MACH: An Introduction to Hybrid Finance (HyFi)

Introduction

Regulators play a crucial role in managing systemic risk within financial markets, ensuring the stability and integrity of the financial system. Financial Market Infrastructures (FMIs) are central to this process, and serve as the backbone of the financial system, providing the essential "pipes" that facilitate trading, clearing, settlement, and reporting of financial transactions. As the financial sector undergoes transformation, FMIs are increasingly in the spotlight, both for their critical functions and the challenges they face in adapting to new technological and regulatory landscapes.

The evolution of financial systems has been a continuous process, from barter systems to commodity-backed currencies, to the current fiat-based global financial infrastructure. Traditional Finance (TradFi) has developed over centuries, creating robust institutions, regulatory frameworks, and market structures. In contrast, Decentralised Finance (DeFi) emerged in the last decade as a novel approach to financial services, promising to democratise finance by disintermediating FMIs and shifting responsibility and power to the end user.

To understand the differences between TradFi and DeFi, it's important to recognise their technological foundations. TradFi relies on institutional databases, proprietary software systems, and established financial protocols, functioning through a network of regulated institutions. DeFi is built on Distributed Ledger Technology (DLT), utilising smart contracts to automate financial services, operating on a peer-to-peer network, and adhering to open-source philosophy. While DeFi is often seen as a disruptor to traditional systems, recent scandals have attracted regulatory attention, suggesting that regulation will significantly influence its future.

The concept of Hybrid Finance (HyFi) is the integration of TradFi systems and DeFi, aiming to harness the strengths of both to enhance efficiency, transparency, and inclusivity in the financial ecosystem.

TradFi as the Foundation

TradFi and DeFi represent two fundamentally different approaches to managing financial systems. TradFi markets are broadly divided into Capital Markets and Money Markets. Capital Markets involve the buying and selling of long-term debt or equity-backed securities, while Money Markets deal with financial instruments with maturities not exceeding one year. These markets rely on centralised institutions such as central banks, custodians, and clearinghouses.  

Collectively, Financial Market Infrastructures (FMIs) play a crucial role in maintaining financial stability and supporting economic growth by ensuring that markets operate efficiently and securely. As one of the key differences between TradFi and Defi is differing degrees of intermediation, the comparison between TradFi FMIs, DeFi and HyFi are shown in Table 1 below.  

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DeFi leverages DLT to eliminate traditional intermediaries, operating through smart contracts on platforms like Ethereum—used as an example of a public blockchain given its popularity and functionality—to automate financial activities such as lending and trading. Unlike TradFi, DeFi utilises transparent blockchain ledgers and transfer mechanisms for real-time transaction access and direct settlements. Automated market makers (AMMs) provide liquidity within DeFi, while credit risk is managed through collateralisation or community consensus models.

While DeFi offers increased transparency, direct control, and reduced settlement times, it also faces significant challenges such as regulatory uncertainty, security vulnerabilities, and the absence of centralised oversight, which can lead to increased volatility and systemic risks. Lack of consumer protection and extreme volatility are amongst the top criticisms of DeFi. Balancing the innovative potential of DeFi with the stability and regulatory safeguards of TradFi markets is pivotal to enabling HyFi.  

Digital Infrastructure of TradFi

Digital transformation in TradFi has introduced significant advancements but also poses challenges due to fragmented IT infrastructures. Financial institutions develop systems independently, leading to limited information sharing and standardisation. This fragmentation complicates collaboration, as institutions must adapt to unique communication protocols. To mitigate these issues, intermediaries have emerged to facilitate interactions between different systems, acting as translators. However, integrating such solutions into existing systems and achieving sufficient adoption often results in additional complexities and points of failure.

Organisations like SWIFT have developed standards such as ISO 20022 for financial messaging. Meanwhile, regulatory bodies like the European Union, through its revised Payment Services Directive (PSD2), promote open banking by mandating that banks provide third-party access to customer account information via standardised APIs. These initiatives aim to enhance interoperability between financial institutions and fintech companies.

However, such efforts can sometimes lead to unintended consequences. For instance, while the European Central Bank's (ECB) Target2 Securities System offers numerous benefits to the industry, it also aimed to provide a central settlement engine in the Eurosystem to simplify processing. Yet, because Central Securities Depositories (CSDs) offer asset servicing, they had to maintain their own settlement engines. This resulted in an additional settlement engine, duplicating costs instead of achieving harmonisation and efficiency. Another example is the European Securities and Markets Authority's (ESMA) implementation of hold and release functionality to reduce instruction mismatching in securities settlement. While this initiative aims to improve settlement efficiency and reduce fails, it may initially increase operational complexity for some market participants and could potentially be misused to manipulate settlement timing, necessitating careful regulatory oversight.

These cases illustrate that while standardisation efforts are crucial for improving financial market infrastructure, they can also introduce new challenges that need to be carefully managed.

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TradFi's digital infrastructure typically operates on a client-server model, where participants communicate through multiple API calls. This setup necessitates continuous reconciliation to maintain data consistency and accuracy, involving the comparison of internal records with external data sources.

The reconciliation process is both costly and repetitive, highlighting the urgent need for automation. Expenses are further increased by the fees charged by FMIs for their services, which significantly raise the overall processing costs for market participants.

‍The Regulatory Challenges of DeFi

DeFi presents unique regulatory challenges due to its innovative structure and operational mechanisms. DeFi operates on a trustless, peer-to-peer model that eliminates traditional financial intermediaries. This decentralised approach offers numerous benefits, including increased accessibility, reduced costs, and enhanced transparency. However, it also introduces complex regulatory challenges.  

