Industries
22 min read

Institutional DeFi: How DeFi is revolutionizing Financial Services

Published on
January 12, 2023
Authors.
Patrick Mehrhoff
CEO | MEHRHOFF DIGITAL
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DeFi protocols can revolutionize the world of finance by streamlining transactions in foreign exchange, equities, bonds, and other real-world assets by creating digital representations or tokens on the blockchain.

This would create cost savings and new business opportunities for issuers, investors, and financial institutions.

However, many DeFi protocols need more safeguards and security standards for use in mainstream finance. This is where Institutional DeFi comes into play, combining the efficiency of DeFi protocols with regulatory compliance and customer-safety requirements.

To make Institutional DeFi a reality, financial institutions must make key design choices in three critical areas:

  • blockchain
  • participation
  • and token design. 

The decisions made regarding privacy and efficiency in transactions, user adoption rate, and interoperability with other tokenized assets will impact the success of DeFi.

Trust anchors are crucial in regulated institutions as they establish the identities of transacting parties and connect with legal frameworks. Technical standards must also be agreed upon to unlock DeFi's transformative potential in financial markets fully.

Institutional DeFi - Tokenisation, DeFi protocols, Safeguards

In essence, Institutional DeFi offers immense benefits to issuers, investors, and financial institutions. With proper design choices and safeguards, DeFi's full transformative potential can be realized.

Why is DeFi necessary for Financial Services?

The world of finance is built on trust and information, but it needs to be more efficient and siloed ledgers. Intermediaries maintain records across different systems, which leads to post-transaction coordination and lengthy settlement times.

Enter blockchain and distributed ledger technology (DLT), which can create a shared ledger that presents transactional and ownership information on a single platform. Tokenization takes this a step further by making digital representations of real-world assets.

By adopting DeFi protocols, institutions can leverage software code to execute financial transactions automatically. Institutional DeFi is a way to apply DeFi protocols to tokenized real-world assets while ensuring regulatory compliance and customer protection.

The potential benefits of this innovative model for the trillion-dollar finance industry are enormous. The race is on for innovators to perfect this approach and reap the rewards.

Breaking Barriers in Money and Asset Management with Tokenization

The financial industry has seen constant technological evolution that creates new business opportunities. Dematerialization, which replaced paper certificates with electronic book entries, paved the way for securitization, which added value to previously illiquid assets. However, despite these advances, trillions of dollars worth of real-world assets still need to be recorded on separate ledgers, creating inefficiencies and increasing costs and risks.

Blockchain technology has garnered increased attention in recent years with its promise of combining ledgers and networks. By creating a shared view of information, blockchain reduces the need for reconciliation after a trade or transaction. This shared view also enables the transparent and automatic execution of business rules and logic through smart contracts, such as the lending process.

The integration of blockchain technology has the potential to streamline financial services and increase efficiency while reducing costs and risks. With its ability to create a shared and transparent view of information, blockchain represents a potential panacea for the inefficiencies that have plagued the financial industry for far too long.

DeFi - History of Money and Assets - Physical, Electronic, Tokenized Form from Traditional Finance, Digital Finance to Institutional DeFi

Blockchain technology has been a game-changer for financial firms seeking to enhance the representation of real-world assets on a blockchain.

Tokenization reduces settlement risk and times, allowing for immediate asset exchange through "atomic" settlement.

With smart contracts powering asset tokenization, new and enhanced offerings have emerged, including intra-day repo solutions for clients on J.P. Morgan's Onyx Digital Assets platform and DBS Digital Exchange's platform for corporates to raise capital through the digitization of securities and assets.

Asset managers are eagerly embracing tokenization, with 70% of institutional investors expressing their willingness to pay a premium for the benefits of enhanced liquidity and quicker asset turnover.

The tokenization craze is in full swing, covering payment instruments and assets, opening the door to end-to-end asset exchange on the blockchain.

