What Is Institutional DeFi — Overview, Potential, Challenges, and Solutions
Decentralization has given rise to novel financial products, with on-chain resources producing above-market returns when deployed effectively. DeFi’s advent provides a new conception of how the financial industry could work, while its macro economic resilience and continued growth in the face of market shocks has begun to turn the heads of financiers who want to expand their operations and create beachheads for their crypto-interested clients.
PWC reports that 74% of hedge fund managers are looking at crypto as an investment opportunity, and hedge funds are expected to hold 7% of their assets in cryptocurrency in the next five years. Around one-fifth of hedge funds are already doing so. And no wonder, DeFi has more security, transparency and interoperability than traditional finance, which is built on antiquated systems — granting it the prime position to reengineer the finance space from the ground up. All recent research points towards huge inflows of institutional capital into the DeFi space, but some remain cautious, yet adamant to not miss out as the new map of the financial world is drawn.
Why DeFi Changes the World
It’s a truth universally acknowledged that “hot money”, or capital funds seeking high yield, is the true driving force of economic growth. When the credit market is buoyant, investment is confident, and banks are issuing loans faster than people can snap them up — this is a general harbinger of prosperity. When the credit market is illiquid, and money seizes up and retrenches itself in less fungible capital, economic recession is never too far away. The faster the money can move, the hotter it can get. The quicker it can move — safely, securely and transparently — the better. Hot money seeks out and rewards innovation, and then stops the calcification of finance in illiquid markets that act as millstones around the neck of emerging markets.
Five hundred years of financial innovation has chased this goal. Money just wants to go where it’s needed most, a thirsty osmosis for new opportunities and higher rate of return. Renaissance bankers in the Medici period in Venice were prized for their ability to offer pan-European access to capital due to their network of bankers — and with it — helped propel Venetian mercantile efforts across the old world and the new.
American’s unlatching from the gold standard allowed money to be minted, and lent out at such a rate that the 80s were a boom of glass skyscrapers and turbocharged growth. At the turn of the century, online digital payments processors, transnational banking alliances, and international accounting have allowed for a globalised world to access value more easily — increasing overseas investment, helping to lift third-world poverty, and inspiring the creation of a truly global workforce.
DeFi, made possible by the technology of the blockchain and the application of community-driven finance, is the final evolution of financial data-value transfer that promises to make all money ‘hot.’ It gives every saver access to the highest yields, and every borrower access to instant capital. It is a financier’s dream. Except, curiously, it’s often stated that cryptocurrency is the enemy of the banks. Not true, DeFi is only the enemy of unproductive banks; banks whose main margins are built on the backs of their retail users.
DeFi for Institutions Primed to Rally
For the investment arm of a bank, DeFi offers an unparalleled opportunity to put its assets to work productively. Goldman Sachs has reopened its cryptocurrency trading desk and other institutions, like JP Morgan, have cooled their anti-crypto rhetoric (Jamie Dimon once notoriously called Bitcoin “a fraud’), and are now even launching their own coin. This partly misses the point of crypto, but it does show a turning of the tide among even the upper echelons of the current system. As the former chief economist of Deutsche Bank, Ed Yardeni says “the big banks have no choice but to go down this road.” Indeed, their recent actions show as much. HSBC, Citigroup, Mitsubishi UFJ Financial Group, UBS, Barclays, Commerzbank, BNY Mellon, Signature Bank, and SBI Holdings are all pursuing blockchain-based projects.
However, it isn’t only financial institutions that are pursuing DeFi adoption. A recent Blockdata report unveiled that 36 of the world’s top 100 public companies have invested in blockchain technology. Some of the most prominent ones include Alphabet/Google, Visa, MasterCard, GoldmanSachs, and Samsung.
CeFi Yields Positioned at Market Lows
Traditional investment vehicles are at an all time low. Andrew Keys from DARMA Capital called the environment “interest-rate starved”. The Federal Reserve’s money printer has crushed yields on assets like treasury bonds to an all time low, with 10-year yields only recently climbing above 1% and has frequently dipped to below 0% yields; meaning you have to pay the government to hold your money for you. This is lower than the rate of inflation of 1.2% seen in 2020; a rate that was significantly depressed by the effects of the Coronavirus pandemic and is certain to escalate this year.
2021 has already seen a 4.2% rate of inflation using the Fed’s PCE inflation gauge, which means that the majority of yield-bearing assets are currently making their investors poorer. Over the last ten years, even the stock market has only seen single digit growth — 9.2%, according to data compiled by Goldman Sachs — and the prediction is for these gains to be cut in half over the next ten, with ETFs and other risk-averse index funds being lower still.
