through continuous movement of assets on public blockchains. It can be optimised so that activity – in terms of public and private blockchains are utilised in the best possible way – which means a firm’s carbon footprint will improve over time.

The key will be how to apply regulation, which was 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 regulate HyFi.

Conclusion

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

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

Financial markets players can utilise this hybrid approach to connect their traditional systems to digital assets, globally, with almost any kind of participant, anywhere in the world, across jurisdictions. It can also align to their ongoing digital transformation agenda to consume and deliver services within the broader market in ways that also meet their broader ESG goals.