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Impact of Recent Institutional Interest in DeFi

A further look into the recent impact and trends on DeFi from recent institutional interest and the remaining barriers to entry for further traditional investor adoption.

Recent Interest in DeFi

Traditional financial institutions and investors are beginning to take notice of the developing decentralized finance (DeFi) space. A new survey from the asset-management giant, Fidelity, finds that 80% of 800 interviewed investors find digital assets to be appealing. Over a third of the respondents mentioned that their portfolio has direct or indirect investments in some form of a digital asset. Additionally, Fidelity also found that the number of U.S. investors who hold digital assets has increased from 22% in 2019, to 27% in Q2 2020.

The director of research at Fidelity Digital Assets stated that the recent surge of adoption comes from the decentralized nature of digital assets in comparison to traditional assets, the unconventional monetary policies amid COVID-19, and the high potential of the underlying technology.

Beyond the acquisition of digital assets, traditional investment firms are expanding their reach and looking to allocate resources to develop the DeFi ecosystem. The Chicago DeFi Alliance (CDA) is an initiative composed of the top brokerage, trading, and investment firms that are supporting crypto start-ups with financing, market making, liquidity provision, product feedback, professional traders, and talent. Institutions such as TD Ameritrade, CMT Digital, DV Trading, and Arca are some of the members of the CDA Initiative. An overall goal by all firms is to provide real-world trading feedback and introduce regulatory requirements to the DeFi ecosystem to help develop the space. The entrance of traditional financial institutions into DeFi is an exciting step for both industries; however, there are still concerns that the space is not ready for large institutions. At Conflux Network, we are working to build a solid foundation to make the space ready for institutional finance based on the current roadblocks investors are facing.

Impact on DeFi

The sudden exposure to established investors is having a positive impact on the DeFi space. With recent injections of liquidity, it is evident that the market is feeling the effects and making changes to welcome the once skeptical private sector. Before this year, futures, options, and derivatives were practically non-existent in the space; but as seasoned investors joined the space, the surge of adoption for investment hedging platforms such as Opyn and Nexus Mutual took off.

In the last 3 months, the number of unique addresses interacting with Opyn’s hedging token oTokens has nearly tripled, protecting more users against DeFi risks. (source)

A CryptoCompare report found digital asset derivatives trading volumes had peaked at $602 billion in May, a new all-time high. The correlation between the increase of value in DeFi risk management and institutional adoption is apparent when noting the growth from 9% in 2019 to 22% in 2020 of U.S. investors with exposure to cryptocurrency futures. While at the same time, the overall total locked value in decentralized derivatives such as Opyn, Synthetix, and Nexus Mutual has grown from $1.96 million in January 2019, to $300 million in June 2020, making it one of the fastest-growing sectors in the DeFi ecosystem, although not all the credit can be given to institutional investors. It is evident that as the growth of cryptocurrency futures grew this year, the derivatives market in DeFi followed, CryptoCompare CEO Charles Hayter stated that it may indicate a “more sophisticated, diverse class of investor” emerging into the market.

Barriers to Entry

Regardless of the increasing number of institutions adopting digital assets, many remain hesitant because of legal, liquidity, and security risks.

  1. Regulatory Authority

Despite a growing interest in digital assets, the regulatory framework of numerous blockchain networks and digital assets remains unclear in major financial hubs across the world. There is still much legislation and regulation to be established before these financial institutions will feel comfortable entering the space. This is one of the key barriers of entry for low-risk institutional asset managers, as those with higher risk tolerance tend to operate based on guidance issued by regulatory bodies. The lack of regulatory authority and correlation to traditional markets is not as big of a concern as it once was, 25% of European investors in the Fidelity survey were initially intrigued by the lack of government intervention in digital assets, whereas only 10% of investors in the U.S. felt the same.

World map displaying the legal status of Bitcoin. Green represents permissive legalities whereas other colors imply contentious or hostile prohibition. Ethereum and other crypto networks still lack regulatory clarity. (source)

2. Capital Allocation

Capital allocation is another issue asset managers face when operating in the digital asset space. Even with new DeFi innovation, there remains a lack of infrastructure and services needed to operate large transactions at an institutional scale. The lack of on/off ramps, liquid exchanges, and trusted custodians, creates operational burdens and exposure to undesired risk. Traditional financial market efficiency is based on the trusting counterparties and intermediaries by off-loading asset management to others such as clearing and prime brokerage houses. In the DeFi space, there is limited demand for these types of services as autonomous smart contracts facilitate all trading and clearing. However, the lack of vertically integrated trading, custody, and liquidity providing platforms means that the management of digital assets is not treated with the same regulatory standards as a traditional asset class. One of the overwhelming factors as to why investors are not entering the space is due to the fact that 45% of institutional investors believe that lack of fundamentals and capital allocation tools are the biggest obstacle to increasing their portfolio with DeFi and digital assets.

3. Operational and Security Risks

Cristian Bohn, the Co-Founder at Parfin — a clearing service for digital assets, finds that in an investment process, asset managers generally consider the following risk factors:

● The overall strength of the market
● Liquidity in the system
● Operational and security risks

Within the crypto ecosystem, the challenge for institutional asset managers is mainly associated with operational and security risks. These risk factors have been relevant areas of focus in the DeFi ecosystem since it was first introduced. When operating in decentralized environments, applications often depend on one another to succeed and must stay connected through several smart contracts and protocols.

Cristian faced a similar predicament with his clients, eventually inspiring Parfin to build the infrastructure for institutional players to enter the space “when you have to keep multiple accounts with different counterparties such as custodians, banks, and trading venues, the operational burden to manage and control the portfolio comes with many operational risks. These are associated with manual controls, difficulties in reconciling accounts, and a lack of proper software and integrations.”

These operational burdens have not been encountered before in traditional finance which ultimately is off-putting to many investors.

Conflux Network Solutions

At Conflux Network, we acknowledge the value that institutions and experienced investors bring to the digital asset space. When forming our DeFi ecosystem, we are constantly looking for new ways to innovate so that investors looking to purchase digital assets can do so in a secure and compliant manner.

Beyond being the only state-endorsed public permissionless blockchain project out of China, we are partnered with several traditional investment firms and developing new innovative platforms that close the gap between digital and traditional assets such as DeFiner for digital asset lending and LISSX a life settlement exchange.

Additionally, when creating our DeFi ecosystem we have made sure to emphasize sectors of the industry that commonly do not receive attention such as trusted oracles, audits, and insurance. This ensures that investors will not have to spend extra resources when researching operational and security risks as our protocols and assets are secured by industry leaders such as Quantstamp audits, and provide several infrastructure tools to easily navigate across our network.

Due to the decentralized nature of DeFi, many believe that the investment requirements of these traditional firms cannot be applied. However, as the DeFi ecosystem develops with new regulatory compliant public blockchains, the opportunities for investors are nearly endless. Additionally, numerous wallets are starting to opt-in to KYC/AML protection, and many DeFi protocols such as lending and borrowing platforms or exchanges are starting to operate in a regulatory compliant manner while keeping their platform as decentralized as possible. This is essential for institutional establishments, as they may need to set explicit boundaries around exchanges, including which DApps to avoid. Investors wishing to consent to existing guidelines can search out a comparatively agreeable accomplice to exchange or advance with. Both DeFi and institutional investors are recognizing the value they can bring to the other’s industries, and the next steps are to build solid infrastructure revolving around operational security to continue to grow DeFi and introduce it to a wider audience.

Written by Conflux Network’s DeFi Analyst, Sami Tannir

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