Convergence of CeFi and DeFi set to revolutionise finance

The emergence of blockchain technology and the third generation of the internet (Web3) has offered the possibility of a transformational change across industries including the finance sector. Web3, the next iteration of the internet, has a decentralised nature, with its access and use controlled by community-run networks. It is helping drive a lot of interest in decentralised finance (DeFi).

Understanding DeFi: Beyond traditional financial intermediaries

While there is no standard definition of DeFi, it primarily refers to the delivery of financial services leveraging distributed ledger technology (DLT) like blockchain without involving any traditional financial intermediaries. Its decentralised aspect arises from the fact that a blockchain operates in a distributed manner across the nodes of a network, with no single party deciding on the participants and the processing of transactions. Different DeFi protocols, though, can exhibit varying degrees of decentralisation, either through design or by governance.

DLT, combined with tokenisation, which creates digital representations of assets on a blockchain, can leverage DeFi protocols that use software code to automatically execute a range of financial transactions based on set rules, bringing multiple efficiencies to traditional finance (TradFi). There are different types of DeFi protocols and applications, and while some mirror the activities found within the TradFi world of centralised finance (CeFi), like borrowing, lending, and exchanges, others display new features and have led to the emergence of innovative solutions like automated market makers and flash loans.

While it is still relatively early days for DeFi, we are starting to see CeFi adopt some of the best aspects of DeFi, and this convergence could be a game changer for the finance industry. DeFi offers possibilities of programmability and composability, and has the potential to significantly enhance the landscape of TradFi through innovation, efficiency, and financial inclusion.

Onno Sterk, chief operating officer at OSL, a digital asset platform, explained: “DeFi revolutionises traditional financial mechanisms through innovations such as asset tokenisation and 24/7 operational capabilities, distinguishing it from traditional finance, which operates within set market hours.

“These features are transformative for Asia’s finance industry, offering continuous access and enhancing transaction efficiency—qualities that are highly valued in our dynamic markets.” OSL provides a range of services, including brokerage, custody, exchange, and software-as-a-service.

Hari Janakiraman, head of industry and innovation for transaction banking at ANZ, added: “With DeFi, you can potentially avoid the middleman and associated fees and time delays. We have seen this through the use of smart contracts and by writing governance into software to carry out financial transactions. With the absence of trusted central parties, for DeFi to become mainstream, we would need to better understand the technology and ensure that everyone in the ecosystem is playing by the rules.”

Onno Sterk, Chief Operating Officer,
OSL

Hari Janakiraman, Head of Industry and Innovation for Transaction Banking, ANZ

CeFi adapting to the DeFi era

While banks have been involved in research and experimentation with blockchain and digital assets for a few years, it was the proposed introduction of Libra by Meta and the subsequent digitalisation push driven by COVID-19 that helped accelerate adoption in banking. There are a few themes that have emerged as the focus areas for banks in DLT, including tokenisation of securities to enable fractionalisation and improve accessibility, tokenisation of money to move liquidity beyond traditional cut-off times, and digitalising trade finance, where the ability to leverage the programmability of smart contracts enables multiple use cases.

Mark Attard, head of digital assets and client engagement for treasury and trade solutions at Citi remarked: “Amongst the benefits of DeFi protocols is the option available for our clients to use the technology to conduct payments and move liquidity real time 24 hours, seven days a week.

“The technology also enables atomic settlements and reduces the risks and inefficiencies that exist in today’s marketplace. Citi Token Services for Cash uses blockchain and smart contract technologies to provide cross-border payments and liquidity solutions on a 24/7 basis.”

Mark Attard, Head of Digital Assets and Client Engagement, Treasury and Trade Solutions, Citi

Banks are leveraging DLT and implementing it with appropriate guard rails to enable new business cases and bring efficiencies. Nikhil Sharma, head of growth, Onyx Digital Assets, Onyx by JPMorgan, said: “While DeFi offers benefits in streamlining human intervention in transactions, financial institutions are still in the early stages of exploration. Current experiments typically involve a blend of DeFi protocols with some degree of centralised governance, often referred to as ‘CeDeFi’ or ‘Institutional DeFi’.

“This represents a middle ground between traditional banking and fully decentralised finance, as banks navigate through aspects of regulatory compliance, risk management, and integration with contemporary systems.”

As banks explore this middle ground, aware of the benefits DeFi could bring, there is clear recognition that much more needs to be done across multiple areas—legal, regulatory, cybersecurity, and investor protection to fully realise the potential of DeFi protocols in CeFi.

“The crypto winter has highlighted the need for the virtual assets space to be regulated,” said Jonathan Gill, senior tokenisation director and legal advisor for the Hashkey Group. He added: “Clear and comprehensive regulations are essential for blockchain-based financial solutions to become mainstream. We accordingly conduct extensive regulatory due diligence before entering a new jurisdiction and adopt a compliance-focused approach in each such jurisdiction.” Hashkey is an end-to-end digital asset financial services group offering solutions across the digital asset ecosystem and Web3 landscape.

