Author: Dan J Sleep; Translator: bocaibocai.eth
Since the Bank for International Settlements (BIS) and the Monetary Authority of Singapore (MAS) launched the "Financial Internet (Finternet)" and the infrastructure Global Layer 1 led by the central bank, respectively, the traditional financial sector is ushering in a huge trend of change: the financial and monetary system is shifting towards tokenization. Global policymakers, financial institutions and startups have paid unprecedented attention to and researched tokenization, and this topic has become one of the core topics of many important industry conferences.
In addition to the technical process and infrastructure of tokenization, decentralized finance (DeFi), as one of the core innovations of the blockchain industry, has also become a hot topic in the traditional financial sector. Therefore, a new concept "institutional DeFi" came into being. Recently, Deutsche Bank published a research report on institutional DeFi, and the author translated this research report.
Different from the characteristics of native DeFi, which is non-accessible, assets are kept by smart contracts, and are governed by DAO organizations, institutional DeFi emphasizes that assets are kept by regulated financial institutions, KYC/AML is carried out in the form of digital identities, and governance is carried out by specialized organizations and professionals. Traditional financial institutions regard this regulated DeFi as a new growth tool that can reduce costs, increase efficiency, and enhance regulatory transparency.
The article also criticizes the phenomenon of "decentralization illusion" in the field of native DeFi, that is, holding high the banner of "decentralization" and governing in the name of DAO, but in fact it is extremely centralized, and the right to speak and governance tokens are in the hands of a small number of people. The author has long noticed this phenomenon, and most people in the industry have turned a blind eye to it, becoming the "elephant in the room", which is something worth reflecting on.
Some people may think that it is ridiculous that decentralized DeFi is used by "removed intermediaries" to carry out financial business. But if you think about it carefully, take DeFi lending as an example. In native DeFi, lending is done by a group of people providing underlying asset liquidity to obtain the income of the lent assets, and another group of people providing collateral assets and lending the underlying assets in the smart contract and paying interest. In this process, the intermediary is simply replaced by the smart contract, and the role positioning has changed, but the intermediary has not disappeared. It is not unrealistic for financial institutions to operate DeFi protocols. On the contrary, it reduces many labor costs and processes.
In fact, no "credit currency" was created out of thin air in this process. The ability of traditional commercial banks to derive credit currency through credit is technically achievable in native DeFi but difficult to achieve at the commercial level. Behind this is the credit assessment of borrowers and a series of social system constraints, which is a governance issue. It is almost impossible to conduct unsecured credit lending in DeFi without access, and there is a lack of accountability system and legal constraints for users.
And institutional DeFi is the path to solve this problem. Financial institutions can greatly reduce the threshold for enterprises and individuals to participate in finance through regulated DeFi protocols, achieve broader financial inclusion, and reduce costs and increase efficiency. From the perspective of central banks and policymakers, this is a positive thing for the economy of the entire national society. This will also be a major trend in the tokenization transformation of the traditional financial sector in the future.
To achieve this goal, technology is not the core obstacle, but governance and laws and regulations are the key. Today, we can see that more and more central banks and financial institutions have begun a series of pilot projects for tokenization and the formulation of regulatory frameworks. I believe that it is only a matter of time before large-scale applications are truly implemented.
Institutional applications of decentralized finance (DeFi) have the potential to create a new financial paradigm based on the principles of cooperation, composability, and open source code, and are based on an open and transparent network. In this white paper, we explore the history of DeFi and its possible future development, focusing on how this affects institutional financial services.
The evolution of decentralized finance (DeFi) and its potential for application in institutional use cases have attracted great interest from industry observers. Proponents argue that there is a strong case for the rise of a new financial paradigm based on the principles of collaboration, composability, open source code, and underpinned by open, transparent networks. As a sector entering the spotlight, the path to regulated financial activities using DeFi is under construction.
The changing macroeconomic and global regulatory environment has hindered widespread meaningful progress, with development primarily occurring in the retail sector or through incubation sandboxes. However, over the next one to three years, institutional DeFi is expected to take off, coupled with the widespread adoption of digital assets and tokenization, a scenario that financial institutions have been preparing for for years.