Tokenized payment instruments are gaining steam, with public and private entities exploring the possibilities.

Central banks are experimenting with central bank digital currencies (CBDCs), with 90% exploring the potential.

Privately issued stablecoins, cryptocurrencies linked to fiat money, have grown to nearly a $150 billion market.

Investors are also interested, with 88% of global institutional investors comfortable with digital representations of cash and a majority interested in investing in tokenized assets, according to Celent.

With regulators also clarifying the status of stablecoins and introducing regulatory frameworks, the tokenization wave is set to continue to surge.

The tokenization trend continues to thrive with various successful pilots across various asset classes, including equities, bonds, real estate, and commodities, with the potential to revolutionize the financial industry.

According to Celent, 91% of institutional investors are keen to invest in tokenized assets. J.P. Morgan, for instance, has already processed over $430 billion in repo transactions since November 2020 through their intra-day repo app on Onyx Digital Assets.

Meanwhile, DBS has already issued the DBS Digital Bond through a security token offering (STO), and French asset manager, Mata Capital, tokenized €350 million ($343 million) worth of funds.

Countries such as Switzerland and Germany have also implemented laws granting legal status to tokenized securities, paving the way for further growth and innovation in the tokenization space.

DeFi protocols open up innovative avenues for the delivery of financial services

Decentralized finance, or DeFi for short, is a rapidly growing sector in the world of public crypto-assets. It refers to decentralized applications (DApps) that provide financial services through automated computer code on a blockchain as the settlement layer. DeFi protocols are the code and procedures that govern these applications, and they operate without centralized intermediaries or institutions, using open-source code that allows for flexible composability.

The DeFi space has grown tenfold to reach $160 billion in total value locked in 2021 before decreasing to just over $50 billion as of October 2022. Many DeFi innovations have attracted billions of dollars of liquidity across decentralized exchanges, lending protocols, and other solutions such as liquidity staking and collateralized debt positions. Some notable innovations in the DeFi space include crypto lending and borrowing protocols and decentralized exchanges.

Liquidity pools are an example of DeFi's innovation, creating all-to-all markets that link buyers and sellers, liquidity providers in decentralized exchanges, or DEXes, and lenders and borrowers in lending protocols. Aave and Compound are prominent crypto lending and borrowing protocols operating through liquidity pools. Automated market markers (AMM) also provide a new method of price discovery, facilitating buy and sell orders in a self-executing manner. Uniswap and Curve are examples of decentralized crypto exchanges that use AMM.

While DeFi currently applies primarily to transactions in the largely unregulated crypto-asset industry, the programmable, self-executing business processes of DeFi protocols can interact with any tokenized asset. Leveraging tokenization and programmability to build full-scale financial services could have far-reaching implications for the finance industry, generating substantial cost savings as code reduces middle and back-office operations across firms and intermediaries.

However, before financial institutions can take advantage of DeFi protocols, they must adapt to the regulatory standards of today's trillion-dollar markets.

DeFi Benefits - Atomic Settlement, Mutualized and transparent ledgers, Composable nature, Interoperability, Programmable logic, Transparen and automated business logic, Innovative DeFi Solutions

DeFi offers a range of benefits, including secure atomic settlement, mutualized and transparent ledgers for real-time value movement, and a composable nature that enables seamless collaboration across multiple services. Its interoperability across asset classes and markets aggregates liquidity and enables a more globally integrated finance industry. Programmable logic automates multi-party operational activities, reducing overhead. Transparent and automated business logic enables new product features and offerings. At the same time, innovative DeFi solutions amplify the liquidity of tokens and tokenized real-world assets, given lower participation thresholds, such as decentralized exchanges.

The safeguards of DeFi for Financial Services: Compliance and Regulation

The finance industry relies on safeguards that defend investors against fraud and misconduct, combat financial crime and cyber malpractice, guarantee investor confidentiality, ensure that industry players fulfil minimum criteria, and provide a means of redress in case things go south.

