More A Marathon Than A Sprint

In the fast-moving world of crypto and digital assets it can be hard to spot turning points, but in the case of Decentralized Finance (DeFi) it is reasonable enough to pinpoint 2020 as a seminal year. Total value locked (TVL) in the system grew from $700 million in December 2019 to more than $20 billion a year down the line and is estimated to be over $200 billion today.

DeFi holds out the promise of doing most of the things that financial institutions do – earning interest, borrowing, lending, buying insurance, and trading assets – but doing it faster, without intermediaries, paperwork and bankers.

It is a digital peer-to-peer ecosystem, without borders, and is open to all – a digital alternative to Wall Street or the City of London without the associated costs of offices and people (and banker salaries) with a promise to creates more open, free, and fair financial markets accessible to anyone with internet access.

Maker, which many would call a pioneer and the very first DeFi project, is a permissionless lending platform responsible for the creation of DAI, the first decentralised stablecoin, built on Ethereum. Maker has long since held the top ranking on virtually all DeFi tracking platforms when it comes to the TVL of ether.

Inevitably the DeFi industry is attracting growing interest and investment from financial institutions, and exchanges are starting to offer DeFi products to customers. U.S. publicly listed Coinbase recently announced that it would start offering yields on stablecoins to users.

The Institutions Are Coming

“State Street, Fidelity and Bank of New York have invested heavily into crypto and are already offering services – these are three of the most conservative and biggest financial institutions on Wall Street. That’s telling you something.” notes Tim T Shan, Chief Operating Officer of cryptocurrency exchange Dexalot.

State Street, a custody bank that oversees more than $40 trillion in assets, launched its very own digital division last year through which it offers crypto services to private-fund clients.

“We are even seeing people in the ultra-conservative repo markets, which usually deal with US Treasuries and AAA corporate bonds, start to lend on BTC,” says Shan, “As someone that used to trade repos, that’s shocking to me. And some of the yields being quoted by these repo participants are better than what I’ve seen on some borrowing platforms.”

Although the first wave of DeFi products were focused on borrowing, lending and staking, some parties are bullish about the sector’s evolution.

“One interesting trend that we anticipate is that institutions will be drawn to DeFi Fixed Income, because it offers enhanced credit risk management and higher returns than traditional bonds. We do see higher-yield and riskier ‘pure’ DeFi products continuing to see growth as education and confidence around these offerings increases,” says James Taylor, Chief Business Officer at trading platform Unizen, a venue that combines the functionalities of both centralized and decentralized exchanges.

Regulatory Responsibility Comes With Scale

The rapid development of DeFi is inevitably focusing the minds of regulators worldwide. US Securities and Exchange Commission Chairman Gary Gensler has warned that DeFi is not immune to oversight and that the decentralized part of DeFi is a misnomer. There are challenges for regulators in DeFi with Decentralized Autonomous Organizations (DAOs) consensus models and legal entity identification is one of the top issues.

A clear regulatory framework with defined roles for the various agencies is expected to emerge in the US, with the Senate and House of Representatives looking at possible legislation to fill in the gaps. 

Benoît Cœuré, the former chief of the Bank for International Settlement’s Innovation Hub, hinted that conversations about high level principles for a global framework for crypto and digital assets has intensified in recent months with the rapid growth of DeFi a major catalyst.

“You can’t regulate the oceans, but you can regulate the ports, harbours, and shipping lanes,” says Steven Becker, CEO of UDHC, the foundation with the former executives from Maker who turned over the operations entirely to its DAO, who are now focused on contributing to public policy for decentralized finance.

Stefano Jeantet, a board member at DeFi asset management platform HyperDEX. says “While traditional institutional investors are certainly showing more interest in the crypto world in general, and DeFi in particular, better regulation will allow these parties to take advantage of this disruptive technology in a more structured and efficient way. The real opportunity will be for DeFi developers to close the knowledge gap and make the investment process friendly for traditional finance investors.”