This path is driven by advances in blockchain infrastructure, in the form of Global Layer 1 or Interlinking Networks to accommodate organizations operating under regulatory compliance requirements. Issues are also emerging to resolve key uncertainties, including compliance and balance sheet requirements, as well as the anonymity of blockchain wallets and how to meet Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements on public blockchains. As these discussions deepen, it becomes increasingly clear that centralized finance (CeFi) and decentralized finance (DeFi) are not binary opposites; and full adoption on the institutional side of finance may only be feasible for organizations that have a hybrid model of centralized operational governance in the ecosystem.
In institutional circles, exploring this space is often positioned as a journey of discovery into a field full of attractive potential, where innovative investment products can be developed to reach new, previously untapped consumers and liquidity pools, and where new digital operating models and more cost-effective market structures can be adopted. Only time (and innovation) will tell whether DeFi will survive in its purest form, or if we’ll see a compromise that enables a degree of decentralization that bridges the financial world.
In this whitepaper, we reflect on the recent history of DeFi, attempt to demystify some of the commonly used terminology, and then take a closer look at some of the key drivers in the DeFi space. Finally, we’ll consider what lies ahead for the institutional financial services community on the road to institutional DeFi.
The core of DeFi is to provide financial services such as lending or investing on the chain without relying on traditional centralized financial intermediaries. There is no official and universally recognized definition in the rapidly developing field. Typical DeFi services and solutions can identify the following elements:
Self-custodial wallets, which allow investors to become their own custodians.
Smart contract custody that uses code to maintain and manage digital asset custody.
Staking contracts that use code to calculate and distribute rewards based on deposit values and/or variables.
Asset exchange protocols that allow one asset to be exchanged for another and used in lending or decentralized exchanges (DEX), such as Uniswap, one of the early players in the DeFi ecosystem, use smart contracts to execute transactions.
Securitization and re-hypothecation structures that issue different assets based on the underlying "wrapped" assets, where the issued assets can have secondary market value.
Institutionalized DeFi - the focus of this article - refers to the institutional adoption and adaptation of DeFi structures, as well as institutional 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 transferred to 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 and the emergence of new operating models.
The difference between institutional DeFi and traditional DeFi is shown in Figure 1.
In an open environment, DeFi-related projects stimulated the crypto market in the summer of 2020, ushering in a new era. Due to its high liquidity, expensive assets, and high mining returns, DeFi quickly rose during the massive quantitative easing (QE) restarted by the Federal Reserve (Fed) in response to the COVID-19 pandemic, and the total assets (total locked value, TVL) in DeFi services rose from US$1 billion at the beginning of the year to more than US$15 billion at the end of the year.
During this period, new DeFi projects received a lot of financial support, and the number of projects and related tokens was relatively saturated, trying to take advantage of the trend. Total DeFi user count surged at the end of 2021, with over 7.5 million unique users transacting in the DeFi ecosystem, up 2,550% from a year ago, and TVL peaking at $169 billion in November 2021 (based on data from DeFiLlama). New terms and names like Uniswap and Yield Farming were introduced into everyday financial life.
During the year, DeFi experienced its fair share of issues, including some well-publicized crashes, due to multiple interest rate hikes and a significant rise in inflation, coupled with some malfeasance in the ecosystem. This meant that the entire market was forced to take a step back and enter a phase of prudence and rationality in the second half of 2022.
This trend became more pronounced in early 2023, as private funding in the Fintech DeFi space dried up as funding costs rose, reflected in a 69% year-over-year decline in transaction activity year-to-date (as of Q1 2023, Fintech Global Research). This caused TVL in the DeFi system to drop to less than $50 billion in April 2023 and to a low of $37 billion at the end of October 2023.
Despite the significant decline and the concurrent “crypto winter” (i.e., the decline in the value of crypto assets), the fundamentals of the DeFi community remain resilient, with a steady increase in the number of users and many DeFi projects persevering and focusing on product and capability building.
In late 2023, the market saw growth due to the first approval of a spot crypto ETF product in the United States, widely seen as a major sign of the further integration of digital assets into traditional financial products. More importantly, this opened the door for institutional players to participate more deeply in these emerging ecosystems, which would bring much-needed liquidity to the space.