This means that, should the direction of travel continue, the stock market will no longer outperform inflation. It’s clear, then, that the financial sands are shifting. Digital assets and the frictionless and transparent data-value transfer they create will be the best way to outstrip inflation and act as a store of value against the debasement pressure being placed on national currencies. According to the Reserve Bank of St Louis, DeFi will cause a ‘paradigm shift in the financial industry and contribute toward a more robust, open and transparent financial infrastructure’.
What Is DeFi and How Does It Work?
DeFi is a blockchain-based system of finance whereby users can deposit assets into liquidity pools that can then be used to make markets, offer lending, engage in speculation on assets, take advantage of arbitrage opportunities, and earn DeFi yields based on their collateral deposits (in crypto-parlance, this is called ‘yield farming’). It is orchestrated entirely by protocol smart contracts which set out the terms in which the money is used.
Think of decentralized finance protocols as collective asset broths to which anyone can contribute and anyone can withdraw from. Engaging with a DeFi protocol means interacting with the smart contract when you deposit your assets or loan from the protocol. When market making, no central liquidity provider is required to provide all the collateral of a single market, rather this market is sourced from a huge variety of sources. In effect, every user of a DeFi protocol is a bank, and every user is a customer.
To put it idiomatically, a DeFi protocol is a giant tub of hotpot soup that everyone can line up to sup the nutrients from, and add their own ingredients when they do. The DeFi industry is a giant kitchen of decentralized pots swapping recipes and sharing ingredients, with the cooks being automatic smart contracts who never add too much salt. It is a self-improving market, where everyone in the canteen gets what they want when they need it and saves what they can when they’re full — automatically.
DeFi — The Financial Hotpot with Plenty of Soup
The sublime benefit of this is that it staves off the threat of liquidity crises that can have an abject effect on markets and increase volatility, as the money is so widely and disparately sourced. Of course, being so green, DeFi markets are still exceptionally volatile as the pool of liquidity providers is so comparatively small when compared to the ammunition of a financial institution using its investors’ and savers’ money to stump up the required finance. However, it also means avoiding the problem of that institution suddenly being liable for debts they can’t pay and closing markets and liquidity seizing due to macroeconomic shocks such as those seen in the 2008 economic crisis.
The wider the sourced liquidity, the more resilient the markets will ultimately be to shocks — and since anyone can contribute to a DeFi protocol, from the individual user with a few dollars to the largest crypto hedge fun with a few billion, the possible pool of liquidity providers is as large as the number of people with internet access.
If Web 1.0 was a series of open sourced protocols that benefited the users and the builders, and Web 2.0 was the sophistication of those services in the hands of the centralized companies, then Web 3.0 will be a merging of the two, where end-user value driven protocols will be delivered with sleek technological delivery mechanisms only centralized institutions have up to now provided. DeFi is the tip of that spear.
Since December 2020, DeFi’s potential has seen enormous interest. In a Consensys report, they state that as of July 2021, 183,000 people had staked upward of 5.8 million ETH on Ethereum protocols, earning an inflation-beating average of 6.8% APR in the process (not taking into account the underlying asset-price gain Ethereum has experienced). At time of writing, defipulse.com reports $85 billion of TVL (Total Value Locked) in Ethereum DeFi protocols, with the all-time high TVL clocking in at just shy of $100 Billion.
Fortunately, it doesn’t all depend on a single asset like ETH. DeFi liquidity pools, credit markets, protection protocols, and other ventures allow staking of multiple assets, including stablecoins and cryptocurrencies available on other blockchain economies. Incentives vary, but users can expect to be paid in kind (via the token deposited), in governance tokens, and even in unrelated crypto assets.
Furthermore, competing blockchains like Solana, Avax and the Binance Smart Chain also offer DeFi solutions, each with their own token sets for their users to interact with. DeFi Llama, which aggregates TVL from all major chains, estimates current TVL in DeFi to be $175 Billion, with an ATH of over $200 Billion.
As reports point out, it’s good to be somewhat circumspect about these TVL values. Locked value can be quickly redeemed, and much of the capital within the DeFi ecosystem at present is at the bleeding edge of mercenary capitalism, as first movers make extravagant gains through their advanced technical knowledge of yield farming strategies and their sophisticated deployment of automated bots. Furthermore, bootstrapped protocols often offer extra incentives in their attempt to onboard capital by offering APRs out of their prudential reserves in an attempt to drive asset liquidity.
