The Road to Institutional Decentralized Finance (DeFi)

Decentralized Finance (DeFi) has the potential to create a whole new financial paradigm in the institutional sector, which is built on cooperation, composability, and open-source code, supported by an open and transparent network. This article will delve into the development history of DeFi and its future prospects, with a focus on its potential impact on institutional financial services.

Introduction

The evolution of Decentralized Finance and its application prospects in institutional scenarios have attracted widespread attention in the industry. Supporters believe that a new financial paradigm based on cooperation, composability, open-source principles, and an open and transparent network is emerging. As an increasingly prominent field, the path to conducting regulated financial activities using Decentralized Finance is gradually being paved.

Changes in the macroeconomic environment and global regulatory landscape have hindered large-scale meaningful progress, with developments mainly focused on the retail sector or taking place through sandbox environments. However, it is expected that institutional DeFi will take off in the next 1-3 years, combined with the widespread adoption of digital assets and tokenization, which financial institutions have been preparing for over the years.

This development trend has been driven by advancements in blockchain infrastructure, such as Global Layer 1 or Interlinking Networks, which can accommodate organizations operating under regulatory compliance requirements. Solutions to key uncertainty issues are also emerging, including compliance and balance sheet requirements, as well as the anonymity of blockchain wallets and how to meet KYC and AML requirements on public blockchains. As discussions deepen, it becomes increasingly clear that centralized finance (CeFi) and decentralized finance (DeFi) are not binary opposites; comprehensive adoption on the institutional side of finance may only be feasible for those organizations that adopt a hybrid centralized operational governance model within the ecosystem.

In the institutional circle, exploring this field is usually positioned as entering an attractive potential area where innovative investment products can be developed, reaching previously untapped new consumers and liquidity pools, and adopting new digital operating models and more cost-effective market structures. Only time and innovation can prove whether Decentralized Finance will exist in its purest form, or if we will see a compromise that allows a certain degree of decentralization to play a bridging role in the financial world.

This article will review the recent history of Decentralized Finance, explain some commonly used terms, and then delve into some key drivers in the DeFi space. Finally, we will explore the challenges that the institutional financial services sector will face on the road to institutional DeFi.

Analysis of the DeFi Landscape

1.1 What is Decentralized Finance?

The core of DeFi is to provide financial services on-chain, such as lending or investing, without relying on traditional centralized financial intermediaries. In this rapidly evolving field, although there is no officially unified definition, typical DeFi services and solutions usually have the following characteristics:

• Self-custody wallets allow investors to become their own asset managers.
• Use code to maintain and manage the smart contract custody of digital asset custody.
• Staking contracts that calculate and allocate rewards based on the deposit value and/or variables using code.
• Asset exchange protocol that allows assets to be exchanged and used in lending or decentralized exchanges (DEX).
• Issuing securitization and remortgaging structures for different assets based on underlying "wrapped" assets.

1.2 What is Institutional DeFi?

Institutional DeFi refers to the adoption and adaptation of DeFi structures by institutions, as well as their participation in decentralized applications (dApps) or solutions. By exploring this topic within the regulatory framework of the financial industry, the advantages of DeFi can be introduced into traditional financial markets, opening up possibilities for creating new cost efficiencies and effects, while also paving the way for new growth paths. These new paths include the tokenization of physical assets and securities, as well as the integration of programmability into asset classes, leading to new operational models.

The development history of Decentralized Finance 1.3

DeFi projects rapidly emerged in the summer of 2020, ushering in a new era. Due to high liquidity, expensive assets, and high mining returns, DeFi developed rapidly during the Federal Reserve's large-scale quantitative easing in response to the COVID-19 pandemic, with the total value locked (TVL) in DeFi services rising from $1 billion at the beginning of the year to over $15 billion by the end.

In 2021, the number of DeFi users surged, with over 7.5 million unique users trading, a 2550% increase from the previous year, and the TVL peaked at $169 billion in November. However, in 2022, due to multiple interest rate hikes and rising inflation, along with some illegal activities in the ecosystem, DeFi faced some setbacks.

At the beginning of 2023, private financing in the DeFi sector was exhausted, and the TVL fell to less than 50 billion USD. Nevertheless, the fundamentals of the DeFi community remain resilient, with a steady increase in user numbers, and many projects continue to focus on product and capability development.

By the end of 2023, with the United States approving spot crypto ETF products for the first time, the market saw growth, opening the door for institutional participants to engage more deeply in these emerging ecosystems.

1.4 Early Commitment to Implement Decentralized Finance

The DeFi movement has led to the emergence of coding structures that demonstrate how to operate without the involvement of certain intermediaries, typically involving smart contracts and/or a peer-to-peer (P2P) basis. DeFi services have been rapidly adopted due to their low access costs and have proven their value in providing efficient asset pools and reducing intermediary fees.

