A Case for Hybrid Finance: HyFi = (CeFi + DeFi)

Compared to traditional finance, blockchain and cryptocurrency remain new concepts that are in their infancy. Because of this, there are still new ideas floating around that many misunderstand, despite their vast potential for shaking up the financial system. 

In the midst of this developing space is a blending of traditional finance (CeFi) with its innovative counterpart, decentralised finance (DeFi). This combination, known as hybrid finance (HyFi), represents a significant, yet realistic, leap within our economy, offering the best “best of both worlds” approach.

This article will look at the potential that HyFi has, and where it’s currently positioned today. But first, it's crucial to first understand the distinct natures of CeFi and DeFi, as they both play an equally important role.

Centralised Finance (CeFi)

Centralised finance, or CeFi, refers to the traditional financial system—the one we have all gotten used to in our lifetime. It’s ‘centralised’ because it operates under the governance of central authorities, like banks and financial institutions. 

This system, with its well-established protocols and regulations, has been the backbone of global finance for centuries. CeFi's structure offers stability and a regulated environment, ensuring security and reliability for its users. It doesn’t frighten most people, because it’s the status quo, although it certainly did collapse in 2008, which posed an existential threat. 

There are some specific drawbacks. Firstly and foremost, it’s not totally accessible in that many people around the world still do not have a bank account, and thus cannot make use of these centralised systems. 

It also has some inefficiencies, high costs, and an inherent lack of transparency, sometimes leaving consumers at the mercy of these central entities. To take a simple example, we must all use either a Visa or MasterCard bank card to pay for goods in a shop (some shops are cashless), meaning we must hold our money in a private bank (which we may not trust) in order to pay for goods.

Decentralised Finance (DeFi)

In stark contrast, decentralised Finance, or DeFi, emerged as a revolutionary concept with the advent of blockchain technology. DeFi operates independently of traditional centralised institutions, instead relying on blockchain's distributed ledger system to facilitate financial transactions. 

The DeFi ecosystem, championed by the principles of decentralisation and transparency, offers an alternative to those disillusioned with the constraints of CeFi. It promises more democratic access (a mobile phone with internet access will do), reduced fees, and enhanced efficiency in some cases. 

However, DeFi is not without its challenges either, of course, as it has unpredictable transaction fees which are sometimes higher than CeFi, slower transaction speeds, and significant concerns around consumer protection and regulatory compliance. And, of course, if it’s based on a non-pegged cryptocurrency, the currency itself may be volatile.

The Rise of HyFi 

Hybrid finance (HyFi) represents a progressive stride in the blockchain and cryptocurrency domain, standing at the crossroads of CeFi and DeFi. HyFi is not merely a bridge between these two worlds; it is a combination that aims to take the strengths and mitigate the weaknesses of each system. This model proposes a compromise, integrating the security and transparency of DeFi with the ease and familiarity of CeFi.

At the heart of HyFi's rise is the concept of tokenisation, a process that transforms real-world assets into digital tokens on the blockchain. This idea is gaining traction, as it allows for the fractionalisation of high-value assets like real estate and art, which can democratise investment opportunities that were previously out of reach for many. 

Tokenisation doesn't just make investment more accessible, it also streamlines asset management and automation, leading to significant time and cost savings. The implications of this are expanding market access, in particular the developing world, and birthing a new era of global commerce. Less friction will stand in the way of cross-border investments, for example.

However, the journey towards integrating HyFi into mainstream finance is not without hurdles. In regions like Europe, the regulatory landscape presents significant challenges. Key issues include defining the legal status of tokens (as securities or virtual currencies), establishing regulatory clarity for market operation, and ensuring investor protection measures. 

But, compliance isn’t quite as challenging as a DeFi proposition. HyFi's growth is a story of innovation tempered by regulatory pragmatism.

The anticipated markets in crypto-assets (MiCA) framework in Europe aim to address these challenges, setting a precedent for regulatory adaptation in the evolving world of HyFi.

HyFi in Practice: Applications

The practical implementation of hybrid finance showcases a range of solutions that blend the best of both worlds. These hybrid models are not just theoretical concepts though, they are already taking shape in various forms.

Hybrid and Tokenised Investment Portfolios

In this model, investment portfolios are a blend of on-chain and off-chain assets. This hybridisation allows investors to diversify their holdings, balancing the volatility of cryptocurrency investments with the stability of traditional assets. By tokenising real-world assets, these portfolios make it feasible for smaller investors to take part in markets that were previously inaccessible.

Decentralised Exchanges With Centralised Order Books

While the decentralised aspect ensures security and transparency, the centralised order book enhances liquidity and trading speed. This hybrid model addresses the common DeFi issues of high latency and liquidity challenges, making it a practical solution for traders seeking both efficiency and trust.

Stablecoins Backed by Mixed Collateral

Within HyFi, stablecoins could be backed by a combination of fiat currencies and decentralised assets. This innovative approach provides the stability of fiat with the flexibility and potential of decentralised assets. Such stablecoins could play a crucial role in reducing the volatility typically associated with cryptocurrencies, making them more appealing for everyday transactions and investments.

Hybrid Lending Platforms

These platforms are designed to merge the advantages of centralised risk management with blockchain-based collateralisation. Ultimately, they offer more secure lending options as they leverage the trustless nature of blockchain for collateral management—all while employing traditional risk assessment methods to determine creditworthiness. This hybrid structure could greatly enhance the efficiency and security of lending in the cryptocurrency space.