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DeFi platforms typically utilise blockchain networks like Ethereum, which provide a cryptographic public key infrastructure, smart contract functionality, immutable transaction ledgers, and peer-to-peer networking. These features enable secure, automated transaction processing without centralised oversight. However, the anonymity enabled by cryptographic keys conflicts with Know-Your-Customer (KYC) and Anti-Money Laundering (AML) regulations, which require identity verification. Smart contracts, while offering efficiency and transparency, raise legal questions regarding enforceability in traditional legal systems, liability in case of errors or unintended outcomes, and compliance with existing contract law.

The global, borderless nature of DeFi complicates regulatory oversight, as different jurisdictions may have conflicting approaches, making it difficult to determine which laws apply and how to enforce them. The pseudonymous nature of blockchain transactions makes it challenging to implement effective AML and KYC measures, forcing regulators to grapple with balancing privacy concerns and the need for financial transparency. Many DeFi tokens may be classified as securities under existing frameworks, requiring compliance with securities laws, including registration and disclosure requirements.

The lack of centralised intermediaries in DeFi raises concerns about user protection, prompting regulators to explore ways to safeguard users from fraud, hacks, and market manipulation without compromising the decentralised nature of these platforms. Additionally, the immutable nature of blockchain transactions conflicts with data protection regulations like the EU's General Data Protection Regulation (GDPR), which includes the "right to be forgotten".

Regulators worldwide are working to develop frameworks that address the unique challenges posed by DeFi. The European Union's Markets in Crypto-Assets (MiCA) regulation aims to create a comprehensive framework for crypto-assets, including some aspects of DeFi. The U.S. Securities and Exchange Commission (SEC) is extending its regulatory reach to DeFi projects, particularly those that may involve securities. The Financial Action Task Force (FATF) has issued guidance on applying AML/CFT measures to virtual assets and DeFi.

To address these challenges, several approaches are being explored, including regulatory sandboxes to allow controlled testing of HyFi innovations, development of decentralised identity solutions for KYC compliance, implementation of on-chain governance mechanisms that align with regulatory requirements, and collaboration between regulators and DeFi projects to develop tailored compliance solutions. As the DeFi ecosystem continues to evolve, finding the right balance between innovation and regulation remains a critical challenge. Regulators and industry participants must work together to develop frameworks that protect users and maintain financial stability without stifling the potential of this transformative technology.

‍The Emergence of HyFi ‍

As digital transformation progresses, the convergence of TradFi and DeFi has led to the emergence of HyFi. HyFi seeks to combine the benefits of both systems while addressing their respective drawbacks.

Driven by regulatory changes, jurisdictional laws, institutional demand, and technological advancements that promise increased market efficiency, HyFi offers a middle ground that satisfies regulatory requirements while utilising the advantages of DLT. Key components of HyFi include regulated asset tokenisation, hybrid custody solutions, smart contract-enhanced products like fractionalised assets, atomic settlement, and blockchain-based settlement systems.

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HyFi typically employs a class of DLT known as 'permissioned DLTs' to support operations in regulated environments. These systems address KYC requirements by enforcing identity verification through digital certificates, verified by trusted participants. HyFi leverages smart contracts distributed to all participants, ensuring no single point of failure, with contracts reviewed by trusted participants before deployment. To comply with privacy regulations like GDPR, technologies such as Zero Knowledge Proofs (ZKP) are expected to be adopted.  

Combining TradFi and DeFi architectures, HyFi integrates FMIs with DLT to provide a comprehensive suite of financial services while adhering to regulatory compliance. Additionally, it seamlessly integrates with existing technologies like SWIFT and Target2, as well as private and public DLTs, supporting a controlled migration to new technologies. A key feature of this architecture is atomic settlement, which enables instant settlement, thereby reducing operational and counterparty risks. This integration enhances efficiency and reduces systemic risks in financial transactions. Depicted below is the MACH architecture, developed by Delta Capita, exemplifying a HyFi platform.

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HyFi has the potential to significantly impact various areas of finance, including asset management, trading, settlement, and cross-border transactions. Tokenisation, a core feature of HyFi, could democratise access to previously illiquid assets, enabling more efficient portfolio management. Blockchain-based systems could reduce systemic risk and free up capital tied up in lengthy settlement processes, while near-instantaneous settlement could reduce counterparty risk and enable 24/7 trading of traditional assets. Furthermore, HyFi solutions could streamline international payments and reduce the reliance on intermediaries, enhancing efficiency in cross-border transactions.

For HyFi's long-term viability, it must align with regulations and jurisdictional laws. Standardisation of legacy data models and transition functions is crucial for FMIs to achieve efficient price discovery and post-trade automation. Without standardised, machine-readable, and executable term sheets, financial institutions may struggle with automation, hindering innovation. Thus, aspects like token standards and DLT interoperability are amongst key considerations when implementing HyFi solutions across regulated financial markets.

The cost of adoption includes integrating new systems compatible with HyFi. For the foreseeable future, HyFi and legacy systems will need to coexist and interoperate. Any HyFi use case should improve operational processes without risking systemic stability or breaching regulatory compliance, ensuring a smooth and sustainable transition. A clear business case is essential for HyFi development and adoption, demonstrating the practical benefits of new financial technologies and justifying investments.

This article has been written by Lars Müller (Product Manager, DLT Product Development), and Paul Sitoh (Senior Developer, DLT Product Development). If you'd like to learn more, get in touch today.

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