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Institutional DeFi is a version of DeFi that combines the efficiency and innovation of decentralized finance with a level of safeguards that is expected from financial institutions.
Institutional DeFi needs to integrate identity solutions to enable regulatory compliance and address security concerns.
Institutional cryptocurrency transaction volume accounted for over 50% of transaction volume between July 2021 and June 2022.
DeFi solutions that comply with today's regulatory framework are likely to position themselves as a viable alternative to traditional financial services.
Over the past year, institutions across the globe, such as American banking giant J.P. Morgan, have been exhibiting increasing interest in decentralized finance (DeFi) and investing in the development of blockchain solutions.
However, there are a number of barriers to entry into DeFi for institutional investors, such as security concerns, regulatory requirements, and compliance requirements. This has given birth to institutional DeFi - an alternative to traditional finance specifically designed to cater to financial institutions with an interest in digital assets, blockchain technology and DeFi applications.
What is Decentralized Finance?
DeFi encompasses financial applications running on public blockchains. Rather than relying on manual input from intermediaries or central counterparties, DeFi usually automates processes like lending and borrowing, trading, and asset management via smart contracts, lending protocols and decentralized exchanges.
READ: Decoding blockchains: An introduction to Layer 1
The DeFi ecosystem is more transparent and efficient compared to traditional financial systems, attracting users with rapid, borderless settlements and the possibility to hold assets in self-custody.
Institutional DeFi
Today's end-user focussed DeFi applications are not designed to meet the requirements of financial institutions and institutional investors, who have to ensure strict regulatory compliance, customer safety, and security.
Whilst there are some participants, such as Yield App's partner Trovio, that have created an entry point for institutional investors by way of meeting mandated requirements including governance and risk management housed within a regulated asset management wrapper: the overall DeFi ecosystem still fails to meet the stricter thresholds required for most traditional or institutional investors.
READ: Yield App’s assets pass second Armanino proof of reserves audit
Institutional DeFi is a version of DeFi that combines the efficiency and innovation of DeFi protocols with a level of safeguards that is expected from professional investors.
First, institutional DeFi must integrate some sort of identity solution to enable:
Anti-money laundering (AML)
Know your customer (KYC)
Know your business (KYB)
Combatting the finance of terrorism (CFT)
Furthermore, institutional DeFi needs to address security concerns. As high-profile hacks plague the digital asset space, security standards that meet the risk management expectations of wholesale capital allocators must be developed before DeFi can scale to the mainstream.
Value of Institutional DeFi
The trust on which financial institutions are built relies on accurate records of ownership, liabilities and agreements that are stored on isolated ledgers.
As those ledgers are gated by intermediaries, their gatekeepers, the regulated and licensed clearing houses, are required to reconcile settled transactions and maintain the integrity of the records through extensive coordination. As a result, international transactions of securities take up to four working days.
READ: GBBC Digital Finance Report paves the way for engagement between DeFi industry and regulators
DeFi's features are poised to address these inefficiencies, as records of ownership and transactions can be stored in a single, shared ledger, while the protocols autonomously execute transactions in accordance with the rules and conditions hard-coded into their smart contracts.
These efficiency gains can be further extended through the tokenization of traditional assets such as stocks and bonds.
Institutional DeFi Design
Permissionless DeFi with a focus on AML and CFT
It is possible for institutions to use permissionless DeFi as it has evolved in recent years by implementing their own security standards. They could, for example, identify all recipients and beneficiaries of DeFi transactions to comply with AML and CFT regulations.
Whitelisted, Permissioned DeFi
Whitelisted, permissioned DeFi is a type of DeFi that implements an extra layer of identification. It runs on a permissionless DeFi platform and relies on an indexer to which all participants must provide their identity before gaining access to the service.
Centralized providers currently dominate this type of DeFi, but there is a movement to decentralize this process with DIDs (Decentralized Identifiers).
Centralized DeFi (CeDeFi)
Centralized DeFi would allow companies to run DeFi applications on their own private blockchain. This would provide a more controlled and compliant experience for institutions that want to use DeFi services.
