- Rishabh's Crypto Newsletter
- Posts
- TradFi vs. DeFi
TradFi vs. DeFi
Illustrating the benefits of DeFi with 16 real implementations
Rishabh Das
April 24, 2025 • Estimated Reading Time: 41 minutes
🌟 Executive Summary
This report explores the transformative potential of Decentralized Finance (DeFi) by comparing it directly to traditional finance (TradFi) using real world implementations. Think of TradFi as the invisible infrastructure beneath New York City – the sprawling maze of electrical grids, plumbing networks, and subway tunnels laid down over centuries. These systems, built with the best technology of their time, have grown organically like roots beneath Manhattan, creating a resilient foundation that keeps the city running. Just as millions in NYC depend on these aging but reliable utilities without thinking about them, billions worldwide rely on TradFi primitives. These systems, while effective, are burdened by inefficiencies such as delays, high costs, and limited accessibility, which have persisted through decades of innovation.
In contrast, DeFi offers a digital, self-optimizing layer to financial operations, analogous to retrofitting a city’s infrastructure with smart technology. It's like giving NYC's infrastructure a digital nervous system that can self-heal, optimize flows, and serve residents directly with fewer manual interventions. Through decentralized networks, DeFi brings automation, efficiency, and trustless exchanges, significantly reducing friction across various financial activities—such as lending, payments, settlement, and market making.
In this report, I examine 16 critical systems that keep the financial "city" functioning. For each topic, I will explain how things work in TradFi markets before presenting the DeFi alternative. My goal is to make these complex concepts accessible whether you're familiar with traditional finance, crypto, or just getting started with either.
Disclaimer: The views and opinions expressed are solely those of the author and do not necessarily reflect those of the author's current employer. This material is for informational purposes only and is not intended to provide legal, tax, financial, or investment advice. Recipients should consult their own advisors before making these types of decisions. The author is not responsible for errors, inaccuracies, or omissions of information; nor for the accuracy or authenticity of the information upon which it relies.
Table of Contents
1. Settlement & Clearing: T+1/T+2 Settlement vs. Atomic Settlement
Traditional Finance Approach
The settlement cycle in traditional markets refers to the time lag between trade execution (T) and the final transfer of securities to the buyer and cash to the seller. This system evolved from physical certificate exchange, where actual paper securities needed to be physically delivered against payment, necessitating time for processing, verification, and delivery.
The industry has progressively shortened this cycle from T+5 to T+3 (1993), T+2 (2017), and now to T+1 (effective May 2024) for most securities in the US and Canada.
The current process involves multiple steps and intermediaries:
Trade execution (T+0)
Allocations (by 7 p.m. ET on T+0)
Affirmations (verification between counterparties by 9 p.m. ET on T+0)
Clearing (reconciliation by the Depository Trust & Clearing Corporation or DTCC)
Final settlement (transfer of assets and funds on T+1)
Despite improvements, fundamental limitations persist:
Significant counterparty risk during the settlement lag
Capital inefficiency as funds remain tied up
Complex coordination between brokers, custodians, and clearing agencies
Dependency on business days and operating hours
Potential failures in the affirmation process causing delays
DeFi Alternative
DeFi revolutionizes this with atomic on-chain settlement, a fundamentally different approach where the exchange of assets occurs simultaneously and conditionally with near-instant finality once a block is confirmed. Decentralized exchanges (DEXs) eliminate central clearing houses – trades are settled peer-to-peer on a blockchain ledger. Key components include smart contracts that custody assets during the trade, automated market makers (AMMs) or order books to match trades, and atomic swap technology ensuring both sides of a trade execute or none do (removing counterparty risk). This means when you swap assets on a DEX, the exchange of Token A and Token B happens in one transaction or not at all, so neither party is left hanging.
How It Works (Example – AMM DEX):
A prominent mechanism for on-chain settlement is the AMM. For example, Uniswap uses liquidity pools instead of order books. Liquidity providers (LPs) deposit pairs of tokens into a pool (e.g. ETH and USDC), and a smart contract uses a formula (x*y = k) to quote prices. When a trader wants to swap ETH for USDC, they send ETH into the pool and take out USDC; the contract automatically recalculates the price based on the new ratio of assets. The trade settles immediately on-chain – the trader receives USDC in the same transaction, and the LP’s pool is updated. There is no separate clearing stage; final settlement is achieved once the transaction is confirmed on Ethereum. This atomic exchange is trustless: neither party needed to trust an intermediary or each other. For cross-chain settlement, atomic swaps can be used (via hash time-locked contracts) to swap assets across different blockchains without a custodian, although these are less common than same-chain DEX trades.
The technological underpinnings include:
Smart contracts that escrow both assets and only release them when all conditions are met
Hashed Timelock Contracts (HTLCs) or cross-chain messaging for interoperability
Consensus mechanisms that provide quick finality
Examples:
Curve Finance: A specialized DEX optimized for trading assets of similar value (like stablecoins), using a unique "StableSwap" algorithm that minimizes slippage. For instance, Curve’s pools allow near-instant clearing of large stablecoin trades with minimal price impact by concentrating liquidity on a narrow price band around $1.
Uniswap: The largest DEX by volume, using a constant product formula (x*y=k) for its general pools and concentrated liquidity in v3 to improve capital efficiency.