Nikhil Sharma, Head of Growth, Onyx Digital Assets, Onyx by JPMorgan

Jonathan Gill, Senior Tokenisation Director and Legal Advisor, Hashkey Group.

Sharma from JPM concurred, saying: “DeFi constructs have the potential to drive innovation and efficiency in financial services. Several financial institutions are already using blockchain technology and smart contracts to streamline processes, reduce counterparty risk, and shorten settlement times. The composable and interoperable nature of DeFi protocols could further enhance this dynamic.

“However, the adoption of fully decentralised solutions by banks will require addressing multiple aspects, including regulatory compliance, scalability, privacy concerns, and the development of secure, auditable smart contracts. As banks continue to experiment with DeFi protocols in permissioned environments, they are laying the groundwork for further using this emerging technology while ensuring the necessary safeguards are in place.”

“While DeFi presents immense opportunities, it also faces significant challenges, such as the need for enhanced governance structures and risk management frameworks tailored to digital assets,” said Sterk from OSL. He added: “These challenges are crucial in Asian markets where compliance and security are paramount. From our experience as a licensed platform, establishing robust governance that addresses unique risks like smart contract vulnerabilities is essential for sustainable DeFi integration.”

Clearer standards to harmonise regulations

There is a growing view that with DeFi being another form of financial market infrastructure, the existing regulations in financial markets should be applied with appropriate adjustments to factor DeFi’s unique characteristics. This is also the approach preferred by regulators in most jurisdictions who view this under the ‘same activity, same risk, same regulatory outcome’ principle.

Attard from Citi remarked: “For blockchain protocols and digital assets to continue their growth in the TradFi world, the industry needs to work hand in hand with the global regulators. It would be important to create standards and harmonise regulations across markets, where possible, so that solutions could scale globally, drive the benefit of DeFi faster to market, and to a wider client base.”

When it comes to DeFi regulation, however, there is added complexity around what exactly needs to be regulated and how it will be implemented. For example, the Markets in Crypto-Assets Regulation (MiCA) in Europe aims to regulate crypto-assets that are not covered by existing European regulations. While MiCA is proposed to be applied to services performed in a decentralised manner, it also exempts “crypto-asset services that are provided in a fully decentralised manner without any intermediary”, thereby leaving it open for discussion on whether a particular service is performed “in a fully decentralised manner” and “without any intermediary”.

Multiple industry associations and central banks have issued public consultations on how to define and regulate DeFi, and the open dialogue between the different stakeholders augurs well for clearer regulation in this space going forward.

As the Web3 ecosystem starts to come under the remit of regulations, it also offers opportunities for banks and the Web3 players to work together. Some banks are working with regulated exchanges to help on-ramp clients into the crypto world, while others leverage these exchanges for the custody of virtual assets.

There are also possibilities to work together on the listing of tokenised securities on these exchanges. Hashkey’s Gill explained: “Some traditional financial institutions issue tokens on private blockchains. These are effectively walled gardens that are not easy to scale. In contrast, issuing tokens on public blockchains and listing those tokens on virtual asset trading platforms can allow their issuers to access a wider pool of investors and facilitate the secondary market liquidity of the tokens.”

The regulated exchanges also provide easier access for investors to the Web3 ecosystem and enable innovative solutions. Gill added: “This is unlike traditional financial institutions that only operate in some parts of the Web3 world, if at all. We have deep experience tokenising Web3-native and real-world assets.

“With respect to the latter, we particularly focus on decentralised physical infrastructure networks. This effectively involves using tokens to crowd-fund real-world infrastructure. For example, we recently advised a client on how to incentivise renewable energy consumers to use and develop a carbon-neutral energy network.”

Encouraging signs on interoperability

With different players in the ecosystem, including banks, fintechs and asset managers developing their own blockchain solutions and using different standards for their respective digital tokens, there is a dynamic of fragmentation in both liquidity and client experience. This has again brought to focus the need to solve for interoperability and bring in standards.

“For DeFi protocols to gain wider acceptance in the CeFi world, we need common standards, because financial markets operate on standards,” said ANZ’s Janakiraman, adding: “The standards would need to come from the industry and would be needed for tokens, smart contracts, as well as for interoperability.

“I’m confident that this will happen, and I always refer to the internet as an example. The internet works today, because we are all on the same protocol, Transmission Control Protocol/Internet Protocol (TCP/IP). We will get there, but it is just going to take some time in terms of what is the best way to do it.”

There are multiple initiatives underway on the interoperability front, which augurs well for the future, although most of them are still at a nascent stage. For a frictionless client experience, it is important to solve for interoperability across both the technology stack and the application layer.

