Spool DeFi Insights: The Growing Wave of Institutional Investors in DeFi

DeFi is bringing radical innovation and rapid change to financial markets, with billions of dollars in TVL, even in the bear market. But, the DeFi ecosystem is relatively small compared to traditional financial markets and that limits liquidity and can create major movements and instability in short spaces of time.

As a comparison, the total TVL in DeFi peaked in December 2021 at around $180 billion. The global bond market alone, on the other hand, was estimated to be $119 trillion globally at the end of 2021, clearly showing the potential for DeFi growth.

As DeFi markets have grown and increasingly stabilised, institutional investors have started to pay closer attention and money started to flow from traditional financial systems into the digital assets space. In the first week of October 2021, net flows into dedicated crypto-asset funds reached a four-year high of more than USD 2.5bn.

Large financial institutions like BlackRock, JP Morgan, Goldman Sachs, and Morgan Stanley have announced they are offering their wealth management clients access to crypto funds. Centralized crypto exchanges are also supporting the DeFi evolution, i.e. Binance users can stake Binance Coin (BNB) in return for rewards.

Why does DeFi need institutional investment?

It seems a paradox. DeFi evolved from the need for people to leverage their cryptocurrency and digital assets. Projects built financial models investors were familiar with that still allowed them to maintain self-custodial ownership of their assets without relying on centralised third parties. In comparison, many of the traditional financial institutions now looking at the space are those highly centralised models DeFi was created to move power away from.

So why are DeFi projects and smaller investors so glad to see the increasing interest from traditional financial institutions?

The problem comes that DeFi, and even the wider cryptocurrency space, is largely a closed system. Adoption rates are improving constantly, but not as fast as the rate of innovation and new projects developing in the space. This means DeFi protocols often face a lack of liquidity, in particular for services such as DEXs, which require larger volumes of liquidity to maintain market and price equilibrium.

Without new money from the outside, the ecosystem becomes a zero-sum game, with each project needing to take a financial piece of the pie from another in order to grow. While institutional movements do make up the majority of DeFi transactions and TVL already, there is still a massive potential, in particular with institutions from the traditional finance world. These finance institutions see opportunities in DeFi not only because of the breathtaking technological progress but also and foremost because DeFi offers more attractive financial returns than traditional financial markets.

What is the major risk for DeFi?

Opening up DeFi for traditional finance institutions seems inevitable in order for DeFi to move forward, however it is not without challenges.

With TradFi financial institutions providing bigger amounts of capital to the DeFi space a centralisation issue might emerge.

As a matter of fact, financial ownership as a means of control is common in decentralized governance models that rule Decentralized Autonomous Organizations (DAOs). In order to solve this issue, many protocols enforce particular distribution models on launch to ensure that control is not maintained too heavily among a small number of individuals or entities. This can include maximum tokens purchased, or tokens being locked for a fixed period.

With institutional money flowing in, there is the risk that it could be used to buy either the tokens used for governance or the votes of those individuals who hold them.

That isn’t to say this would happen, or even that in cases where it does the centralised body would act against the best interests of the other holders and users, but it might mean they could if they wanted to.

What Institutional movements are we seeing & why?

There are a number of reasons traditional financial institutions are looking at moving into DeFi, and in some cases have already started to do so. In essence, these reasons can be looked at in the same way as for any investor, namely financial reward vs risk.

Since the advent of true DeFi following the launch of Ethereum and the concept of programmable money in 2016, the ecosystem has rapidly grown in value. On one side this has allowed users to reap double-digit or even higher rewards from their investments. On the other side, over the last several years we’ve seen a lot of scams, hacks, and fraud within DeFi. However, the space is now maturing rapidly. Some protocols have stood the test of time and continued to grow securely, and better standards for new projects are being enforced by the teams and expected by users.

More advanced risk models, such as those Spool and its users are developing, enable investors to better understand DeFi protocols and how to break down the risks associated with them. We are also seeing models emerging, such as our own “Smart Vaults”, that allow investors of any size to safely and securely spread their risk among multiple DeFi projects, much as investors do in a traditional financial portfolio.

These factors combined create a much more appealing ecosystem for institutional investment. TradFi institutions tend to be more risk-averse than individuals but may not want to build the technical expertise to analyse the risks of DeFi protocols. For them, it’s important to rely on frameworks they are familiar with and that they can easily explain to their own clients.

It is this combination that creates a promising environment for institutional investors, particularly those looking for a first mover advantage, to invest in DeFi.

Cryptocurrency adoption is a key first step.

The final key for institutional investors into DeFi is proving the water is safe by holding and trading cryptocurrencies. Investing in Bitcoin and Ethereum has proven to be a viable strategy over the longer term. As a result, many companies (and even countries) have chosen to hold them as financial investments or as hedges against fiat inflation.

If cryptocurrency prices recover after the bear market this will further increase the confidence of institutions in moving into the space. In turn, many will then look at how they can leverage those assets. One way to do so is by using stablecoins during periods of uncertainty.

What does the future hold?

In order to find new and alternative sources of return, as well as stay relevant to an increasingly knowledgeable investor base, traditional financial institutions will need to understand and move into the DeFi space. This will increase liquidity as well as project value and enable their clients, and thus more users, to become part of the system.

______________________

Spool is a permissionless DeFi platform that connects Capital Aggregators with DeFi Yield Generators. Funds are dynamically and efficiently allocated to ensure optimized yields, for custom strategies, managed by DAO-curated Risk Models.

Spool was established as a DAO, with a selection of founding contributors representing a diverse cross-section of the blockchain community.

Stay tuned as we shine a spotlight on more Spool Team members over the coming weeks.

Website | Telegram Ann | Twitter | Medium | Discord