2. Banking & Deposits: Commercial Banks vs. DeFi Lending Protocols (Deposits)
Traditional Finance Approach
Commercial banking operates on the fractional reserve model that emerged over centuries as goldsmiths evolved into bankers. Originally, banks would issue receipts for gold deposits, eventually realizing they could lend more receipts than actual gold reserves since not all depositors would withdraw simultaneously.
Modern fractional reserve banking is operationally complex:
Banks accept deposits across various account types (checking, savings)
They maintain only a fraction as reserves (either at the central bank or as vault cash)
The remainder is lent out, creating "money" through the multiplier effect
Central banks traditionally set reserve requirements
Capital adequacy requirements under frameworks like Basel III have replaced or supplemented reserve requirements
Deposit insurance schemes (like FDIC in the US) protect depositors up to certain limits
This system creates significant drawbacks:
Interest rates on deposits are typically well below inflation
Deposit insurance has limits (e.g., $250,000 in the US)
Banking access requires meeting institutional requirements (identity verification, credit checks)
Limited transparency on how deposited funds are utilized
Slow movement of funds, especially internationally
DeFi Alternative
DeFi offers alternatives to traditional banking and deposit services through stablecoins and yield-bearing accounts. At its core, a stablecoin is a cryptocurrency pegged to a stable asset (usually USD) and acts as a digital dollar – essentially a deposit you hold in a crypto wallet rather than a bank account. Mechanisms in this category provide ways to store value securely, earn interest on deposits, and access money-like services without traditional banks.
Beyond just holding value, DeFi enables earning interest on those deposits. DeFi lending protocols offer a fundamentally different model where users directly supply assets to liquidity pools governed by smart contracts.
How It Works:
Alice has $5,000 in savings. Instead of leaving it in a bank at 0.1% interest, she converts it to 5,000 USDC and deposits into a DeFi lending protocol (say Compound). The smart contract pools her USDC with others and lends out to borrowers who pay interest. Alice starts accruing interest immediately; she can see her balance of cUSDC tokens slowly increase in value, reflecting earned interest (e.g., at 4% APY, she’d earn about 0.011% per day). She can withdraw her USDC plus interest anytime by redeeming the cUSDC. These operations are non-custodial – no bank holds Alice’s money, she interacts directly with smart contracts using her wallet, maintaining control of her funds.
The technological foundations of these protocols include:
Smart contracts that pool funds and enforce lending/borrowing rules
Algorithmic interest rate models that adjust based on utilization rates
Trustless escrow of funds with no human intermediaries
Real-time interest accrual often calculated per block
Over-collateralization to secure loans without credit checks
Examples:
Aave: A non-custodial liquidity protocol where users can deposit crypto assets and earn yield generated from borrowers. Upon supplying assets, users receive aTokens representing their share plus accumulated interest.
Compound: A similar protocol where suppliers receive cTokens that continuously accrue interest, with rates determined by supply and demand in each asset's market.
The overall DeFi market has experienced tremendous growth, with total value locked (TVL) surging by 211% to reach $214 billion by the end of 2024 according to a report by DappRadar (however, TVL currently sits at ~$95B as of April 2025). Lending platforms like Compound and Aave are major contributors to this expansion, utilizing TVL as a key measure of their liquidity and lending capacity which directly impacts their interest rates and loan offerings. Compound and Aave each have TVLs in the billions (Aave’s TVL was reported around $28 billion in April 2025 across all deployments.
3. Payments: SWIFT/ACH/Cards vs. Blockchain Payment Networks
Traditional Finance Approach
Traditional payment systems evolved separately across different geographies and use cases, creating a fragmented global landscape:
ACH (Automated Clearing House): Developed in the 1970s to replace paper checks, ACH processes payments in batches through central clearing houses.
Wire Transfers: Designed for high-value, time-sensitive payments, wires involve direct, real-time message exchange between banks. Fedwire (operated by the Federal Reserve) and CHIPS (Clearing House Interbank Payments System) handle domestic large-value transfers. These systems prioritize speed and certainty over cost, explaining their $20-50 fee structures.
SWIFT: Created in the 1970s, SWIFT addressed the need for standardized international banking communications. It's important to note that SWIFT itself doesn't move money—it's a messaging system that coordinates payments through a correspondent banking network, explaining the delays (1-6 days) and high costs of international transfers.
Card Networks: Visa and Mastercard built infrastructure connecting consumers, merchants, acquiring banks, and issuing banks. Their complex fee structures (interchange, processing fees) reflect the multi-party nature of these transactions and the value-added services they provide.
These systems face common limitations:
Variable settlement speeds constrained by batch processing, business hours, and intermediaries
High costs for cross-border transactions due to multiple involved parties
Limited transparency on transaction status and fees
Accessibility barriers for the unbanked/underbanked
DeFi Alternative
DeFi’s payment mechanisms enable fast, low-cost, global payments using crypto assets, effectively creating an alternative payment rail. Users and merchants can transact with stablecoins. The volume and growth of crypto payments underline their significance. By the end of 2024, stablecoins had settled more than $27.6 trillion in on-chain transactions, which remarkably outpaced Visa and Mastercard's combined transaction volume by 7.68% (CryptoSlate).
