Merging traditional finance and DeFi is critical for mass adoption

When the capital markets first opened this year on January 4, 2021, the Financial Times front page focused directly on Bitcoin (BTC) with the headline, “Bitcoin Exceeds $ 34,000 If Record-Breaking Rally Resumes. ”

It is certain that Bitcoin is seeing an institutional buy-in at a level unmatched in its history, but what does this mean for the broader crypto space? How are we moving from the institutional rollout of Bitcoin or other crypto assets to connecting traditional financial markets with the markets for decentralized finance and digital assets? If we can achieve this lofty goal, the inflows of capital, resources, and attention would far exceed even the significant current DeFi space, resulting in greater potential.

Only a few institutions are now able to invest in Bitcoin. The difficulty of reaching such a stage should not be underestimated, and funds investing in Bitcoin remain outliers. The largest institutional investors, such as pension and insurance funds, require highly developed and liquid markets, longstanding historical successes, and significant internal risk and compliance concerns to be overcome. These hurdles are multiplied when using crypto protocols. For example, a company that wants to use digital tokens that represent a company’s shares on the Ethereum blockchain must comply with global financial and capital market regulations. This includes aspects such as cross-border know your customer and anti-money laundering regulations.

In order for institutions to be able to introduce DeFi, we must first allow them to access it in a compliant manner. This does not mean that all DeFi need to be inappropriately regulated. This would destroy the purpose of a decentralized system. However, it is possible to have a protocol in place to facilitate the compliant use of DeFi. There are several aspects that make up such a system.

digitalization

While it is easy to create a digitized asset, the difficulty arises when compliance is introduced. One of the most important issues concerns global securities regulation, which requires a number of required actions before a security is issued, including legal advice, documentation, due diligence, marketing and secondary trading, and corporate actions. All of this creates additional costs.

The relentless inefficiencies during this process also present an opportunity for DeFi. A protocol that could resolve these issues would significantly reduce a company’s capital and resource expenditures while improving the process for investors who can access and trade in ways similar to crypto assets today.

Due diligence reviews

Due diligence, including KYC and AML, is a costly and mandatory process for institutions. An investor who invests in multiple companies must perform the same reviews on each one – a time-consuming process for all parties. This also means that the investor entrusts confidential data to several institutions.

DeFi offers the ability to redefine the completion of KYC. Instead of each company doing its own KYC, an investor could conduct KYC protocols with an approved partner. This would allow the investor to keep control of their data while the institutions could share the burden of KYC costs among themselves. Institutions could of course complete their own KYC if they did not approve the KYC operator.

Data

Access to and control of data has become increasingly controversial. The two main issues institutions face in relation to data are the security and privacy of user data, especially under the General Data Protection Regulation, as well as the ability to connect to DeFi via user-friendly application programming interfaces.

User data can be protected using encryption methods such as knowledge-free evidence, which allows users to provide validated data to a third party without disclosing the data to that party. This would allow investors to demonstrate that they are authorized to complete a transaction without having to prove who they are or why they are authorized. This data can be encrypted and stored securely while always staying in the hands of the user.

Institutions also need an easy way to exchange data. This can be achieved through APIs that make it easier for institutions to connect to DeFi protocols while complying with regulations such as European Union Payment Services Directive 2. This API must enable both on-chain and off-chain data.

Cross-border regulation

Requirements and processes vary from country to country, while the fines for violations have increased significantly since the financial crisis. The burden of resources to meet this growing compliance oversight has also increased. At the same time, investors expect to be able to invest globally instead of being limited to their own jurisdiction. Blockchain technology, with its ability to digitize assets and instantly trade with colleagues around the world, can be a means to achieve this. However, companies must be able to adhere to the same regulatory standards.

For this reason, a protocol is needed that can embed regulation at the layer level. Once a rule has been created or modified and then accepted as smart contract logic, companies have no choice but to adhere to it. Additionally, this can be linked to the aforementioned KYC checks to ensure that an investor can invest in the desired product. This automates cross-border transactions and significantly reduces costs for institutions.

DeFi Investment Terminal

Just as institutes use tools such as Bloomberg terminals, they also need DeFi investment terminals in order to be able to access real-time data. This would consolidate information across decentralized exchanges and blockchains and provide powerful and detailed information.

Bridging TradFi and DeFi

In the DeFi sector it is often reluctant to develop a solution that is acceptable for TradFi. The fear is that it will damage the DeFi room. This is an unrealistic problem. DeFi and blockchain in general offer myriad benefits to the financial system that can be used to make TradFi companies more efficient and to comply with increasingly complex and increasing regulations.

By bringing TradFi to DeFi, we are in a more effective position to shape the future of finance. It would bring resources and attention to a different extent than currently. We have seen the power few teams can have in creating the “Lego” blocks that the rest of DeFi has built on. The task now is to build the infrastructure over which TradFi can also develop.

The views, thoughts, and opinions expressed here are the sole rights of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Rachid Ajaja is the founder and CEO of AllianceBlock, the globally compliant decentralized capital market. With a deeply rooted understanding of traditional financial institutions, Rachid spent six years as a quantitative risk analyst at Barclays Investment Bank, BNP Paribas and Moody’s Analytics. As a serial entrepreneur with a passion for modeling, analysis development, quantitative analysis and data science, Rachid has developed and implemented models and methods over the past decade to support companies with forecasting and risk management. He is currently also working as a venture partner at Alpha Omega Capital.