In the native crypto asset space, the DeFi movement has led to coding structures that demonstrate how DeFi can work without the involvement of certain intermediaries, typically involving smart contracts and/or peer-to-peer (P2P) foundations. Due to the low cost of access, DeFi services were quickly adopted in their early days and quickly proved their value in providing efficient asset pools and reducing intermediary fees, and applying economic behavioral finance techniques to manage demand, supply and price.
These new advantages are achieved because DeFi redesigns or replaces existing intermediary activities through smart contract programming to achieve greater efficiency, thereby changing workflows and transforming roles and responsibilities. In the "last mile" with investors and users, DeFi applications (i.e. DApps) are the tools to provide these new financial services. As a result, existing market structures can change.
Pioneering Institutional DeFi Activity
There are many institutional use cases that can be extracted from the DeFi space, leveraging the tokenization of real assets and securities.
Below are some examples that try to outline the connection between financial service products and technology and regulations to create new value; exemplifying why institutional DeFi is attractive.
Case 1: Interoperability, 2023 By using DeFi constructs in the institutional space, self-custodial wallets can implement a distributed asset custody model while providing comprehensive and independent digital accounts (addresses) that can be used for transaction flow, settlement and reporting. An important use is the smart contract bridge, connecting different blockchains to achieve interoperability and avoid fragmentation caused by blockchain selection.
Applicability: Serves as a connection point to connect public, public permissioned and private networks to minimize fragmentation while allowing high access and participation.
Example:
https://www.mas.gov.sg/-/media/mas-media-library/development/fintech/guardian/interlinking-networks-technical-paper-vfinal.pdf
Case 2: Refinancing Tokenized Financial Instruments Using Stablecoins, 2023
DeFi systems can also be used for financing in traditional industries, although they are not yet widely used. For example, security tokens representing certain real-world financial instruments can be placed in a smart contract "vault" as collateral, receive stablecoins, and then converted into fiat currency.
Reference:
https://www.sgforge.com/refinancing-dai-stablecoin-defi-makerdao/
Case 3: Tokenized Funds in Asset Management, 2023
Tokenized fund units or tokens can be distributed through the blockchain, directly open to qualified investors, and maintain investor records on-chain, while smart contract facilities allow for fast or near-instantaneous subscription and redemption using regulated stablecoins.
Further, tokenized fund units representing high-quality, liquid traditional financial instruments can be used as collateral.
Example:
https://finance.yahoo.com/news/blackrock-launches-first-tokenized-fund-222700828.html?guce_referrer=aHR0cHM6Ly93d3cuYmluZy5jb20v&guce_referrer_sig=AQAAAKT37GXfe84hphq0iMK6yz h8B9rXpnPwpnPonYy1t7sBzLgpCAdM7Lo3TaQqzplg62uy34Nlh0QwotmrfATOLgFLlUWOrM4Jx6Qe_tYFQCjpr-QpS6ZxvYQnBEdUPH-6CKs8nbkAE5BmfHIgpOqxxSbEJEelcA7SBtbiMeDxsokm&_guc_consent_skip=1720507214
The concept of markets driven by DeFi presents a fascinating market structure that is inherently dynamic and open, and whose native design will challenge the norms of traditional financial markets. This has led to a lot of discussion on how DeFi can integrate or collaborate with the broader financial industry ecosystem, and what form the new market structure might take.
In the institutional space, there is a greater emphasis on governance and trust, requiring ownership and accountability in the roles and functions performed. While this may seem contradictory to the decentralized nature of DeFi, many believe that it is a necessary step to ensure regulatory compliance and to provide clarity for institutional players to adapt and adopt these new services. This dynamic has given rise to the concept of the “decentralization illusion”, as the need for governance inevitably leads to a certain degree of centralization and concentration of power within the system.
Even with some degree of centralization, the new market structure is likely to be more streamlined than the one we have today, as there is a significant reduction in organizational intermediation activities. As a result, orderly interactions will become more parallel and parallel. This in turn helps to reduce the number of interactions between entities, thereby improving operational efficiency and reducing costs. Under this structure, regulatory activities, including anti-money laundering (AML) checks, will also become more effective – as the reduction of intermediaries can improve transparency.
Institutional DeFi Ecosystem
The pioneering use cases listed in Section 1.4 highlight how today’s market structure may evolve into the next wave of DeFi innovation.