How It Works:
A simple blockchain payment is a token transfer from one wallet to another – for example, sending 100 USDC from Alice to Bob for a service. The transaction is broadcast to the network, miners/validators include it in a block, and within a short time Bob has the USDC in his wallet, which he can then swap to local currency or use elsewhere. On Ethereum mainnet, a USDC transfer might cost a few dollars in gas, which is why layer-2 solutions (like Polygon, Optimism, Arbitrum) are often used – on these networks the same payment might cost a fraction of a cent and confirm in seconds.
The technological foundations include:
Public blockchain networks that operate continuously without central authorities
Stablecoins pegged to fiat currencies to avoid crypto price volatility
Non-custodial wallets that give users full control of their funds
Cross-chain bridges to enable interoperability between different networks
Examples:
Circle's USDC: A regulated stablecoin backed 1:1 by US dollar reserves, usable across multiple blockchains including Ethereum, Solana, and Polygon. Circle provides business-focused infrastructure for global payments.
Stellar: A network specifically designed for payments and cross-border transfers, focusing on connecting financial institutions, payment systems, and individuals with minimal fees.
4. Lending & Credit: Bank Loans vs. DeFi Lending Protocols (Borrowing)
Traditional Finance Approach
Traditional lending evolved from interpersonal lending to institutional frameworks as economies grew and specialized. Modern bank lending involves a complex underwriting process:
Loan officers collect extensive documentation (income verification, credit history, collateral valuation)
Credit scoring models (like FICO in the US) standardize risk assessment
Risk departments assess the probability of default based on historical data
Loans are priced based on risk assessment, funding costs, and profit margins
Approved loans are disbursed, then monitored for repayment
Non-performing loans trigger collections processes
This system developed to address information asymmetry between borrowers and lenders. Without reliable data on borrower creditworthiness, lenders would face adverse selection (attracting high-risk borrowers) and moral hazard (borrowers taking excessive risks). Credit bureaus, standardized documentation, and regulatory frameworks evolved to mitigate these risks.
The system has significant limitations:
Lengthy approval processes (days to weeks)
Exclusion of those without established credit histories
Subjective elements in underwriting can perpetuate biases
Inflexible terms once loans are originated
DeFi Alternative
DeFi lending takes a fundamentally different approach by replacing identity-based credit assessment with collateral-based asset verification. The fundamental mechanism is over-collateralized lending via smart contracts: users can deposit crypto assets as collateral and borrow other assets against it. This mirrors a secured loan (like a mortgage, where the house is collateral) but happens trustlessly on-chain – if the borrower doesn’t repay, the collateral is automatically liquidated to cover the loan.
How It Works
A holder of $100,000 worth of Ethereum can deposit it as collateral in a MakerDAO Vault and borrow up to $66,000 in DAI (at 150% collateralization ratio). Importantly, loans are typically over-collateralized (user has to lock in more value than he borrowed). This provides liquidity without selling the original asset, potentially avoiding capital gains taxes. The borrower must actively monitor collateral ratios and add more collateral or repay part of the loan if ETH price drops, or risk liquidation.
New mechanisms like Morpho have emerged to improve capital efficiency by matching lenders and borrowers peer-to-peer on top of these pools. For example, Morpho sits atop Compound/Aave. When a lender and borrower can be matched directly, both get a better rate (somewhere between the pool’s deposit and borrow rate). If no match is available, they fall back to the pool, ensuring no one waits for a counterparty. This hybrid P2P model can boost yields.
The technological underpinnings include:
Smart contracts that escrow collateral and release loans
Oracles that feed real-time price data to assess collateralization ratios
Automated liquidation mechanisms that maintain system solvency
Decentralized governance to set system parameters
Example:
MakerDAO: Users can deposit collateral (ETH, WBTC, etc.) in "Vaults" to generate DAI stablecoin loans. If collateral value falls below the required threshold, the position is automatically liquidated.
5. Asset Management: Mutual Funds/ETFs vs. On-Chain Asset Management
Traditional Finance Approach
The modern asset management industry developed to provide professional investment management and diversification to retail and institutional investors. The operational mechanics include:
Fund Structure: Mutual funds are typically organized as separate legal entities (e.g., investment companies under the Investment Company Act of 1940 in the US), with assets held by a custodian bank separate from the fund manager.
NAV Calculation: A fund administrator calculates the daily Net Asset Value (NAV) by valuing all holdings and subtracting liabilities, then dividing by outstanding shares.
Distribution: Mutual funds are sold directly or through broker-dealers, with transactions typically processed at the end-of-day NAV.
ETF Creation/Redemption: ETFs add a layer of complexity through the "in-kind" creation/redemption process. Authorized Participants (APs) exchange baskets of underlying securities for ETF shares (creation) or vice versa (redemption), providing market efficiency and tax advantages.
This complex ecosystem evolved to provide investor protection through segregation of duties, regulatory oversight, and economies of scale. The multiple intermediaries (manager, administrator, custodian, transfer agent, distributor) reflect specialization and institutional checks and balances.
Limitations include:
High expense ratios eating into returns
Limited transparency on holdings (often quarterly disclosure)
Trading constraints (end-of-day pricing for mutual funds)
Complex fee structures including hidden costs
DeFi Alternative
DeFi asset management platforms use smart contracts to create on-chain investment vehicles.