There are, also, still technical oversights in the smart contracts of some of the less established protocols, and malicious users have been successful in draining protocols of liquidity outside the bounds of the smart contract. These factors can make TVL a fairly volatile metric. However, over time, the trend is defiantly up, with the DeFi market effectively recovering after April’s gut punch to the entire crypto market. Crucially, the biggest DeFi protocols, including AAVE, Maker and Compound, suffered no calamitous loss of capital for their users even as the market worked against them — with the successful over-collateralisation of these protocols insulating them successfully against negative macro economic outlooks. Technical oversights are also becoming less common and older, established protocols have, so far, remained impervious to assault.
The Pillars to Sustaining Decentralized Finance
Citibank, in their report titled “Future of Money: Crypto, CBDCs and 21st Century Cash” state that the removal of third party intermediaries and increased financial transparency are traits that make DeFi the perfect tonic to the arbitrary barriers that make money go cold.
Three of the powerful features of crypto and DeFi that make them a perfect financial instrument for the 21st century include:
- Decentralized Finance Never Goes Dark — Yield While You Sleep
This, in itself, is a colossal advantage when money is seeking yields. For both retail and institutional users, passive income with DeFi happens all day, every day. Simply put, this is the daydream of Reddit’s FI/RE (Financial Independence; Retire Early) subreddit.
In the traditional banking system, there is a network of acquirers, processors, messaging systems (like SWIFT) and clearing houses that are involved in validating and transferring money from user to user. These systems follow their own timings, and transactions done outside certain hours are often queued up for processing in the morning. The old refrain of waiting ‘until the Chinese wake up’ or ‘when the NYSE opens’ have significant, and sometimes, debilitating effects on money markets. Important international investments can be held up just because the bank of the country being invested in hasn’t opened its doors for business yet. Clearly, in the digital age, this is no longer an acceptable state of affairs for modern yield-hunters.
- The Programmability of Smart Contracts — DeFi Code Is Law
Traditional financial operations can be written in smart contracts in such a way that it becomes clear, transparent and unimpeachable. Furthermore, assets in the smart contract are non-custodial. Either the user controls their money, or the contract does — there is no problematic chain of fund custody. With the smart contract governing the facilitation and deployment of yields, the vulnerability for human risk in handling of capital is removed, and more importantly, execution of deployed funds is done both automatically and to the letter, resulting in far less friction in the committing of assets to profitable farms.
These smart contracts bear additional properties that further engender more fluid and accessible economies. They are permissionless — which means any user can get involved. It creates the opportunity to give financial access to the poor and the unbanked who are otherwise unable to access legacy systems due to their cost. Sometimes, this lack of access is continent-wide, leading to stuttering and staggering economies even at times of economic prosperity. As Monica Singer — an early crypto investor highlights in the Citibank report — “traditional bank and payment rails work poorly intra-Africa, people who switched to crypto realised they can bypass middleman, expensive money changers … bank penetration remains critically low.”
- Atomic Settlement of Transfers — Be The Flash
Finally — and possibly most crucially — is the concept of atomic settlement. In traditional finance, and in all forms of money except cash notes, there is a divide between the message and settlement. This divide is a crucial breakwater in the flow of international money. For the retail user, they may have to wait a few days and pay high fees that represent the burden of connecting messages and settlement. For institutional users, market making in foreign territories, trading stocks on disparate exchanges and supplying investment rounds and loans to international companies are all held up, at massive expense, due to the shadow between signalling the money to move (messaging) and it actually arriving (settlement).
With blockchain technology, these two strands are unified and collapsed into a single action, and both the message and settlement are simultaneous. As Naveed Sultan of Citibank states, “part of the vital infrastructure to enable digitisation will be the removal of the remaining frictions in the payments plumbing.” The far-reaching consequences of this characteristic of tokenized exchange is the fire under the DeFi broth economy that has the potential to strip away so many of the inefficiencies of international money markets and will be a massive boon to the financial institutions who first adopt them at a large scale.
These three factors all contribute to one overriding idea: it makes money cheaper. If money is cheaper, it can move faster and into the hands of people who need it. This, in turn, is the core historical driver of economic growth. It further means that more of the costs of lending and borrowing can be mitigated. Thus, savers and lenders make bigger yields and borrowers can borrow at cheaper rates. This is the fundamental desire of financiers, investors and speculators, and DeFi makes it a reality.
This cost-suppression also creates a far bigger margin for institutions to work with to create their own profits while still passing on the advantages to their clients and consumers. An institution that can successfully offer DeFi-based services to their client base will be able to earn a significant boost on their traditional saving and lending operations, as well as modernising their asset pools for the new crypto economy.
