The Road to Institutional Decentralized Finance

Decentralized Finance(DeFi) is expected to create a new financial paradigm in the institutional sector, which is based on the principles of collaboration, composability, and open-source code, supported by an open and transparent network. This article delves into the development history of DeFi and its potential impact on institutional financial services.

Introduction

The evolution of DeFi and its application potential in institutional scenarios has attracted widespread attention in the industry. Supporters believe that a new financial paradigm based on collaboration, composability, open-source principles, and built on open and transparent networks is emerging. As a highly regarded field, the pathway to conducting regulated financial activities using DeFi is gradually being constructed.

Changes in the macroeconomic environment and global regulatory landscape hindered large-scale meaningful progress, with development mainly focused on the retail sector or conducted through sandbox environments. However, institutional DeFi is expected to take off in the next 1-3 years, combined with the widespread adoption of digital assets and tokenization, as financial institutions have been preparing for this for years.

This development path benefits from the advancements in blockchain infrastructure, supporting institutions operating under regulatory compliance requirements in the form of a global layer network or interconnected network. Key uncertainties are also being resolved, 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 mutually exclusive; comprehensive adoption on the institutional end in the financial sector may only apply to institutions with a hybrid centralized operational governance model within the ecosystem.

For institutions, exploring this field is often positioned as a journey into an attractive domain, where innovative investment products can be developed, previously untapped new clients and liquidity pools can be reached, and new digital operating models and more cost-effective market structures can be adopted. Only time and innovation will prove whether DeFi will exist in its purest form, or if we will see a compromise solution that allows a certain degree of Decentralization to play a bridging role in the financial world.

This article reviews the recent history of DeFi, attempting to unveil the mystery behind some commonly used terms, and then delves into some key drivers in the DeFi space. Finally, we will explore what challenges the institutional financial services sector will face on the road to institutional DeFi.

DeFi Overview

What is DeFi?

The core of DeFi is to provide financial services on-chain, such as lending or investing, without relying on traditional centralized financial intermediaries. There is currently no official and universally recognized definition in this rapidly evolving field, but typical DeFi services and solutions usually contain the following elements:

• Self-custody wallets allow investors to be their own asset custodians.
• Use code to maintain and manage smart contract custody of digital assets custody.
• Use code to calculate and distribute rewards for the staking contract based on deposit value and/or variables.
• An asset exchange protocol that allows asset swapping and usage in lending or decentralized exchanges (DEX).
• Issuing securitization and re-collateralization structures for different assets based on underlying "wrapped" assets.

What is institutional DeFi?

Institutional DeFi refers to the institutional adoption and adaptation of the DeFi structure, as well as the 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 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 integrating programmability into asset classes, leading to the emergence of new operational models.

The differences between institutional DeFi and traditional DeFi are as follows:

• Asset Custody: Institutional DeFi has assets held by regulated financial institutions instead of smart contracts.
• Access: Institutional DeFi needs to conduct KYC/AML through digital identity, rather than being permissionless.
• Governance: Institutional DeFi is governed by specialized organizations and professionals, rather than a DAO.
• Regulation: Institutional DeFi is under the supervision of regulatory agencies, rather than community governance.
• Goal: Institutional DeFi aims to improve efficiency, reduce costs, and increase transparency, not just financial innovation.

The development history of DeFi

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

During this period, new DeFi projects received significant funding support, and the number of projects and related tokens surged. By the end of 2021, the number of DeFi users skyrocketed to over 7.5 million, a 2550% increase from a year earlier, with TVL reaching a peak of $169 billion in November 2021. New terms and concepts such as Uniswap and Yield Farming were introduced into everyday financial life.

In 2022, due to multiple interest rate hikes and significant inflation, along with some misconduct within the ecosystem, DeFi experienced numerous issues, including some well-known collapse events. This led the entire market into a cautious and rational phase in the second half of 2022.

This trend became more pronounced at the beginning of 2023, as financing costs rose and private financing in the fintech DeFi sector dried up, leading to a year-on-year decline of 69% in trading activity in the first quarter of 2023. This caused the TVL in DeFi systems to fall to less than $50 billion by April 2023, and it dropped to a low of $37 billion by the end of October 2023.

Despite experiencing significant declines and the "crypto winter" at the same time, the fundamentals of the DeFi community remain resilient, with a steady increase in the number of users. Many DeFi projects persistently focus on building products and capabilities.