Shan concurs, “The regulations are not quite there to allow, say, public money such as pensions to easily invest in DeFi. With that said, I think we will see better guidance from regulators over the next few years that will allow public money to more freely invest in this space.”

The Institutional Search For Answers

There are emerging answers from firms operating in the market. UK-based digital institutional investment platform VALK has been recognized through its inclusion in the UK’s Financial Conduct Authority’s regulatory sandbox which allows companies to test products and services in a controlled environment.

VALK has developed Merlin, a DeFi smart wallet, and its unique Aggregator portfolio management system, enabling institutions to manage their DeFi portfolio on one interface on a smart account. Its DeFi Aggregator platform is a non-custodial portfolio management system for digital asset managers and hedge funds that will allow them to connect and trade across DeFi protocols using various complex strategies from a single interface.

Merlin’s offering is one of several new products from a growing number of companies that are developing DeFi solutions addressing the institutional market.

Aave is an open source and non-custodial liquidity protocol for earning interest on deposits and borrowing assets, and the amount of total value locked on it is approximately $12 billion. One of its flagship products is “flash loans,” the first uncollateralised loan option in the DeFi space. People who borrow through Aave can alternate between fixed and variable interest rates.

Aave Arc, the DeFi platform’s institutional offering, is attracting TradFi investors and crypto institutions like Galaxy Digital and Coinshares. Arc is a deployment of Aave v2 hosting asset lending and borrowing with a consensus layer restricted to permissioned entities to help overcome regulatory issues around legal identity.

The Current State Of Institutional Play

VALK’s recent global research indicates that DeFi adoption among institutional investors is growing rapidly. According to the study, 30 percent of investors are currently using DeFi while another 39 percent plan to do so within six months.

This isn’t mass adoption of DeFi by institutional investors as most are just testing the market, how it works, its infrastructure, and the liquidity. The key concern for investors remains regulation with 54 percent very concerned about custodial services and 52 percent very concerned about security issues.

On the whole, respondents were optimistic that regulators will come to their rescue with 84 percent of those questioned expect the regulatory environment to improve over the next three years with 12 percent banking on a dramatic improvement. That neatly passes the ball to the regulators.

Antoine Loth, Valk co-founder says, “DeFi is rapidly growing, so it is natural that institutional investors handling billions of dollars of assets have concerns about how they fit into the market. We expect to see much transparency regarding usage of DeFi protocols within the coming months and years, and with this, institutional interest in the use of DeFi will grow.”

Brian Mahoney, Co-Founder of liquidity network Alkemi, expressed similar sentiments, adding “The juice has to be worth the squeeze for major institutions to come in. There has to be enough breadth and depth of assets on DeFi platforms, meaning they need to be able to deploy large amounts with pricing and yields worthy of their time. The liquidity needs to be there for these institutional players to make the leap into the world of DeFi.”

What the future holds

The VALK research provides a snapshot of the current state of play in the institutional DeFi market and a hint at what the future holds. It found around 69 percent of institutional investors who are using DeFi utilize web browser wallets for their activities, ahead of 48 percent who use physical wallets and 43 percent who rely on custodians. Around 27 percent use multi-party computation (MPC) solutions such as Fireblocks and 83 percent rely on systems to consolidate all of their DeFi positions.

There is concern about the range of solutions available on the market including discontent about the lack of adequate reporting and accounting functionalities. Institutional investors expecting to receive daily reports on NAV, P&L and institutional-grade analysis on each transaction are going to be sorely disappointed with DeFi.

“There needs to be an evolved compliance framework that can introduce CeFi-like risk management strategies without compromising the user’s sovereignty,” suggests Taylor, “We are currently tackling the policy framework aspect in the CeDeFi Alliance.”

The decentralized finance space has come a long way in a short time, but there is still a very long way to go before it comes close to meeting its potential of replacing Wall Street or the City of London.

We are far from mainstream adoption of DeFi, but institutions hold the keys to the ongoing growth of the sector. The challenge coming for TradFi incumbents is how agile they are with this new technology and the evolving regulatory landscape. This will likely determine how rapidly DeFi scales to mainstream adoption.