The Convergence of CeFi and DeFi: The Banks’ Big Opportunity

The following is a guest post from Richard Gendal Brown, Chief Technology Officer at R3, an enterprise blockchain firm. In keeping with our focus on the adoption of digital assets by mainstream regulated markets, Brown argues: “While the utopian ideal of full decentralisation is unrealistic for financial markets, integration with and adoption of the good parts can be utilised, and the unrealistic elements will fall away over time.” R3 focuses on direct collaboration in regulated markets with digital ledger technology.

There’s a weird little conundrum amid the exuberance around decentralised finance (DeFi): have you ever thought about quite how much the ecosystem depends on centralised services?! There’s a reason for that and it points the way to the big opportunities for existing institutions.

The idea that much of the ‘DeFi’ ecosystem depends on centralised services isn’t as contradictory as it may first appear, but the reason for it – convenience – is massively misunderstood. And it helps us see where the traditional world of centralised finance and the new world of decentralised finance might converge, to the benefit of all — though new models and solutions inspired by the DeFi concept must be combined with technology that delivers the level of trust, distribution, compliance – and convenience – that is necessary for businesses in a market as complex and highly regulated as financial services.

The role of centralised services in the world of decentralised finance was, of course, brought into sharp relief with the recent listing of Coinbase. But it goes further. Just look at how many ‘decentralised’ services stopped working when Infura went down last year, for example.

The technical details aren’t that important; the key point is merely that Infura is a centralised platform that many DeFi services rely on to connect to the Ethereum network, and so when it went down many of those decentralised services stopped working. Infura is an impressive project, and the event was newsworthy only because of how rarely it had happened before — this is not a criticism of the Infura team. Nor is this a criticism of all those Ethereum services that depended so heavily on Infura.

It would be easy to say this kind of event means that decentralised finance is decentralised only in name. But that would be to entirely miss the point: yes, many services choose to use Infura for its convenience and superior service versus taking a ‘purist’ decentralised approach. But those same projects also have the power of exit: a centralised service in a decentralised world will be dominant only for as long as it delivers value.

And so this leads to an interesting insight about how centralised services can and do legitimately exist in an otherwise decentralised world.

Indeed, centralised services that deliver value reliably and in a mutually beneficial way will almost invariably be preferred by users. What’s not to like? There’s an identifiable operator to get support from and to yell at if things go wrong. And it saves you the hassle of building and operating everything for yourself. Convenience always wins.

If you’re active in the blockchain space and doubt me, ask yourself this: do you run your own Bitcoin node? Do you rely on a custodial wallet? If you’re one of the rare people who use a hardware wallet, when was the last time you audited the source code of its firmware for yourself?

For as long as humans walk on the earth, firms that can offer the convenience of a well-run service will make a good living, even in a supposedly decentralised world.

This insight, I think, is key to addressing the dilemma being faced by senior executives at banks across the world as they watch the DeFi revolution unfold. Is it real? And if it is, is there a role for us? And what might it be?

After all, it’s highly unlikely the global financial system will be completely dismantled and replaced by DeFi models, so there’s an argument to do nothing. But it’s also easy to see that these worlds are edging closer together.

The answer is to think about convenience.

After all, and for all the scorn they receive – and despite how it feels when you actually interact with most of these institutions as a consumer – the primary value proposition of many banking services is convenience.

It’s the only reason many banks still exist!

  • Banks sell the convenience not to have to secure your savings in your own steel vault.
  • Banks sell the convenience not to have to use cash to make every payment.
  • And – whisper it – banks sell the convenience of not having to be tooparanoid in your interactions with others: if you truly get defrauded, they’ll usually bail you out.

Now, most financial services firms are well on their way to capitalising on the application of these technologies to their own business problems. So they’re well placed to broaden their focus to their clients too.

Indeed, it was enterprise blockchains such as CordaHyperledger Fabric and Quorum that led the way with this convergence. The initial Bitcoin revolution triggered a response from enterprises and authorities, which led to these platforms and solutions like SpuntaContourMarco PoloB3iHQLAxSDX and more. And this, in turn, catalysed progress with new regulated digital assets such as CBDCs, which will incorporate systemically critical intermediaries such as central banks and apply the key benefits of this technology in a way that is safe, regulated and achievable within the near future.

But the convergence of this enterprise world with the fully anarchic world is still a difficult path to navigate. While the utopian ideal of full decentralisation is unrealistic for financial markets, integration with and adoption of the good parts can be utilised, and the unrealistic elements will fall away over time.

This approach recognises that regulators and central banks are vital components with a role to play in maintaining orderly market conditions and provides the infrastructure to connect them with new DeFi technology.

This DeFi-CeFi hybrid is already happening amongst real organisations within the regulated financial system, many of them utilising enterprise-grade blockchain technology as their starting point. It provides the level of access and decentralisation people want, and the new services and innovation they desire, but in step with the regulated world and institutions within it.

One example might be the XKD cryptocurrency, the first to launch on Corda Network, which offers an excellent example of Corda functioning as a bridge between DeFi and CeFi. As Corda provides a permissioned network, all participants are known entities and existing rules and regulations can be applied, while still delivering the benefits of a decentralised cryptocurrency. XKD was unveiled by the Cordite Society, a UK cooperative and as such an existing legal form. Regulated digital assets payment firm BCB Group is also one of the three founders of XKD.

And as CBDC work continues and gets more serious, it’s clear that purist DeFi platforms are unable to deal with real world regulatory challenges and the necessary performance requirements. Bank of Thailand, for example, recently found that increased privacy on the public blockchain-based solution it was testing had an adverse effect on performance. That’s because a DeFi platform cannot simply be re-engineered and applied to the world of centralised finance. A hybrid approach is required.

Ultimately, real change in financial markets is driven by collaboration. Improvements to the way money and assets flow through the global financial system have almost always been achieved by successfully integrating a new technology with the existing infrastructure and institutions within it.

And let’s not forget most businesses’ inbuilt penchant for convenience. Very few – if any – firms operating in the financial services industry would suddenly refuse to participate in the centralised world they are entrenched in, and switch to a completely new way of working. If they are to switch to a new technology, it needs to be seamless and with minimal disruption to their day-to-day operations. And it needs to enable them to connect with their peers and other parts of the financial market infrastructure.