More a marathon than a sprint

In the fast-paced world of crypto and digital assets, it can be difficult to spot turning points, but in the case of decentralized finance (DeFi), it’s pretty reasonable to point to 2020 as a pivotal year. The total value locked (TVL) in the system has grown from just $700 million in December 2019 to over $20 billion per year and is estimated to be over $200 billion today.

DeFi delivers on the promise of doing most of the things financial institutions do — earn interest, borrow, lend, buy insurance, and trade assets — but do it faster, without intermediaries, paperwork, or bankers.

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

Maker is a permissionless lending platform responsible for creating DAI, the first decentralized stablecoin, built on Ethereum. As what many would call the very first DeFi project, Maker has long held the No. 1 spot on virtually every DeFi tracking platform when it comes to Ether TVL.

Inevitably, the DeFi industry is seeing increasing interest and investment from financial institutions, and exchanges are starting to offer DeFi products to customers. US-listed Coinbase recently announced that it will begin offering returns on stablecoins to users.

Institutions arrive

“State Street, Fidelity and Bank of New York have invested heavily in crypto and already offer services – they are three of the most conservative and largest financial institutions on Wall Street,” notes Tim T Shan, director of the operation of cryptocurrency exchange Dexalot, “That tells you something.”

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

“We’re even seeing people in the ultra-conservative repo markets, which typically deal in US Treasuries and AAA corporate bonds, start lending on BTC,” Shan says, “As someone who had the I’m used to trading repos, that shocks me.And some of the returns quoted by these repo participants are better than what I’ve seen on some borrowing platforms.

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

“An interesting trend we foresee is that institutions will be drawn to DeFi Fixed Income because it offers improved credit risk management and higher yields than traditional bonds.

“However, we are seeing higher yielding and riskier ‘pure’ DeFi products continue to grow as education and trust around these offerings increases,” says James Taylor, chief commercial officer of trading platform Unizen, a place that combines the functionality of both. centralized and decentralized exchanges.

Regulatory responsibility comes with scale

The rapid development of DeFi inevitably focuses the minds of regulators around the world. US Securities and Exchange Commission Chairman Gary Gensler has warned that DeFi is not immune to scrutiny and that the decentralized part of DeFi is a misnomer. There are challenges for regulators in DeFi with Decentralized Autonomous Organization (DAO) consensus models and legal entity identification is one of the main issues.

A clear regulatory framework with defined roles for the various agencies should emerge in the United States, with the Senate and House of Representatives able to pass legislation to fill the gaps. Benoît Cœuré, the former head of the innovation hub at the Bank for International Settlements, hinted that conversations on high-level principles for a global framework for crypto and digital assets have intensified in recent months with the growth rapidity of DeFi, a major catalyst.

“While traditional institutional investors are certainly showing more interest in the crypto world in general, and DeFi in particular, better regulation will allow these players to leverage this disruptive technology in a more structured and efficient way.

“The real opportunity will be for DeFi developers to bridge the knowledge gap and make the investment process user-friendly for traditional financial investors,” says Stefano Jeantet, board member of the DeFi asset management platform. HyperDEX.

Shan agrees: “The regulations are not quite there to allow, for example, public funds such as pensions to easily invest in DeFi. That said, I think we will see better guidance from regulators over the next few years that will allow public money to flow more freely into this space.

The institutional search for answers

There are responses emerging from companies operating in the market. UK-based digital institutional investment platform VALK has been recognized for its inclusion in the UK 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 portfolio management system Aggregator, allowing institutions to manage their DeFi portfolio on a single 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 many new products from a growing number of companies developing DeFi solutions aimed at the institutional market.

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

Aave Arc, the institutional offering of the DeFi platform attracts TradFi investors and cypto institutions like Galaxy Digital and Coinshares. Arc is a deployment of Aave v2 hosting asset lending and borrowing with a consensus layer limited to authorized entities to help overcome legal identity regulatory issues.

The current state of the institutional game

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

This is not a massive adoption of DeFi by institutional investors, as most are just testing the market in terms of operation, infrastructure, and liquidity. Investors’ top concern remains regulations with 54% very concerned about custodial services and 52% very concerned about security issues.

Overall, respondents were optimistic that regulators would come to their rescue – 84% of respondents expect the regulatory environment to improve over the next three years, with 12% banking on an improvement spectacular. This cleanly passes the ball to the regulators.

Antoine Loth, co-founder of Valk, says: “DeFi is growing rapidly, so it is only natural that institutional investors managing billions in assets are concerned about their integration into the market. We expect to see a lot of transparency around the use of DeFi protocols in the months and years to come, and with that, institutional interest in using DeFi will increase.

Brian Mahoney, co-founder of liquidity network Alkemi, expressed similar sentiments, adding, “The juice has to be worth it for the big institutions to come in. There must be enough breadth and depth of assets on DeFi platforms, which means they must be able to deploy large amounts with prices and returns 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

VALK research provides insight into the current state of affairs in the institutional DeFi market and a glimpse of what the future holds. He revealed that around 69% of institutional investors who use DeFi use web browser wallets for their business, ahead of 48% who use physical wallets and 43% who rely on custodians. Around 27% use multi-party computing (MPC) solutions such as Fireblocks and 83% rely on systems to consolidate all their DeFi positions.

There are concerns about the range of solutions available on the market, including dissatisfaction with the lack of adequate reporting and accounting functionality. Institutional investors who expect to receive daily reports of institutional-grade NAV, P&L, and analysis on every trade are going to be deeply disappointed with DeFi.

“There needs to be an evolved compliance framework that can introduce CeFi-like risk management strategies without compromising user sovereignty,” suggests Taylor, “We are currently addressing 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 reaches its potential as a replacement for Wall Street or the City of London.

We’re a long way from mainstream adoption of DeFi, but institutions hold the key to the industry’s continued growth. The challenge ahead for TradFi holders is their agility with this new technology and the changing regulatory landscape. This will likely determine how quickly DeFi moves towards mainstream adoption.

About Charles D. Goolsby

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