Hybrid Payment Platforms

Integrating traditional payment methods with blockchain-based solutions like stablecoins, these platforms offer a seamless payment experience. They might combine features of established networks like Visa or Mastercard with the advantages of cryptocurrencies, offering users a wide range of payment options. 

This inclusivity could significantly expand the utility of cryptocurrencies in everyday transactions, bridging the gap between traditional finance and the digital asset world. And, the threat of volatility in the currency’s value is diminished, particularly with the UK’s new stablecoin regulation.

Regulatory Challenges and Solutions

As Hybrid Finance blends the distinct offerings of CeFi and DeFi, it inherits a complex web of regulatory challenges. The primary issue stems from the inherent dichotomy of HyFi: it leverages decentralisation while necessitating some level of centralised oversight for consumer protection and market integrity. Is that less regulation than just CeFi or DeFi, or is it double the trouble?

In DeFi, the absence of a centralised authority or identifiable intermediaries poses a significant regulatory challenge. The defining characteristic of true DeFi is its lack of accountable entities, which is why traditional regulatory frameworks are rendered so ineffective. This has led to calls for innovative regulatory approaches, such as embedded supervision, which utilises the blockchain's trust-creating mechanisms for regulatory purposes. The Bank of International Settlements suggests leveraging the blockchain’s transparent and verifiable data for regulatory oversight.

For HyFi, however, the landscape is somewhat different. Hybrid models often include centralised components, such as front-end interfaces or entities providing real-world data to smart contracts. These points of contact—this element of centralisation—offers regulators tangible targets for regulation. There are still some big challenges, such as defining the roles and responsibilities of personnel and determining the extent and nature of regulatory oversight. Policymakers are trying to delineate who and what should be regulated within the HyFi ecosystem, striking a balance between consumer protection without stifling blockchain’s innovative solutions.

The European Central Bank’s recent discussions around decentralised autonomous organisations (DAOs) highlight the urgency for a regulatory framework that accommodates the nuances of these infantile technologies. This requires collaboration between technologists, regulators, and industry players to come up with a regulatory standard that is both effective and adaptable to the evolving nature of HyFi.

So, the regulatory path for HyFi is an ongoing endeavour, with bodies around the world chiming in. 

The Future of HyFi and Blockchain Integration

The integration of HyFi within the blockchain ecosystem is certainly in its early stages, but many remain hopeful that this is the way for blockchain to really make its way into the mainstream. The future of HyFi is closely intertwined with the broader adoption and evolution of blockchain technology. For some, this needs to be done as DeFi, where it can fully operate without centralisation. For others, this is unrealistic and the pragmatism and compromises that HeFi makes are necessary to propel blockchain’s influence.

The potential of HyFi lies in its ability to offer a more balanced, user-friendly financial experience. Combining elements from both CeFi and DeFi could address critical challenges like scalability and mass adoption that have hindered blockchain’s full integration into mainstream finance. And, forgetting compromises, the addition of centralised security and decentralised security is arguably more powerful, as opposed to an awkward compromise.

A big challenge lies in maintaining the core ethos of blockchain—decentralisation—without becoming dogmatic about it. The concept of decentralisation, while appealing as an ideal and often rooted in libertarianism, needs to be tempered with practical considerations—much like how taking libertarianism to the extreme leads to anarchy. The dissolution of the government, here, is analogous to the centralisation within CeFi. 

The reality is that most aspects of our lives involve some degree of centralisation. So, to achieve mass global adoption of blockchain and its derivatives, including HyFi, some concessions will likely be necessary. This is precisely what hybrid products speak to, as they look to integrate new technology within the current system, as opposed to overhauling that system with new technology.

Looking ahead, the future of HyFi and blockchain integration will likely be characterised by a continuous balancing act between innovation and regulation, decentralisation and centralisation, and tradition and advancement. The potential for HyFi to create a more inclusive and efficient financial system is immense, and each year regulators take a step towards legitimisation as they become eager to oversee (and therefore accept) its existence. 

Global Impact and Adoption of HyFi

The advent of Hybrid Finance is poised to have a profound global impact, as it could reshape how systems between economies interact. HyFi presents a unique opportunity to address the financial needs of a diverse global audience, which sometimes CeFi fails to do. Its inclusive nature has the potential to democratise access to financial services, particularly in underbanked or unbanked regions. 1.7 billion, which is a quarter of the global population, still do not have a bank.

Regulating financial institutions is already difficult domestically, but there is a reason that even today, banks take days to send money across borders, often costing customers £30 + a 3–5% exchange rate spread to do so. 

The international cooperation required to establish standards that ensure security will be challenging because it already is for CeFi. HyFi here does have an advantage in that the DeFi aspect of it is truly universal, and the experience for customers is the same wherever they are. But, with the collapse of many DeFi companies, it’s currently difficult to gain trust, and it’s even more difficult having multiple countries agree on a perception, use case, and protocol for HyFi providers.

Whilst HyFi offers more equality, it may struggle with sustainability. Many cryptocurrency projects have gotten bad PR from the resources used for mining, and so solutions will need to meet the ever-changing green requirements of countries around the world.

Conclusion 

Hybrid finance (HyFi), representing the blend of centralised and decentralised finance, arguably proposes blockchain’s most realistic argument for global adoption yet. Its potential to reshape the financial landscape is far-reaching, promising a future where finance is more accessible, efficient, and inclusive. However, one of the largest challenges it faces is in regulation, as bodies around the world continue to figure out a way to oversee it. For HyFi projects facing these new regulatory hurdles, contact Englebert—we can offer guidance and training to ensure up-to-date compliance.

‍