How It Works
Dana has 1000 USDC and wants to earn yield but doesn’t want to constantly switch platforms. She deposits her USDC into a Yearn vault. Behind the scenes, Yearn deploys those funds to, say, lend on Compound. Compound gives COMP tokens as rewards for lending; the Yearn vault automatically sells Dana’s share of COMP for more USDC and deposits back, growing the pool. If Compound’s rate drops and another protocol (perhaps a Uniswap USDC-ETH LP that yields trading fees + incentives) is more lucrative, Yearn’s strategists shift the strategy. Yearn aggregates everyone’s funds to execute the strategy at scale, saving costs.
Another rapidly growing area has been liquid staking derivatives (LSDs) – arguably asset management of staked ETH. Lido, for example, lets users stake ETH and receive stETH token, which appreciates as staking rewards come in. Lido’s stETH essentially manages a huge pool of ETH (over 9 million ETH, ~$16B in 2025) on behalf of users, distributing rewards. This shows how even participation in blockchain consensus (staking) became wrapped in an asset management tool.
The technological underpinnings include:
Smart contracts that enforce investment parameters and fee structures
Composability allowing interaction with other DeFi protocols
Automated NAV calculation and fee accrual
On-chain transparency of all transactions and holdings
Examples:
Yearn.finance (Yield Farming Protocols): Yearn Finance demonstrates the use of TVL to optimize yield farming strategies, attracting investors by automatically moving assets to protocols offering the highest returns.
Lido: Lets users stake ETH and receive stETH token, which appreciates as staking rewards come in.
6. Insurance: Traditional Insurance vs. DeFi Risk Pooling
Traditional Finance Approach
Insurance evolved from informal risk-pooling arrangements like merchant guilds to today's highly regulated industry. The operational mechanics include:
Underwriting: Actuaries analyze historical data to estimate the probability and severity of covered events, determining appropriate premium levels.
Risk Pooling: Insurers aggregate premiums from many policyholders to pay claims for the few who experience losses, based on the law of large numbers.
Claims Processing: Adjusters investigate incidents, determine coverage, and assess damage to establish appropriate payouts.
Reserves and Capital Requirements: Regulators require insurers to maintain adequate reserves for expected claims and capital buffers for unexpected losses.
Reinsurance: Insurers often purchase their own insurance (reinsurance) to manage catastrophic risks that could threaten solvency.
This system developed to address information asymmetry (adverse selection and moral hazard) while providing a financially sustainable model for risk transfer. The extensive regulation reflects both consumer protection concerns and the systemic importance of insurer solvency.
Limitations include:
High operational costs reducing premium-to-payout ratios
Claims processes that can be slow, adversarial, and opaque
Incentive misalignment between insurers (profit from denied claims) and policyholders
Exclusionary practices limiting access for high-risk individuals or communities
DeFi Alternative
DeFi insurance protocols use smart contracts to create decentralized risk pools.
How It Works
A user depositing $50,000 in Aave wants protection against smart contract risk. They purchase coverage from Nexus Mutual, paying a premium based on the perceived risk of Aave's contracts. If Aave experiences a hack resulting from a smart contract vulnerability, the user submits a claim with evidence of their loss. NXM token holders vote on claim validity, and if approved, the user receives compensation from the capital pool.
The technological underpinnings include:
Smart contracts that manage capital pools and process claims
Staking mechanisms where capital providers earn premiums for backing specific risks
Decentralized governance for claims assessment and risk parameter setting
Token incentives to align stakeholder interests
Examples:
Nexus Mutual: A member-owned cooperative providing coverage for smart contract failures, exchange hacks, and other crypto-specific risks. Members stake NXM tokens to provide coverage capacity.
InsurAce: A multi-chain insurance protocol offering coverage for smart contract vulnerabilities, custodian risks, and stablecoin de-pegging events.
7. Derivatives: Exchange-Traded Derivatives vs. On-Chain Derivatives
Traditional Finance Approach
Derivatives evolved from agricultural forward contracts to today's sophisticated market with standardized contracts and central clearing. The operational mechanics include:
Contract Standardization: Exchanges developed standardized terms for futures contracts (asset quality, delivery terms, contract size) to promote liquidity and price discovery.
Central Counterparty Clearing: CCPs evolved to eliminate counterparty risk by becoming the buyer to every seller and seller to every buyer, a structure that prevented cascading defaults during crises.
Margining System: Initial margin provides a buffer against potential losses, while variation margin (daily mark-to-market) prevents the accumulation of unsettled losses.
Risk Models: Sophisticated models like SPAN (Standard Portfolio Analysis of Risk) calculate margin requirements based on historical volatility, correlations, and stress scenarios.
This infrastructure developed to manage the inherent leverage and counterparty risks in derivatives trading while promoting market efficiency. The extensive regulation reflects derivatives' role in previous financial crises and their systemic importance.