Perhaps more importantly, though, is that as more and more financial institutions begin dabbling in DeFi, the more the value of the protocols will naturally increase. DeFi, due to the nature of shared liquidity pools, is an exponential-sum game. The more assets are on-chain and deployable, the more robust and interoperable the market becomes.
If banks were to commit just 1% of AUM into DeFi and take advantage of the cheaper cost of money-moving, then a trillion dollars could flow into the space, and those who are already in the space making yields will find their underlying collateral go — in colloquial crypto terms — ‘to the moon’.
What Are the Challenges to Institutional DeFi Adoption?
What’s stopping more institutions from adopting DeFi right now? Well, although mid-sized crypto hedge funds and those with some liberal autonomy over their users’ assets have already begun migrating assets on-chain, banking and other large investment institutions have been slow to capitalize on DeFi’s colossal growth and potential for growth. This is not for bad reason. Large institutions have a fiduciary duty to their investors and are regulated by the government to ensure wider financial security.
Regulation in the crypto space so far has been impressively light-touch, as the SEC is sensible enough to realise that cryptocurrency as a whole benefits the American economy more than it hampers it — driven as it mainly is by America’s incomparable technological prowess and boots on the ground retail investment. However, stricter regulation is coming. Gary Gensler, chair of the SEC, said that the agency had “robust authorities” and it was “going to use them”. In an interview with the Financial Times he also said “[crypto] is at the level and the nature that if it’s going to have any relevance five and ten years from now, it’s going to be within a public policy framework.” He cites DeFi as particularly hard to regulate, however, as its an evolution of peer-to-peer lending, he still believes it’s possible as certain DeFi entities “have a fair amount of centralisation.”
This is often seen as the impending death knell for the crypto bull run. Andrew Cronje, who created yearn.finance — once of the largest DeFi protocols, warns of a ‘dark phase’ and that ‘a different future’ awaits once the SEC moves. However, most impending regulation can only target centralized ventures, rather than DeFi protocols that stay true to the ethos of decentralization. There’s little that can be done against ‘shadowy supercoders’ who are actively reengineering the future of finance in their pyjamas, while sipping on coffee, all through open source code contributions. Blockchains are decentralized — shutting one down virtually entails access to validator nodes worldwide. Sure, local jurisdiction may attempt to hinder usage and adoption, but where there’s a will, there’s a way for DeFi to succeed even then. More so, there’s the solid belief that when done right, regulation helps mature markets, creating safer means for users to deploy their capital. The future is here, with regulatory entities, institutions, and retail users facing a single choice — adopt.
For institutions who want to bridge their assets on-chain, regulation — as long as it’s appropriate and clear — is exactly what is needed. The SEC has spoken extensively about employing regulation, but still hasn’t done it. This is because it is waiting for the space to mature by itself before it runs a systems check and throttles the vast advantages of DeFi and its ability to empower and revamp the financial system.
There are three major obstacles in the DeFi space for institutions that are now beginning to be solved:
- DeFi and Compliance — The Criteria to Investing Public Capital
One of the inherent qualities of DeFi is the fact that accounts are pseudonymous by default. Although technically tracing an account is possible (and with blockchain, tracing the financial movements within the account easy), it’s still an uneasy situation for banks to be dealing with unknown counterparties who may be engaged in fraud or money laundering as it means laws like the Bank Secrecy Act can’t be enforced. However, DeFi protocols like AAVE have begun to set up permissioned pools. These are DeFi pools that are only operated by legally identified users, and where accountability for funds invested can be as concrete as is required by law for banks.
- Managing Financial Risk — To Degen or to Play It Safe?
Risk also needs to be mitigated. Not only does this account for settlement and transactional risk, but the much more human error of crypto-naivete.
Onomy Protocol is plugging the $6.6T per day Forex market into DeFi, a bold endeavour that also addresses settlement risk, which happens when one side of the transaction fails to fulfil its obligations. In decentralized crypto markets, there is no settlement risk. Funds simply flow from A to B directly, and this also applies to fiat-pegged on-chain currencies being exchanged for one another as part of the Forex market.