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This version differentiates itself from “traditional” DeFi, as the underlying blockchains would be set up and controlled by a group of centralized institutions. Their validators might be decentralized and shared among the different parties, but both roles of validators and participants will be permissioned and exclusive.
Challenges that drive innovation
Cybersecurity
The nature of digital assets makes DeFi prone to cyberattacks. In the first eight months of 2022 alone, more than $273.9 million has been lost to private key compromises, according to the blockchain security company CertiK.
READ: The Merge – What to expect from Ethereum’s long-awaited upgrade?
This number is dwarfed by cross-chain bridge hacks, which are estimated to account for $2 billion of stolen funds (69% of all stolen funds) in the first seven months of 2022 alone. Bridges often lock the funds that users are porting to another blockchain in a smart contract or a centralized custodian to issue the equivalent amount of crypto assets on the bridged blockchain.
The funds held as collateral are a natural target for hackers waiting to be exploited until best practices are developed over time.
Regulatory Uncertainty
Institutional finance will increasingly rely on DeFi for efficient, accessible and competitive financial services, but the current lack of regulatory frameworks poses a risk to institutions.
READ: Proof of Stake vs Proof of Work: All you need to know ahead of the Ethereum Merge
However, as jurisdictions around the world are revising existing norms in response to digital assets and DeFi, this hurdle is likely to be resolved over time.
While new regulations may introduce operational complexities at first, they will also improve the security of institutional DeFi solutions.
Settlement Treatment
Record keeping, reporting, and auditing need to be redefined and extended to on-chain ledgers and synchronized with their off-chain counterparts. Institutions need to gain clarity regarding on-chain reporting and accounting requirements to comply with regulations.
KYC and AML
The pseudonymous nature of existing DeFi protocols makes it difficult for institutions to comply with KYC/AML regulations. A common underpinning standard for identity verification needs to be established in collaboration with regulators to ensure that each counterparty is an authorized and trusted entity.
Solutions such as Polygon ID, a Web3 identity solution that uses zero-knowledge proof technology combined with permissioned liquidity pools, could be one such solution.
The DeFi–TradFi gap
Today's crypto off-ramps are not sufficiently developed, making it difficult for institutions and institutional investors to bridge their crypto assets between DeFi and existing systems and products. Withdrawal remains a single point of failure.
In response, new 24/7 withdrawal services are being introduced, allowing institutions to conduct withdrawals at any time while keeping their assets secure in cold storage.
Current Institutional DeFi Adoption
Despite cybersecurity risks and regulatory uncertainty, institutional cryptocurrency transaction volume market share accounted for over 50% of global transaction volume between July 2021 and June 2022 (transactions over $1 million are assumed to come from institutional investors).
However, even though institutional transaction volume accounts for the majority of transaction volume, it is still negligible compared to global TradFi volume.
Outlook
While TradFi services are investing in institutional blockchain-based solutions, DeFi-native projects continue to disrupt the industry and it is too early to assess which solutions will prevail.
There are still many challenges that need to be overcome. It will take time and effort for the space to mature and prepare for true mass adoption. However, the industry is aware of institutional needs and is preparing to meet these challenges with innovative solutions.
Due to the diversity of challenges, collaboration among key technologies and projects will be critical to address these issues.
READ: The Yield App Q3 2022 Report: Successful Earn+ launch as assets pass second Armanino audit
A good example of how collaborations can drive strategic expansion is Aave Arc, a permissioned liquidity pool for institutions.
Aave Arc is a partnership between Fireblocks, a digital asset wallet, custody and security platform, and lending and borrowing protocol Aave. Fireblocks acts as a whitelister and ensures KYC and AML compliance for Aave's liquidity pool.
Institutional DeFi is still in an early stage of development. However, the first movers who are prepared to mitigate risk will benefit from a competitive edge, allowing them to gain an advantage over their competitors. DeFi solutions that comply with today's regulatory framework are likely to position themselves as a viable alternative to traditional financial services.
Do you want to earn a secure and sustainable yield on your digital assets? Sign up for a Yield App account today!
DISCLAIMER: The content of this article does not constitute financial advice and is for informational purposes only. The price of digital assets can go down as well as up, and you may lose all of your capital. Investors should consult a professional advisor before making any investment decisions.