Limitations include:
High barriers to entry due to margin requirements and broker relationships
Limited customization compared to OTC derivatives
Complex and potentially opaque margin calculations
Dependence on the operational and financial resilience of CCPs, which themselves can become points of systemic risk
DeFi Alternative
DeFi has developed a rich suite of derivatives analogous to those in traditional markets: futures, options, swaps, and synthetic assets. DeFi derivatives protocols use smart contracts to create on-chain derivative markets without centralized intermediaries. The core mechanisms include perpetual futures contracts (perpetual swaps) that mimic futures with no expiry, on-chain options (calls and puts on crypto assets), and synthetic asset protocols that create tokens tracking the value of assets.
How It Works
A perpetual swap is essentially a futures contract that auto-rolls indefinitely, with a funding rate mechanism to tether its price to the spot index. On dYdX (which operates an order book on a Layer-2), traders deposit USDC as collateral and can go long or short on, say, BTC-USD with up to 20x leverage. If Alice goes long 5x on BTC with $1000, she’s controlling a $5k position. Every hour, depending on whether the perp price is above or below the true BTC price, she’ll pay or receive a small funding payment (ensuring the contract price doesn’t drift too far from spot). If BTC’s price rises 10%, her position earns 50% (5x leverage), so a $500 profit she can withdraw; if BTC falls 10%, she loses $500 (if it fell 20%, she’d be liquidated since she only had $1000 collateral to start). The smart contract handles these automatically: it matches trades (dYdX uses off-chain matching with on-chain settlement), calculates unrealized P/L, and will liquidate positions that breach maintenance margin by selling the collateral to cover the loss.
The technological underpinnings include:
Smart contracts that hold collateral and enforce trading rules
Oracles that provide price feeds for settlement and liquidations
Automated liquidation mechanisms to maintain system solvency
Pooled counterparty models where all participants collectively back the system
Examples:
Synthetix: A protocol for creating synthetic assets ("Synths") that track the price of underlying assets without requiring ownership of the actual asset, using SNX token as collateral.
dYdX: A decentralized exchange for perpetual futures contracts with up to 20x leverage, using a hybrid model combining on-chain settlement with off-chain order books.
8. Foreign Exchange: FX Markets vs. Decentralized Exchange
Traditional Finance Approach
The modern FX market evolved from the Bretton Woods fixed exchange rate system to today's massive OTC market. The operational mechanics include:
Interbank Market: Large banks serve as market makers, quoting bid-ask spreads to clients and each other, creating a tiered market structure.
Correspondent Banking: Banks maintain accounts with each other (nostro/vostro relationships) to facilitate settlement across currencies.
Continuous Linked Settlement (CLS): Established in 2002 after the Bankhaus Herstatt failure highlighted settlement risk (one party pays but doesn't receive), CLS provides Payment-versus-Payment (PvP) settlement for 18 major currencies.
Electronic Trading Platforms: Systems like EBS and Reuters Matching provide electronic price discovery and execution for the interbank market.
This infrastructure developed to address the unique challenges of settling transactions across different currencies, time zones, and national payment systems. The role of central banks and correspondent banks reflects the sovereign nature of currencies and the need for ultimate settlement in central bank money.
Limitations include:
High costs for retail and small business customers due to wide spreads and fees
Limited transparency on pricing and execution
Restricted access for smaller participants
Settlement delays due to operating hours and correspondent banking chains
DeFi Alternative
DeFi exchanges use automated market makers (AMMs) and liquidity pools for permissionless currency exchange.
How It Works
An individual in Europe holding USDC wants to convert to EUR. They connect their wallet to Curve Finance and swap USDC for EURS (a euro-backed stablecoin) in a single transaction that settles in seconds with minimal slippage. The trade executes directly against the liquidity pool with no counterparty risk and fees of less than 0.1%.
The technological underpinnings include:
Smart contracts that hold liquidity and execute trades
Algorithmic pricing based on pool balances rather than order books
Atomic settlement eliminating counterparty risk
Liquidity provider incentives through trading fees and sometimes token rewards
Example:
Curve Finance: A specialized DEX optimized for trading assets of similar value (like stablecoins), using a unique "StableSwap" algorithm that minimizes slippage.
9. Identity & KYC: Traditional KYC vs. Decentralized Identity
Traditional Finance Approach
KYC procedures evolved from basic customer identification to today's complex compliance regimes. The operational mechanics include:
Customer Due Diligence: Financial institutions collect personally identifiable information (PII) and verify it against government-issued documentation.
Risk Assessment: Customers are categorized by risk level based on factors like jurisdiction, business activities, and transaction patterns.
Screening: Verified identities are checked against sanctions lists, politically exposed persons (PEP) databases, and adverse media.
Ongoing Monitoring: Customer transactions are monitored for suspicious activity, with periodic reviews of high-risk relationships.
This infrastructure developed in response to anti-money laundering (AML) regulations that expanded significantly after the 9/11 attacks through legislation like the USA PATRIOT Act. The siloed approach reflects both the historical development of separate financial institutions and data privacy considerations.