For Institutional DeFi to meet regulatory requirements, establish trust, and encourage adoption by issuers, investors, and financial institutions, it must meet or surpass these standards.

Here are some of the critical safeguards necessary to create Institutional DeFi-based solutions:

  • Anti-Money Laundering/Know-Your-Customer risk controls
  • Protection of data privacy 
  • Cybersecurity measures 
  • Established governance and conduct models 
  • Effective mechanisms for recourse 
  • Legal clarity around smart contract-based business activity
DeFi - Safeguards - Compliance and Regulation
AML/KYC risk controls

AML/KYC risk controls are essential to safeguard financial institutions against legal liability and prevent inadvertent participation in money laundering. Properly designing risk controls, however, can be quite a task.

Financial institutions faced a hefty fine of $2.7 billion in 2021 for AML compliance policy failures.

To avoid the catastrophic consequences of control failures, the average mid-size to large organization must invest $22.7 million annually in financial crime compliance operations to establish practical standards.

Regulated financial activities through DeFi protocols require appropriate controls, and regulatory bodies are already setting expectations.

In August 2022, the US Department of the Treasury's Office of Foreign Assets Control (OFAC) slapped sanctions on Tornado Cash, a cryptocurrency mixer that cloaks the origin, destination, and counterparties of transactions, alleging that it had abetted the laundering of over $7 billion in cryptocurrency.

Blockchain technologies could offer innovative and cost-effective ways to implement proper controls.

For example, there are techniques for complying with AML/KYC without revealing personal information, such as using zero-knowledge proofs combined with pseudonymous identity mechanisms.

Data privacy

Data privacy is paramount for particular client segments, particularly for safeguarding their trading activities and positions in specific asset markets. However, public blockchains expose all information to anyone, making it possible to infer investor orders from publicly available data. As time passes, this likelihood only increases. Even tracking tools on Twitter and Telegram allow people to monitor large crypto-asset transactions by "whales" who hold a considerable amount of cryptocurrency.

In finance, client information is concealed and secured through brokers to prevent it from being exposed to the market. Privacy protections will be crucial in ensuring the same level of confidentiality for individuals in the blockchain space.

Cybersecurity protections

Given the blockchain's vulnerability to hacking, the need for cybersecurity protections cannot be overstated regarding digital assets and DeFi protocols.

Institutional DeFi solutions must consider cybersecurity vulnerabilities in cross-chain bridges, digital keys, price oracles, and market manipulation. These controls are essential to build client trust and ensure the secure ownership of digital assets.

In 2022, thefts from DeFi protocols have increased significantly, leading to a 58% rise in crypto hacking losses, totalling $1.9 billion. Hackers targeted cross-chain bridges in July 2021, causing Ethereum and other token losses worth around $600 million.

Additionally, compromised private keys, which users handle, have resulted in $274 million in losses in the first eight months of 2022 alone.

Mature governance and conduct models

To ensure the quality of Institutional DeFi solutions is up to par with traditional financial services, reliable governance and stakeholder conduct standards are necessary.

Unlike DeFi, traditional finance is highly regulated with quality assurance processes in place. There are more than nine federal financial regulators in the United States alone. Multilateral organizations assist in coordinating financial regulation internationally.

To comply with regulatory obligations, banks invest over $270 billion a year and allocate an average of 10% to 15% of their staff to this task. While DeFi protocols utilize governance tokens for governance and conduct assurance mechanisms, they lack the same level of corporate governance as traditional equity structures.

In addition, research indicates that fewer than 1% of token holders held 90% of the voting rights, resulting in a high concentration of voting control. Participants may want to consider whether to cover DeFi protocols under a corporation construct to allow for structured governance and liability recourse.

Proper recourse mechanisms

Recourse and dispute management are essential in DeFi protocols to address theft or operational errors in any financial system.