In this way, public blockchains can become the de facto industry utility platform, just as the Internet became the delivery infrastructure for online banking. There is already some precedent for launching institutional blockchain products on public blockchains,7 Particularly in the area of money market funds. The industry should expect further progress, for example in the area of tokenization. Or virtual funds, asset classes and intermediary services; and/or with a permission layer.
The nature of DeFi itself is both daunting and compelling for institutions.
Participating, operating and trading in the open ecosystem provided by DeFi products may conflict with the closed-loop or private environment of traditional finance, where customers, counterparties and partners are all known and risks are accepted based on appropriate levels of disclosure and due diligence. This is one of the reasons why many of the advances in the institutional digital asset space to date have occurred in the field of private or permissioned blockchain networks, where trusted management parties act as "network operators" and owners are responsible for approving participants to enter the network.
In contrast, public chain networks have potential for open scale, low barriers to entry, and ready 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." The consensus protocols that maintain the security and consistency of the blockchain (Proof of Stake (POS), Proof of Work (POW) are the main examples) may be different on different chains. This is a way for participants - as validators - to contribute and be rewarded in what we think of as the "blockchain economy."
When evaluating participation in any digital asset and blockchain ecosystem, key considerations should include the maturity of the blockchain and its corresponding roadmap, the final settlement consensus that can be achieved, liquidity, interoperability with other on-chain assets, regulatory perspectives and adoption; the risks of the network technology, network security, continuity plans, and the core community and developer participants of the network should also be evaluated. The degree of technical standardization and a common understanding of taxonomies can also pave the way for the development of applications.
On this basis, private chains appear to be less risky and more attractive. However, the lower risk level of private chains relative to public chains should also be considered. The factors that can make or break a project are: availability of expertise, vendor dependency, accessibility, liquidity scale, and the cost of creating, maintaining, and running a private blockchain. Imagine if every bank had to run its own private internet to support its internet banking applications. Cost would be a key factor, especially during the transition period when blockchain will operate in parallel with existing technology stacks.
Ultimately, businesses must adapt to the level of transparency and new ways of working that they can accept and manage, while maintaining a strong focus on their own and their respective customers’ interests in terms of data and asset protection. Regardless of where you stand, Asset custody and safekeeping are critical on either side of DeFi. The key is to understand novel approaches – such as assets held by smart contracts as an extension of custody – and to substantively address the grey areas in these areas, which can help reduce risk and regulatory issues.
As another example, identity is very important, and deploying verifiable credentials is one of the essential elements in the process of institutionalizing DeFi. These credentials will facilitate governance and provide safeguards for institutions when participating in these open blockchain ecosystems. Verifiable credentials enable anyone to prove their identity using cryptographic proofs without directly sharing personally identifiable information (PII), while storing such PII materials off-chain or in a cryptographically decentralized manner for added protection.
Therefore, centralized governance under such digital identities in the "DApps" layer can enable reliable customer due diligence (KYC), sanctions checks, and money laundering prevention in areas such as investors entering and exiting institutional DeFi structures. In addition, trading market abuse detection and other market integrity measures such as investor suitability will become new safeguards that can be implemented. Digital identities help identify risk patterns while maintaining transaction confidentiality and banking privacy.
In this way, the core advantages of DeFI in terms of cost-effectiveness and innovative value are preserved and certain key attributes are brought together to successfully achieve a regulatory balance.
In recent years, early development and evaluation of blockchain in institutions have been advocated. Notably, the multi-stage industry-level "Guardian Project" launched in June 2022 by the Monetary Authority of Singapore (MAS) seeks to make progress on the path to institutional-grade DeFi. Develop “open and interoperable” networks and explore the potential of interconnected markets.
This is in line with the broader industry vision of innovation, which is to achieve scale, liquidity and new market connections through the use of blockchain-based technologies, without compromising the financial stability and integrity of the ecosystem. How to achieve this goal while taking into account regulation? This is the trillion-dollar question facing DeFi institutions.
There is no doubt that the road ahead is long and full of innovation, exploration and review/reflection. The DeFi system requires regulators, standard setters and policymakers to rethink their traditional supervisory frameworks, which are built with intermediaries at the center. Given the potential lack of regulatory and supervisory access points for decentralized systems, DeFi is undoubtedly driving a paradigm shift.