Limitations include:
Repetitive onboarding processes across different institutions
Security and privacy risks from centralized PII databases
High compliance costs passed on to customers
Exclusion of individuals without standard documentation
DeFi Alternative
Identity and KYC (Know Your Customer) in DeFi address the challenge of verifying user identities, reputations, or credentials without sacrificing decentralization and privacy. Some examples include decentralized identity (DID) systems (e.g., self-sovereign identity frameworks) and on-chain reputation and credit scoring (tracking address behavior to infer creditworthiness)
How It Works
A user completes KYC with a regulated entity that issues a Verifiable Credential to their Polygon ID wallet. Later, when accessing a DeFi platform that requires KYC, the user generates a Zero-Knowledge Proof demonstrating they've been verified without revealing their personal data. The platform instantly verifies the proof's cryptographic validity without receiving or storing any PII.
The technological underpinnings include:
Decentralized Identifiers (DIDs) registered on blockchains
Verifiable Credentials (VCs) issued by trusted entities
Zero-Knowledge Proofs (ZKPs) enabling selective disclosure
User-controlled digital wallets storing credentials
Example:
Polygon ID: A self-sovereign identity framework using zero-knowledge proofs to enable privacy-preserving verification of credentials.
10. Custody: Bank/Broker Custody vs. Self-Custody/Smart Contract Custody
Traditional Finance Approach
Custody evolved from physical safekeeping of certificates to today's complex digital record-keeping. The operational mechanics include:
Asset Segregation: Customer assets are legally and operationally segregated from the custodian's own assets, often in "omnibus accounts" at central securities depositories.
Reconciliation: Regular reconciliation processes ensure records match across the custodian, sub-custodians, and central securities depositories.
Corporate Actions: Custodians collect dividends, process stock splits, and facilitate proxy voting for securities.
Regulatory Controls: Frameworks like SEC Rule 15c3-3 (the "Customer Protection Rule") mandate safekeeping practices and reserve requirements.
This infrastructure developed to address the operational complexities of securities ownership in a multi-tiered market structure while providing investor protection. The role of regulated custodians reflects both practical needs for specialized services and regulatory requirements.
Limitations include:
Dependence on the custodian's operational integrity and financial solvency
Limited transparency into actual asset location and handling
Potential for rehypothecation or misuse of customer assets
Complex cross-border custody chains increasing operational risks
DeFi Alternative
Custody in DeFi refers to how digital assets are stored and secured, with a strong emphasis on self-custody (users holding their own private keys) as opposed to entrusting funds to intermediaries. For institutions or less crypto-savvy users, MPC (multi-party computation) wallets allow a form of distributed key where no single device has the whole private key; instead, multiple parties (or servers) each hold a shard and they collaboratively sign transactions without ever exposing the full key.
How It Works
A DAO treasury uses Safe{Wallet} configured to require 4-of-7 signatures from core contributors to authorize any spending. The treasury's assets are held directly by the smart contract on the blockchain, visible to anyone. When the DAO votes to fund a grant, the authorized signers review and sign the transaction, which executes only after reaching the required threshold of signatures (4-of-7 signatures).
The technological underpinnings include:
Public-private key cryptography enabling direct asset control
Multi-signature technology distributing security across multiple keys
Time-locks and transaction limits for enhanced security
On-chain transparency of all asset movements
Examples:
Self-Custody Wallets: Non-custodial wallets like MetaMask where users control their private keys directly.
Safe{Wallet} (formerly Gnosis Safe): Smart contract wallets that implement multi-signature security, requiring multiple authorized signers to approve transactions.
11. Market Making: Traditional Market Making vs. Automated Market Makers
Traditional Finance Approach
Market making evolved from designated specialists on exchange floors to today's electronic market makers. The operational mechanics include:
Two-Sided Quotes: Market makers continuously post bid and ask prices in a central limit order book, standing ready to buy or sell the asset.
Spread Capture: The primary revenue source is capturing the bid-ask spread across many transactions, with sophisticated firms executing millions of trades daily.
Inventory Management: Market makers actively manage their position inventory to minimize directional risk.
Risk Controls: Sophisticated algorithms adjust quotes based on volatility, order flow toxicity, and market conditions.
This structure evolved to address the fundamental need for continuous liquidity in markets. The specialization of market making firms reflects the capital, technology, and expertise required to profitably perform this function while managing risks.
Limitations include:
High barriers to entry due to capital requirements and technology costs
Potential for liquidity withdrawal during market stress
Information asymmetries between professional market makers and other market participants
Limited transparency into market making practices
DeFi Alternative
Automated Market Makers (AMMs) use smart contracts and liquidity pools to enable permissionless trading. Instead of specialized firms posting buy/sell orders (as in traditional order books), DeFi allows anyone to become a market maker by contributing assets to liquidity pools, and pricing is handled by algorithms. Liquidity pools aggregate capital from many individuals, and trading fees are split among them, providing incentive to supply liquidity.
How It Works
An individual with $10,000 in ETH and $10,000 in USDC provides liquidity to the ETH/USDC pool on Uniswap V3, concentrating their liquidity between $1,800-$2,200 per ETH. They receive LP tokens representing their share of the pool and earn 0.3% fees on trades that occur within their price range, effectively becoming a passive market maker without needing specialized trading knowledge or active management. Over many trades, LPs earn a lot of fees, but also they experience impermanent loss – if the price of ETH moves significantly from when they deposited, the value of their pool share may be less than if they just held assets, because the AMM would end up holding more of the less valuable asset. Nevertheless, if fee earnings exceed impermanent loss, LPs profit.