While traditional finance has robust mechanisms to protect investors, public DeFi solutions need to improve their recourse mechanisms, which are currently uncertain and leave affected users uncompensated without legal remedies.

For instance, when a hacker stole $130 million in crypto assets from BadgerDAO users, the platform could not afford full restitution, leaving some users uncompensated immediately.

To avoid such situations, DeFi protocols must establish proper recourse and dispute management mechanisms upfront.

Legal clarity around smart contract-based business activity

The legal landscape for traditional financial businesses is well-established and continually refined through legislation and litigation. However, the same level of clarity is yet to be established for DeFi activity that relies on smart contracts. While some states in the US have amended their laws to include blockchains and smart contracts explicitly, there still needs to be a clear indication of which smart contracts are legally enforceable, and it may depend on the intentions of contracting parties or local jurisdictions.

Specific code-only smart contracts can be enforceable under state laws. The International Swaps and Derivatives Association has developed legal guidelines for smart derivatives contracts to provide general guidance for different jurisdictions. Nonetheless, more legal clarity is required in commercial law to reinforce these requirements and promote a reliable environment for smart contract-based business.

The era of Institutional DeFi is upon us

The era of Institutional DeFi is upon us, and it's time to seize the opportunity. The emergence of real-world asset tokenization and DeFi innovations lay the foundation for transforming the financial industry.

By integrating DeFi protocols and regulatory-compliant safeguards, financial institutions can revolutionize their operations to satisfy the demands of regulators and clients.

Institutional investors' hunger for digital assets is insatiable, and they're willing to pay a premium for increased liquidity and faster transactions.

Despite the market's downturn, 88% are determined to pursue digital asset plans.

Institutional DeFi Design

While Institutional DeFi holds excellent potential, financial institutions must identify the areas where tokenization and programmability provide the most value and tailor DeFi protocols accordingly instead of simply copying what works in the crypto finance industry.

To start, institutions must define their objectives for exploring Institutional DeFi solutions. By asking, "why DeFi?" they can determine commercial viability, adoption feasibility, and competitive advantage.

Objectives may range from creating new products and reducing data reconciliation tasks to cutting costs and accelerating settlement times. In addition to these objectives, firms must consider broader objectives when designing Institutional DeFi solutions.

These should include:

  • Ecosystem objectives encompass the aim of seamless interconnectivity between existing trading systems, preparation for the imminent CBDC frameworks, and fostering an open innovation environment that facilitates the creation of market-driven solutions.
  • Protection objectives encompass compliance with legal and regulatory frameworks, access to qualified users only, and mitigation of financial and operational risks, including cybersecurity threats.
Craft design decisions that align with your objectives

Once your objectives are established, focus on making informed decisions in three critical areas: 

  • Blockchain: Selecting the most suitable underlying network and determining the degree of transparency required for various stakeholders.
  • Participation: Defining the participation mechanisms that govern who can create and access solutions
  • Token design: Outlining the token issuance, transaction, settlement, and standardization process.
DeFi Design - Blockchain, Participation, Token Design

Design choices can make or break the success of Institutional DeFi solutions, and firms must carefully consider the pros and cons of their options. These decisions will significantly impact the offerings' performance and whether they achieve their objectives.

Blockchain

Public permissionless networks (e.g., Ethereum, Polygon)

These networks do not restrict access, allowing for broader participation and facilitating interoperability with existing digital assets and DeFi protocols. They have a broad base of DeFi developers and open-source code that can be leveraged for continued innovation.

Advantages
  • Wider participation
  • Easier interoperability
  • Access to a large developer community
  • Open-source code
Disadvantages

The potential risks are due to the network's openness and scalability issues under high usage.

Public permissioned networks

These cutting-edge networks provide a powerful means to regulate user access and limit transaction visibility. They make instituting essential checks and balances simpler while providing an enhanced ability to track and scrutinize transactions for investigative purposes.

Advantages

It provides better control over user access and visibility of transactions, a more straightforward implementation of checks and balances, and better traceability for investigation purposes.