Since the end of 2023, the development momentum and cross-jurisdictional progress in this field has been growing: in December, the International Organization of Securities Commissions issued the “Regulations on DeFi”. 9 This follows the publication of the IOSCO Policy Recommendations on Crypto-Assets in November 2023, which is positioned to complement the policy recommendations covering DeFi. With these two interoperable global policy recommendations, an activity that is not subject to one regulation will be subject to the other. 10 As a result, the regulatory landscape is now clearer and will be further clarified as the IOSCO recommendations are implemented by its members around the world.
This clarity is also driven by the global regulatory principles of same activity, same risk, same regulation and technology neutrality. This means that a tokenized traditional financial instrument should be regulated according to its nature as a financial instrument, rather than being treated differently simply because it is tokenized. As tokenization is a technological process, existing technology risk regulations will apply. Financial institutions’ management of their assets and liabilities exposed to new technologies is increasingly influenced by how to understand and calculate the risks arising from the unique characteristics of the technology.
The impact of participation in the digital asset field on the balance sheet is another challenge in terms of regulatory evolution. The final standard of the Basel Committee (BCBS) on the prudent treatment of crypto assets by banks was also released for comment in December 2023. Its focus is on recognizing the combination of markets, which is concentrated in recognizing the market, credit and liquidity risks inherent in crypto-asset related activities (essentially including DeFi), as well as defining disclosures and required safeguards. The Basel Committee's standards also address the need to roughly divide asset types into Group 1 and Group 2 based on classification criteria that reflect the potential risks that need to be managed. Another consultation on the Basel Accord on disclosure requirements ended on January 31, 2024. Most recently, on May 16, 2024, the Basel Committee announced that the implementation date would be postponed by one year to January 1, 2026. How institutional DeFi is classified in these circumstances remains to be substantively tested.
These are important milestones in the industry’s journey of discovery. They are the result of years of intensive advocacy work by the public sector and industry to understand, discuss, calibrate and agree on interpretations that could pave the way for further progress as markets and technologies evolve in tandem. Building and unifying an understanding of how to think about new digital domains, including the risks associated with engaging in them, will serve as an important foundation and guardrail for innovation, while providing greater regulatory clarity.
Many use cases demonstrate that innovative technologies, combined with appropriate regulations, can be a very powerful force for change, reshaping and rearranging business models and markets.
Light bulbs did not evolve from the continuous improvement of candles, but rather from the continuous improvement of alternative technologies that address the deficiencies of wax candles.
If we think about the above and believe in the potential power of a broadly regulated or institutional version of DeFi, we must acknowledge that it requires a set of core tenets, standards, and prerequisite capabilities that build the structure of the ecosystem. Only then, in fact, will institutional players adopt it as a new growth tool and move forward with sufficient safeguards and regulatory certainty.
After a turbulent period for all forms of DeFi, 2024 will be a defining moment. The implementation of regulation is a driving force that will continue to determine the interest and speed of institutional adoption of the digital space. It can be said that DeFi has amplified the challenges of risk management, anti-money laundering, and information privacy. However, if considered in conjunction with the opportunities presented by institutional DeFi, including financial inclusion, it is difficult to ignore its potential benefits for new products, services, and operating models in the future digital-first financial industry.
The technology itself is maturing and people's understanding of the technology is deepening. Regulations are becoming clearer and the necessary expertise is now more accessible as lessons are learned from pilots. For example, increased regulation and expertise in control functions such as compliance and auditing can help introduce DeFi technologies to the financial industry.
The industry is currently in a “post-proof-of-concept” phase, where visible and successful “live” products need to be upgraded to scaled commercial products. This transition will help achieve cost efficiencies or new growth and further the path to institutional development. It remains to be seen how the factors covered in this article will influence or inhibit the trajectory of institutional participation in regulated DeFi.
The continued maturation of technology, innovation, and regulation in key areas such as cross-chain interoperability, Oracles, digital or decentralized ID solutions, and trust anchors will only add fuel to the adoption momentum required to reach critical mass. While the path to institutional DeFi may not take us to the “moon,” it will certainly be an exciting journey that takes us to a new and fascinating destination.
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