The technological underpinnings include:
Smart contracts that hold liquidity and execute trades
Mathematical formulas (bonding curves) that determine prices based on pool ratios
Liquidity provider (LP) tokens representing pool shares
Fee mechanisms to incentivize liquidity provision
Examples:
Uniswap: The most widely used AMM, utilizing the constant product formula (x*y=k) in v2 and concentrated liquidity in v3 to improve capital efficiency.
Curve Finance: A specialized AMM optimized for stable asset pairs, using a StableSwap invariant that minimizes slippage for assets expected to trade at or near parity.
12. Monetary Policy: Central Banks vs. Algorithmic Monetary Policy
Traditional Finance Approach
Central banking evolved from private banks of issue to today's independent monetary authorities. The operational mechanics include:
Open Market Operations: Central banks buy or sell government securities to inject or withdraw money from the banking system, affecting interest rates.
Reserve Requirements: Mandating minimum reserve ratios for commercial banks (though many central banks have reduced or eliminated these).
Policy Rate Setting: Directly setting key interest rates that influence interbank lending and, by extension, the broader economy.
Forward Guidance: Communicating future policy intentions to shape market expectations.
Quantitative Easing/Tightening: Large-scale asset purchases or sales during extraordinary circumstances.
This infrastructure developed to address monetary stability needs as economies moved from commodity money to fiat currencies. The independence of central banks reflects the political temptation to manipulate money for short-term gain at the expense of long-term stability.
Limitations include:
Political pressure potentially compromising independent decision-making
Information lags affecting policy timing and effectiveness
Uneven transmission of monetary policy across economic sectors
Limited tools to address specific regional or sectoral issues
DeFi Alternative
DeFi protocols implement algorithmic monetary policy through smart contracts, particularly for stablecoins.
How It Works
When FRAX stablecoin trades above $1 due to high demand, the protocol's algorithm automatically decreases the collateral ratio, allowing new FRAX to be minted with less USDC collateral and more FXS tokens. This incentivizes arbitrageurs to mint FRAX (at cheaper input costs) and sell it on the market, increasing supply and pushing the price back toward $1.
The technological underpinnings include:
Smart contracts that automatically adjust monetary parameters
Oracles providing real-time market data
Economic incentives that encourage arbitrage to maintain pegs
Governance mechanisms for parameter adjustment
Examples:
FRAX Finance: A fractional-algorithmic stablecoin that adjusts its collateral ratio (CR) based on market conditions to maintain its $1 peg.
MakerDAO: Governs the DAI stablecoin through adjustable parameters like the Stability Fee (interest rate) and Debt Ceiling, determined through token holder governance.
13. Capital Markets: IPOs/Bond Issuance vs. Token Offerings
Traditional Finance Approach
Capital raising evolved from private placements to today's regulated public offerings. The operational mechanics include:
Issuer Preparation: Financial statement audits, business plan development, and corporate governance improvements prepare companies for public scrutiny.
Underwriting: Investment banks assess issuer quality, help determine offering size and price, and commit to purchasing shares for resale to investors.
Registration/Prospectus: Detailed disclosures are filed with regulators (e.g., S-1 with the SEC) providing comprehensive information to potential investors.
Marketing/Roadshow: Company executives present to institutional investors to gauge interest and build a book of orders.
Pricing/Allocation: Final offering price is set based on demand, with shares allocated to investors through the underwriters.
This infrastructure developed to address information asymmetry between issuers and investors while providing efficient capital formation. The extensive regulation reflects historical abuses and investor protection concerns.
Limitations include:
High costs (typically 5-7% of capital raised for IPOs) due to multiple intermediaries
Length process (often 6-9 months) delaying access to capital
Limited access for retail investors in desirable offerings
Geographical restrictions limiting cross-border capital formation
DeFi Alternative
Token offerings leverage blockchain technology to raise capital directly from investors.
How It Works
A Web3 project conducts an IDO on Balancer, using a Liquidity Bootstrapping Pool that starts with a high token price and gradually decreases it over 72 hours. This mechanism discourages front-running and allows price discovery. Investors connect their wallets and participate directly without intermediaries. Upon completion, trading begins immediately on decentralized exchanges, providing liquidity for both investors and the project.
The technological underpinnings include:
Smart contracts managing token distribution and funding collection
Decentralized exchanges providing immediate liquidity
Token standards (ERC-20, ERC-1400) defining behavior and compatibility
On-chain transparency of all transactions and token movements
Examples:
Initial DEX Offerings (IDOs): Projects launch tokens directly through decentralized exchanges like Balancer or PancakeSwap, often using liquidity bootstrapping pools.
Security Token Offerings (STOs): Platforms like Polymath facilitate compliant issuance of security tokens representing traditional assets like equity or debt.
14. Cross-Border Finance: Correspondent Banking vs. Blockchain Networks
Traditional Finance Approach
Cross-border payments evolved from physical gold shipments to today's correspondent banking networks. The operational mechanics include:
Nostro/Vostro Accounts: Banks maintain accounts with each other in different currencies, creating a network of bilateral relationships.
SWIFT Messaging: Banks exchange standardized messages (e.g., MT103 for credit transfers) to initiate and confirm transactions.
Serial Processing: Payments often hop through multiple banks (correspondent chain) before reaching the final beneficiary.