Disadvantages

It may limit participation and innovation due to smaller developer communities and a need for more open-source code.

Data Security and Visibility

This refers to the level of data transparency and security of the solution. It affects the level of data privacy and the ability to comply with regulatory data requirements.

Advantages

It allows for proper data management and protection, ensures regulatory compliance, and prevents issues such as maximal extractable value (MEV).

Disadvantages

It may limit the level of data transparency, which could impact the solution's value proposition. Also, ensuring proper data privacy and compliance can be challenging and require additional resources.

Participation

DeFi Participation - Fully Open vs Assurance-Based - Permissionless vs Permissioned
Deployment

Governance of developing and deploying smart contracts and protocols

Advantages
  • A fully open model lowers barriers to application development and encourages competition.
  • An assurance-based model ensures adherence to specific standards before deployment.
Disadvantages
  • A fully open model entails risk with fewer checks and balances before deploying protocols.
  • An assurance-based model can limit innovation and development by imposing controls and restrictions.
Access and Usage

These are controls for managing user access and usage of services and functions.

Advantages
  • The permissionless participation model maximizes the potential user base and fosters growth.
  • The permissioned participation model helps comply with regulatory requirements.
Disadvantages
  • The permissionless participation model can lead to increased risk and potential for abuse.
  • The permissioned participation model can limit access and growth potential.

Token Design

DeFi Token Design - Non-native vs Native and Off-Chain Settlement vs On-Chain Settlement
Token Issuance

Tokens are used to represent real-world assets in DeFi. Non-native tokens are created to represent off-chain processes and control mechanisms, while native tokens are issued directly on the blockchain. However, there is currently some legal uncertainty surrounding the use of both native and non-native tokens, particularly in terms of recognition and regulation. Therefore, the decision to use native or non-native tokens depends on the nature of the asset, the required linkage to off-chain assets, the need for blockchain ledgers, and whether the asset lives in a legacy off-chain system.

Legal Uncertainty

Legal uncertainty is a challenge for both native and non-native tokens in the blockchain world. The legality of native tokens can be ambiguous as there is no clear guidance on whether they can survive solely on the blockchain without external validation. Non-native tokens, on the other hand, are subjected to on-chain settlement finality concerns.

Settlement Recognition

Settlement recognition depends on the legal recognition of token transfers as a final transfer based on law, regulation, or contractual arrangement. This issue is significant for non-native tokens, where additional steps may be required for off-chain asset representation. However, native tokens may also face recognition issues due to regulations like CSD registration requirements. The on-chain settlement recognizes the blockchain as the single source of truth for transfer and ownership, while off-chain settlement relies on legacy ledgers and processes. To determine the settlement process for a transaction, regulatory and commercial laws, as well as contractual arrangements, must be taken into account.

Token Standards

Token standards influence the ability to interact with various DeFi protocols, making them a critical design choice. Different standards are suitable for different types of tokens, such as the ERC-721 standard for non-fungible tokens (NFTs), while the ERC-1155 standard is ideal for both fungible and non-fungible tokens. Choosing the appropriate token standard ensures maximum interoperability and functionality for asset tokens.

DeFi Token Standards ERC-20, ERC-721, ERC-1155, BEP-20, TRC-20 Advantages Disadvantages Comparison

Institutional DeFi solutions are not one-size-fits-all

Institutional DeFi solutions are not one-size-fits-all, and design choices must be customized to cater to specific business objectives. However, it's essential to recognize that a design choice that helps achieve one objective might hinder another. To tackle this challenge, companies must select design options that complement each other while addressing their unique business objectives, accounting for asset classes, jurisdictions, and their target value proposition. So, it's crucial to approach Institutional DeFi solutions with a tailored and strategic mindset that considers the nuances and complexities of each decision.Decentralized finance (DeFi) is the hot topic on everyone's lips, captivating technology developers, investors, and financial institutions alike.