Swift has successfully conducted experiments on a cross-chain interoperability protocol where it has worked with major financial institutions, market infrastructures, and a Web3 services platform and demonstrated that its infrastructure can facilitate the transfer of tokenised value across multiple public and private blockchains.

Another interesting project on interoperability is Project Agora (Greek for marketplace), driven by the Bank of International Settlements that brings together central banks and private financial firms from across the globe. The project aims to build on the unified ledger concept and will explore how tokenised commercial bank deposits can be integrated with tokenised wholesale central bank money in a public-private programmable core financial platform to remove frictions in cross-border payments.

Another project that has excited many is Global Layer One (GL1), where the Monetary Authority of Singapore, in partnership with global industry associations and financial institutions, is exploring the development of a multi-purpose, shared ledger infrastructure based on DLT.

The vision is for regulated financial institutions to leverage this shared ledger infrastructure across countries to deploy digital asset applications, governed by common standards and technology for assets, smart contracts, and digital identities. GL1’s foundational digital infrastructure would be developed according to a set of principles, including being open and standards-based, compliant with applicable regulations, well-governed, and having clear and transparent operating arrangements and rules.

The envisaged architecture of GL1 can be described as the base layer in a four-layered conceptual model for digital asset platforms. The intended interactions of GL1 with other component layers would include, firstly, an access layer through which end users would access the range of digital services built around the GL1 platform.

There would be a service layer where selected participants would be able to build and deploy application services such as interbank transfers and collateral management on the GL1 platform. The asset layer would support both native issuance of cash, securities, and other assets, as well as tokenisation of existing physical or analog assets.

Assets on GL1 would be deployed in the form of tokens and would be designed to be technologically interoperable across multiple GL1 applications and service providers.

GL1 would provide the infrastructure components for the platform layer, which is envisioned to encompass the blockchain infrastructure that would include the ledger and consensus mechanism, libraries and templates, data standards, and platform-wide services. The infrastructure used for record keeping would be distinct from the application layers, ensuring that assets on the GL1 platform would be compatible with multiple applications, even if offered by different institutions.

The GL1 platform would include a standardised protocol for consensus and synchronisation mechanisms, which would enable asset transfer and cross-app communication. The platform would also ensure privacy, permissioning, and data segregation from other applications and participants.

Faster acceptance of DeFi in TradFi world

With a lot of good work happening across interoperability, setting standards, and building up a shared ledger infrastructure, how does the industry foresee the convergence of DeFi and CeFi in the coming years?

Sharma from JPM observed: “The path to mainstream institutional adoption of DeFi is a complex journey and will likely involve a gradual convergence of centralised and decentralised models.

“Several aspects need ironing out, such as establishing clear accountability, implementing robust identity verification, ensuring the security and auditability of smart contracts, and operating within well-defined legal frameworks. Overcoming these challenges will require close collaboration between the DeFi community, financial institutions, and regulators.”

Attard from Citi said: “I envisage a hybrid between a CeFi and DeFi world. As the legal and regulatory framework evolves, we’re likely going to find an equilibrium where the regulators become more comfortable with the control elements of digital assets and may potentially facilitate the operating environment for these to develop in.

“Further, as we progress on interoperability solutions, we will be able to leverage the tokenisation of assets to create new business models.”

“It’s an exciting time to be at the forefront of this financial revolution,” said Sterk from OSL, adding: “The future of finance is set to be deeply influenced by the integration of fintech, digital assets, and innovations from DeFi, particularly through the expansion of exchange-traded funds, the rise of stablecoins, and the increasing adoption of asset tokenisation.

“As the industry evolves, it represents a step towards a more adaptable, inclusive, and efficient financial ecosystem. As these DeFi platforms mature and continue to innovate, we anticipate a broader adoption across various sectors, leading to more integrated and seamless financial services.”

Janakiraman from ANZ agreed: “Practical usage of DeFi is certainly applicable in regulated financial markets, and bank adoption of DeFi protocols will continue to increase. We are all moving towards a ‘real-time’ economy with real-time payments and real-time treasury, and digital tokens are going to accelerate that development. There are challenges that need to be addressed, including standards, but as we go forward and overcome those challenges, there are exciting times ahead.”

It is difficult to get a consensus on the end state of the convergence between DeFi and CeFi, but as regulators get more comfortable with the DeFi world, especially with additional control elements being incorporated into the current set-up, it is clear that there will be a faster acceptance of DeFi within the TradFi world, albeit within a controlled and regulated environment.

The most likely scenario will be a hybrid model that incorporates the best of both worlds—the efficiencies, programmability, and atomic settlement of DeFi with the trust and compliance of CeFi. This will bring efficiencies, and most importantly, it will help evolve finance by unlocking new asset classes and turbo charge the new business models of tomorrow.