FX Conversion: Currency exchange typically occurs at one or more points in the payment journey, often at non-transparent rates.
Compliance Checks: Each bank performs its own sanctions and AML screening, potentially introducing delays.
This infrastructure developed to address the practical challenges of transferring value across jurisdictions with different currencies, regulations, and payment systems. The complexity reflects both historical legacy and the sovereign nature of financial systems.
Limitations include:
High costs (often 3-7% for retail remittances) due to multiple intermediaries
Slow settlement (typically 2-5 days) due to sequential processing
Limited transparency on status and fees
Restricted access hours based on banking hours in relevant jurisdictions
DeFi Alternative
Blockchain networks enable direct cross-border value transfer without traditional intermediaries.
How it Works
A Filipino worker in Dubai needs to send money home to family in Manila. Using a Stellar-based app like Vibrant, they convert UAE Dirhams to USDC and send it directly to their family's digital wallet in the Philippines. The transfer completes in seconds at a cost of less than 1%, compared to traditional remittance services charging 3-7% and taking days.
The technological underpinnings include:
Distributed ledgers providing a shared source of truth across borders
Native digital assets or stablecoins for value transfer
Atomic settlement eliminating counterparty risk
Continuous 24/7/365 operation regardless of location
Examples:
Stellar: A network specifically designed for payments and cross-border transfers, focusing on connecting financial institutions, payment systems, and individuals.
Strike (built on Lightning Network) allows a user to send money across borders by converting fiat to BTC behind the scenes and back to fiat for the receiver, all abstracted in an app. They launched in El Salvador to help wit
15. Risk Management: Traditional Hedging vs. DeFi Risk Instruments
Traditional Finance Approach
Risk management evolved from simple insurance to today's sophisticated derivatives markets. The operational mechanics include:
Risk Identification: Quantitative analysis of exposure to various risks (market, credit, operational, etc.).
Derivatives Contracting: Customized or standardized contracts transferring specific risks (options, futures, swaps, etc.).
Margining and Collateral: Initial and variation margin requirements to manage counterparty risk.
Netting Agreements: Legal arrangements allowing offsetting of exposures between counterparties.
Credit Enhancements: Third-party guarantees, letters of credit, or insurance further mitigating risks.
This infrastructure developed to address the need for price discovery, risk transfer, and uncertainty management in complex economies. The extensive regulation reflects both consumer protection concerns and systemic risk considerations.
Limitations include:
High barriers to entry due to minimum transaction sizes and specialized knowledge
Complex documentation and legal frameworks
Counterparty risk despite margining and clearing mechanisms
Limited transparency in OTC markets
DeFi Alternative
DeFi offers programmable risk management instruments accessible to anyone.
How It Works
An ETH holder concerned about potential price declines uses Opyn to purchase put options giving them the right to sell ETH at a specified price within a certain time frame. The options are fully collateralized by funds in the protocol's smart contracts, eliminating counterparty risk. The entire process occurs on-chain without traditional brokers or clearinghouses.
Another example: automated market makers for options (Lyra on Optimism uses a volatility surface to price options and adjust liquidity dynamically) let users buy a put option to hedge (spend a premium to get insurance against price drops).
The technological underpinnings include:
Smart contracts automating option issuance, exercise, and settlement
Liquidity pools providing capital for options writing
Oracles supplying price data for settlement
On-chain transparency of all positions and transactions
Examples:
16. Security and Trust Models: Institutional Trust vs. Cryptographic Verification
Traditional Finance Approach
Financial security evolved from physical vaults to today's complex cybersecurity systems. The operational mechanics include:
Perimeter Security: Firewalls, intrusion detection, and physical access controls protecting financial systems.
Identity and Access Management: Multi-factor authentication and least-privilege principles controlling system access.
Regulatory Examinations: Regular audits by regulators ensuring compliance with security standards.
Business Continuity Planning: Redundant systems and disaster recovery plans ensuring operational resilience.
Insurance and Guarantees: Deposit insurance, errors and omissions coverage, and bonds providing financial protection.
This infrastructure developed to address the practical challenges of securing financial operations while maintaining client trust. The extensive regulation reflects both consumer protection concerns and financial stability considerations.
Limitations include:
Reliance on institutional reputation and regulatory oversight
Centralized databases creating "honeypots" for attackers
Information asymmetry between institutions and clients regarding security practices
Significant time lags in discovering and disclosing breaches
DeFi Alternative
DeFi uses cryptographic mechanisms and economic incentives to create trustless security.
How It Works
MakerDAO implements multiple security layers: formal verification of core contracts, multi-sig controls requiring multiple key holders to authorize changes, time-delayed governance actions allowing users to exit if they disagree with changes, and a multi-million dollar bug bounty program incentivizing vulnerability disclosure.
The technological underpinnings include:
Open-source code enabling community review
Immutable transactions providing audit trails
Economic incentives aligning participant interests
Multi-sig and time-lock mechanisms adding security layers
Examples:
Formal Verification: Companies like Runtime Verification use mathematical proofs to verify smart contract correctness before deployment.
Bug Bounty Programs: Platforms like Immunefi facilitate security research by rewarding white hat hackers who find vulnerabilities.