By the end of 2023, the market experienced growth as the United States approved spot cryptocurrency ETF products for the first time, which is widely seen as an important sign of digital assets further integrating into traditional financial products. More importantly, this has opened the door for institutional participants to engage more deeply in these emerging ecosystems, which will bring much-needed liquidity to the field.

Early Commitment to Achieving DeFi

In the field of native crypto assets, the DeFi movement has spawned coding structures that demonstrate how to operate without the involvement of certain intermediary institutions, often involving smart contracts and/or peer-to-peer ( P2P ) foundations. Due to the low barriers to entry, DeFi services were rapidly adopted in the early stages and quickly proved their value in providing efficient asset pools and reducing intermediary costs, applying economic behavioral finance techniques to manage demand, supply, and prices.

These new advantages are achieved because DeFi reprograms or replaces existing intermediary activities through smart contracts, achieving greater efficiency and thereby changing workflows and transforming roles and responsibilities. In the "last mile" with investors and users, DeFi applications (, namely DApps ), are the tools for providing these new financial services. Therefore, the existing market structure may change.

Pioneer Institution DeFi Activities

Many institutional use cases can be extracted from the DeFi space, utilizing the tokenization of physical assets and securities. Here are some examples that demonstrate how financial service products combine with technology and regulations to create new value; illustrating why institutional DeFi is attractive.

1. Interoperability ( 2023: By using DeFi structures in the institutional space, self-custody wallets can achieve a distributed asset custody model while providing comprehensive and independent digital account ) addresses ( that can be used for trading liquidity, settlement, and reporting. An important use case is the smart contract bridge, connecting different blockchains to achieve interoperability and avoid fragmentation caused by blockchain selection.

2. Use stablecoins to refinance tokenized financial instruments ) 2023: The DeFi system can also be used for financing in traditional industries, although it has not yet been widely applied. For example, security tokens representing certain real-world financial instruments can be placed as collateral in a smart contract "vault" to obtain stablecoins, which can then be converted into fiat currency.

3. Tokenized Funds in Asset Management ( 2023: Tokenized fund units or tokens can be distributed via blockchain, directly accessible to qualified investors, while maintaining investor records on-chain. At the same time, smart contract facilities allow for the rapid or near real-time subscription and redemption using regulated stablecoins. Furthermore, tokenized fund units representing high-quality liquidity traditional financial instruments can serve as collateral.

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The Evolution of DeFi Institutional Market Structure

The market concept driven by DeFi presents an intriguing market structure that is inherently dynamic and open, with its native design challenging the norms of traditional financial markets. This has led to much discussion about how DeFi may integrate or collaborate with the broader financial ecosystem and the forms that new market structures may take.

) Governance, trust, and centralization

In the institutional realm, there is a stronger emphasis on governance and trust, requiring ownership and accountability in the roles and functions played. While this seems to contradict the decentralized nature of DeFi, many believe it is a necessary step to ensure regulatory compliance and 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 our current market structure, as the intermediaries' activities within organizations have been significantly reduced. As a result, orderly interactions will become more parallel and concurrent. This, in turn, helps reduce the number of interactions between entities, thereby improving operational efficiency and lowering costs. Under this structure, management activities, including anti-money laundering ( AML ) checks, will also become more effective—because the reduction of intermediaries can enhance transparency.

The potential for new roles and activities

The pioneering use cases in the institutional DeFi ecosystem highlight how today's market structure might evolve. In this way, public blockchains can become de facto industry utility platforms, much like the internet became the delivery infrastructure for online banking. There have already been precedents for launching institutional blockchain products on public blockchains, particularly in the money market fund sector. The industry should anticipate further developments, such as in the areas of tokenization, virtual funds, asset classes, and intermediary services; and/or with permissioned layers.

Participate in the Decentralized Finance market

For institutions, the nature of DeFi is both daunting and convincing.

Participating, operating, and trading in the open ecosystem provided by DeFi products may conflict with the closed loop or private environments of traditional finance. In traditional financial environments, clients, counterparties, and partners are well-known, and risks are accepted based on appropriate levels of disclosure and due diligence. This is also one of the reasons why many of the advancements in the institutional digital asset space have occurred within the realm of private or permissioned blockchain networks, where trusted administrators act as "network operators" and owners are responsible for approving participants' entry into the network.

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