Financial services institutions and banks have increasingly engaged with Web3 since 2020. This is also true within institutional decentralized finance (DeFi), as several potential use cases have emerged that could trigger a new wave of innovation within these organizations.
Institutional DeFi does not refer to growing institutional investments in DeFi protocols and decentralized applications (DApps) but rather to large institutions using DeFi protocols to tokenize real-world assets with regulatory compliance and institutional-level controls for consumer protection. A common question that comes up is: What benefits does DeFi offer on top of digital banking?
Not long ago, banking was a physical effort where transactions were paper-based and interactions took place through a network of banks. Digitization added efficiencies by automating services and reducing the burden on bank branches. Fintech-led innovation enabled seamless customer interactions with very few physical touchpoints.
The digitization of banks still meant that information was distributed, creating reconciliation overheads. While transactions were executed over digital networks, bookkeeping still had to be performed separately. DeFi would bring the execution of transactions and bookkeeping onto the same network. That’s the advantage that DeFi provides over plain vanilla digitization.
While banks understand the opportunities that lay ahead with institutional DeFi, there are several hurdles to overcome before benefits can be realized at scale.
In 2019 alone, banks spent over $270 Billion per year to comply with regulatory obligations toward offering mainstream financial services. Banks and financial services firms must collaborate with regulators and will need to get several controls in place to tap into institutional DeFi.
Regulatory compliance for institutional DeFi
Banks go through high levels of rigor before offering their products and services to consumers. They are checked for viability through stress scenarios, but more importantly, are also checked for conduct issues. For instance, lending products are scrutinized for mis-selling to customers if the interest rates are very high.
In the DeFi world today, there are products that wouldn’t survive banks’ usual degree of due diligence. Several DeFi platforms offer three and four-digit annual percentage yields to their liquidity providers, which is unheard of in mainstream financial services.
The DeFi world also suffers from a lack of corporate governance. The tokenized world hands over governance to its tokenholders. While most DeFi ecosystems have high degrees of centralization through uneven token ownership, they still often lack sufficient corporate governance.
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The other key focus area for regulatory compliance is when products are launched on-chain. In today’s environment, a bond’s issuance goes through regulatory approvals depending on the bond’s structure. But if the bond issuance is done on DeFi, there is no regulatory framework to rely on or control the process.
Banks must work with each other and with regulators to drive product innovation and regulatory frameworks around native institutional DeFi products.
Legal framework for smart contracts
Smart contracts are a critical aspect of DeFi. They offer the ability to programmatically trigger and settle transactions. However, they are still a nascent technology, and the legal enforceability of a transaction triggered by a smart contract is unclear in many jurisdictions and situations.
There are pockets of guidelines from various regulatory and legal bodies across the world. For instance, the state of Nevada in the United States has made smart contracts legally enforceable, but there needs to be a broader legal framework that nation states sign up to so that financial services that rely on programmable money can have robust legal foundations.
DeFi applications have not only taken pride in but also have relied upon the transparency of on-chain transactions. The broader ecosystem has used this feature effectively in understanding market behaviors. For instance, whale activity is regularly tracked by applications to assess market sentiment.
Models like automated market making (AMM) have emerged within DeFi thanks to on-chain transparency. DeFi protocols are able to calculate asset prices based on real-time supply and demand data. Institutional DeFi looks to draw inspiration from these models.
Yet, conventional capital market participants rely on the privacy of transactions. Brokers have acted as proxies for institutions that look to place large market orders. While the market sees large transactions happening, it is not possible for them to spot the institution that is behind the transaction.
Institutional DeFi would need to find a good middle ground between the transparent DeFi world and traditional capital markets that are intermediated to create privacy. In the past, banks have tested DeFi using permissioned blockchains that allowed only certain participants to use the chain.
In recent times, however, institutional participants have been more open to try out permissionless blockchains like JPMorgan’s collaboration with Polygon. However, it remains to be seen how they will achieve the required level of privacy of transactions while providing the algorithms with on-chain information for AMM to happen effectively.
Last but not least, banks and financial services firms rely on robust Anti-Money Laundering (AML) and Know Your Customer (KYC) controls. Some 10%-15% of the workforce in banks ensure that compliance and risk standards can meet regulatory rigor.
On the other side of the spectrum, a recent Chainalysis report highlighted that as of early 2022, nearly $10 billion worth of cryptocurrencies were held by illicit addresses. According to the report, nearly $8.6 billion worth of cryptocurrencies were laundered by cybercriminals in 2021.
Again, there is a middle ground that needs to be identified where institutional DeFi participants identify themselves through robust KYC processes. In order to use DeFi services offered by institutions, users must also adhere to any AML controls and on-chain analytics that are mandated by the institutions.
This is not an exhaustive list of capabilities that institutions must have in place to explore DeFi effectively. There are other aspects such as aligning standards across banks, jurisdictions and asset classes. Institutional DeFi can only work if many institutions come to the table in a planned fashion.
Self-custody wallets with very little friction should be in place. For institutional DeFi to go mainstream, user experiences must be seamless. Wallets like ZenGo already onboard users without the need to use private keys. This should be the norm for institutional DeFi to go mainstream.
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On-chain and off-chain interoperability must be in place as the onboarding of institutions to the global banking infrastructure could potentially take decades. Banks must also be open to dialogues when they use different chains and cryptographic technologies that need to talk to each other in order to achieve an integrated market infrastructure.
The next couple of decades is going to be fascinating as controlled, regulated and intermediated capital markets look to tap into the DeFi “wild west.” How banks and financial institutions work together and with regulators globally will decide whether institutional DeFi can be the utopian middle ground that brings together the best of both worlds.