TradFi or traditional finance is the mainstream financial system. Institutions operate on this system. Some institutions include, for example, banks, hedge funds or brokerage firms.
What is TradFi (Traditional Finance) Theory?
TradFi stands for “traditional finance”. In other words, it meets the mainstream financial system in which institutions operate. TradFi is characterized by a high degree of centralization control and the exclusion of individual investors from many financial services offered in crypto, such as participating in Automated Market Maker (AMMs) or investing in trading firm with tools like flexUSD.
Traditional finance theory is based on three basic assumptions:
- All people are rational.
- Individual choices are consistent with expected utility theory.
- People accurately update their ideas and beliefs based on new information received.
Traditional Finance Theories
Traditional finance (TradFi) theories; It consists of Markowitz’s Modern Portfolio Theory and the Capital Asset Pricing Model and Arbitrage Pricing Theory built on its foundations. The Efficient Markets Hypothesis is the building block of traditional market assumptions.
Modern Portfolio Theory
According to the Traditional Portfolio Theory, the aim of the investor is to maximize the expected return on the investment at a level of risk that he will accept. To achieve this goal, it creates a portfolio by bringing together multiple assets. Purpose of creating a portfolio
to reduce risk through diversification. Traditional portfolio theory has been criticized on the grounds that it is difficult to manage an over-diversified portfolio, there is a possibility to include securities that do not provide the required return, and that excessive diversification will increase research and transaction costs.
Capital Asset Pricing Model,
The Capital Asset Pricing Model begins where Markowitz’s efficient frontier ends. The main objective of the theory is to calculate the theoretically correct price of a new asset to be added to a sufficiently diversified portfolio according to the systematic risk of this asset. The asset’s sensitivity to systematic risk is measured by the beta coefficient. This coefficient shows the relationship between the expected return of the security and the degree of risk, and this relationship is generally linear. In short, low betas are interpreted as low returns, and high betas as high risk.
Arbitrage Pricing Theory
The theory was developed by Stephan Ross in 1976 as an alternative to SVFM. The basic idea of the theory based on the law of one price; The expected return of stocks is dependent on macroeconomic factors independent of each other and microeconomic factors belonging to the enterprise. The sensitivity of the portfolio return to the relevant factors included in the model is measured by the beta coefficient. The rate of return determined by the model is used to convert the future cash flows of the stock to the present. If the theoretically calculated price is different from the current price, the arbitrage phenomenon brings the price to the right level over time. In summary, AFT assumes that the returns of two portfolios with the same betas will be the same.
TradFi in Crypto
Michael Casey, Co-Founder of Streambed Media and economics writer, argues that traditional finance and decentralized economic systems should work together in an article published on the IMF’s website. He also states that these two models can develop together with open standards and certain rules.
While highlighting the need to integrate decentralized assets with some regulators that bring functionality and stability to TradFi, he notes that DeFi and crypto can be addressed through financial innovation fostered by open-source developer communities.
Noting also how to follow the path for TradFi application in crypto, Casey uses the following statements in his article:
“If we can’t keep Bitcoin under control, then the goal should be to move it away from renewable sources or fossil fuel sources. The time has come for sensible energy policies that remove subsidies for dirty power plants and persuade Bitcoin miners to provide long-term financing commitments to renewable providers with minimum capacity thresholds for their communities.”
You can reach Michael Casey’s full article titled “DEFI” AND “TRADFI” MUST WORK TOGETHER at the link.