Decentralized Finance reprograms or replaces existing intermediary activities through smart contract programming to achieve higher efficiency, thereby changing workflows and transforming roles and responsibilities. DeFi applications (i.e., DApps) are the tools that provide these new financial services.

The Evolution of the Market Structure of DeFi Institutions

The DeFi-driven market concept proposes a dynamically open market structure, whose native design will challenge the norms of traditional financial markets. This has sparked discussions about how DeFi might integrate or collaborate with the broader financial ecosystem, as well as the potential forms that new market structures might take.

2.1 Governance, Trust, and Centralization

In the institutional space, there is a greater emphasis on governance and trust, requiring ownership and accountability in the roles and functions being played. This seems to contradict the decentralized nature of DeFi, but it is seen as a necessary step to ensure compliance with regulations and to provide clarity for institutional participants to adapt to and adopt these new services. This situation has given rise to the concept of "decentralization illusion," as the need for governance inevitably leads to a certain degree of centralization and concentration of power within the system.

Even with a certain degree of centralization, the new market structure may be more streamlined than the existing market structure, as intermediary activities are significantly reduced. This will lead to interactions becoming more parallel and concurrent, reducing the number of interactions between entities, thereby improving operational efficiency and lowering costs. In this structure, management activities, including Anti-Money Laundering (AML) checks, will also become more effective, as the reduction of intermediary institutions increases transparency.

2.2 The Potential of New Roles and Activities

Pioneering use cases in the institutional DeFi ecosystem highlight how today's market structure may evolve. Public blockchains could become the de facto industry utility platform, much like the internet became the delivery infrastructure for online banking. The industry should anticipate further advancements in areas such as tokenization, virtual funds, asset classes, and intermediary services; and/or applications with permissioned layers.

Participate in the Decentralized Finance market

For institutions, the nature of Decentralized Finance (DeFi) is both intimidating and convincing. Participating, operating, and trading in the open ecosystem offered by DeFi products may conflict with the closed or private environments of traditional finance. This is also one of the reasons why many advancements in the institutional digital asset space have occurred in the realm of private or permissioned blockchain networks.

In contrast, public chain networks have the potential for open scalability, low entry barriers, and readily available opportunities for innovation. These environments are inherently decentralized, built on the principle of no single point of failure, and user communities are incentivized to "do good."

3.1 Participate in the verification table outline

When evaluating participation in any digital asset and blockchain ecosystem, the main considerations should include the maturity of the blockchain and its corresponding roadmap, achievable final settlement consensus, liquidity, interoperability with other on-chain assets, regulatory perspectives, and adoption; it is also necessary to assess the risks of network technology, network security, continuity plans, and the core community and developer participants of the network.

Enterprises must adapt to the level of transparency and new working methods they can accept and manage, while maintaining a high degree of concern for their own and their respective clients' interests in data and asset protection. Asset custody and secure storage are crucial, requiring an understanding of novel approaches and a substantive addressing of the gray areas in these fields.

Identity is very important. In the process of institutionalizing Decentralized Finance, deploying verifiable credentials is one of the basic elements. These credentials will facilitate governance and provide assurance for institutions when participating in these open blockchain ecosystems.

Regulatory Barriers

4.1 A framework without intermediaries

The DeFi system requires regulators, standard setters, and policymakers to reconsider their traditional oversight frameworks, which were established alongside intermediaries. Given that decentralized systems may lack regulatory and oversight access points, DeFi is undoubtedly driving a paradigm shift.

4.2 Market Integrity and Investor Protection

Since the end of 2023, the development momentum and cross-jurisdictional progress in this field have been growing. The International Organization of Securities Commissions has released policy recommendations for Decentralized Finance and crypto assets, providing more clarity for the global regulatory landscape.

4.3 Handle with caution

The final standards of the Basel Committee on the prudent handling of banks' crypto assets will be released in December 2023, focusing on the inherent market, credit, and liquidity risks associated with crypto asset-related activities, as well as defining disclosure and the required safeguards.

5. DeFi: What is the next step?

The year 2024 will be a turbulent time for all forms of Decentralized Finance, and thereafter, 2025 will be a decisive moment. The implementation of regulation is a driving force that will continue to determine institutional interest and adoption speed in the digital realm.

The technology itself is maturing, and people's understanding of it is becoming deeper. Regulations are becoming clearer, and with lessons learned from pilot programs, it is now easier to acquire the necessary expertise. The industry is currently in the "post-proof of concept" stage, where it needs to upgrade visible and successful "live" products into scalable commercial products.

In key areas such as cross-chain interoperability, Oracles, digital or decentralized ID solutions, and trust anchors, the continuous maturation of technology, innovation, and regulation will only fuel the adoption momentum needed to reach critical mass. While the road to institutional DeFi may not take us to the "moon", it will certainly be an exciting journey as we steer towards a new and captivating destination.