DeFi is complex and the financial models underpinning it are equally complex. Banks will need to educate themselves fast on this new financial universe if they are to compete, but greater crypto-literacy will help with that. As crypto-literacy spreads within the population and the financial world, the understanding of the importance of keeping private keys safe becomes more well-known, and this applies to companies too. Perhaps another great challenge to institutional DeFi is that of complicated interfaces and the lack of an all-inclusive ecosystem that serves industry-wide needs. At Onomy Protocol, our decentralized financial products feature intuitive interfaces that facilitate simple onboarding for both institutional and retail users. Decisions like creating Natural Rights, a private key management suite that enables a familiar single sign-on portal to help users manage any blockchain assets (across chains), whilst retaining asset custody is only one example.
Smart contracts have become coded better, audited more regularly, and evolved in lockstep with the wider DeFi industry. The potential for hacks for a well-audited smart contract is decreasing, but the millions lost so far teach us valuable lessons.
With Onomy Protocol, the go-to CeFi to DeFi bridge, security is of utmost importance. We believe that even with audits, code logic may be prone to failure. This is why we are designing our hybrid AMM/orderbook DEX, stablecoin minting system, and layer-1 blockchain network using TLA+, a formal specification language that allows you to solve high-level conceptual problems in software engineering at the design stage. Coupled with complex audits and formal code verifications by prominent partners like Informal Systems and RedHat, we strive to create a safe DeFi ecosystem of financial applications that will not put user capital at risk. Keeping funds SAFU is the only way.
As the technology evolves and capital inflows increase, volatility risk will also be kept down, as the market will be large enough to absorb the ebbs and flows of value. Crypto volatility is a rather interesting narrative. On one side, we have traditional crypto-assets like Bitcoin, which are on their way to serving as digital gold, whereas on the other side, we have stable on-chain representations of fiat currencies like the U.S. Dollar. The stablecoin market has seen over $100B in capitalization over the previous year, with traditional fiat collateral, crypto collateral, and algorithmic stable assets actively keeping their peg. We firmly believe that eventually, the world’s currencies will be migrated on-chain, a paradigm shift that we refer to as The Great Financial Migration. And we’re not the only ones, with others predicting the market cap of stablecoins at $1T by 2025.
To do this, the DeFi market demands interoperability of these stable assets between major blockchain economies, as well as on-chain representations for fiat currencies other than the U.S. Dollar. We are actively focusing on becoming the de-facto migration route institutions by building a stablecoin minting protocol that leverages a single-collateral unit and deploy complex stabilization mechanisms to maintain pegs. The purpose here is simple — to eventually enable any institution or retail user to use their nation’s currencies on-chain, and therefore tap into the many benefits available in the DeFi realm.
Our institutional DeFi approach will also see the creation of effective monitoring and reporting systems that banks, enterprises, and other financial institutions can use to track their financial obligations, all under the roof of a single ecosystem.
- Blockchain Interoperability, Transaction Fees, and DeFi Ease of Access
Thirdly, the DeFi seed is sprouting, but it still has a long way to go, and there are still problems with the clunkiness and interoperability of assets. Tokens still need to be wrapped to be migrated from chain to chain. It can also, especially if using the market leader Ethereum, be plagued with high transaction costs that — unless harvesting substantial yield — threatens to wipe out any gains made and simply replace the problems of the banking system with a new one.
For institutions, it’s important to have their DeFi initiatives in place before these advances solidify and complete, as by then, the runaway gains will be already underway and they will be a step behind the banks that moved first.
Onomy is also addressing this bottleneck. We focus on creating inter-chain travel standards that help stablecoins and crypto assets move efficiently, without wrapping or utilizing middleman tokens. On the narrative of transaction fees, we’re building on Cosmos, which already offers 100x the efficiency of the Ethereum network, in terms of both speed and fees. Our upcoming custom consensus mechanism will further boost blockchain scalability, spearheading the advancement of DeFi communication to a level that can support the world’s hot money.
The DeFiance of DeFinance Is Over
The DeFi world is maturing, but it hasn’t reached adulthood yet. Increased liquidity onramps, clear-sighted regulation, and great crypto literacy will unlock the truly giant potential of this new technology. The possibility for global and permissionless engagement with the market, access to capital cross-border wherever its required, and the opportunity to outstrip inflation and earn a true yield on AUM makes DeFi the next tier of evolution of the financial meta-space.
Quite simply, institutional DeFi at large scale will make all money hot, let capital investments run riot, and reward innovation at the very highest and very lowest levels. Community-driven finance governed by unimpeachable code promises a better financial future, not just for the banked, but also for the unbanked. The financial institutions which make the right moves to be part of that community, and engage positively with the regulatory environment, will be those that create the most value for themselves and their investors. Blockchain revolutions are often touted, but in the financial sector, they have already begun — institutional DeFi has now arrived.
