Translation: 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, the traditional financial sector is ushering in a huge trend of change: the financial and monetary systems are 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 field. 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 permissionless, has assets kept by smart contracts, and is governed by DAO organizations, institutional DeFi emphasizes that assets are kept by regulated financial institutions, KYC/AML is performed in the form of digital identities, and governance is carried out by specialized organizations and professionals. Traditional financial institutions view this regulated DeFi as a new growth tool that can reduce costs, increase efficiency, and enhance regulatory transparency.
The article also criticized the phenomenon of "decentralization illusion" in the native DeFi field, that is, holding high the banner of "decentralization" and governing in the name of DAO, but in fact it is extremely centralized, with the right to speak and governance tokens in the hands of a small number of people. This phenomenon has long been noticed by the author, 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 conduct 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 borrowed 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 feasible for native DeFi, but difficult to achieve at the commercial level. This involves 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.
Institutional DeFi is the path to solve this problem. Financial institutions can greatly lower the threshold for companies 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 country and society. This will also be a major trend in the future transformation of traditional financial fields to tokenization.
To achieve this goal, technology is not the core obstacle, governance and laws and regulations are the key. Today, we can see that more and more central banks and financial institutions have started a series of pilot projects and regulatory frameworks for tokenization projects. I believe that it is only a matter of time before large-scale applications are truly implemented.
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Institutional applications of decentralized finance (DeFi) have the potential to create a new financial paradigm based on the principles of collaboration, composability, and open source code, and underpinned by an open, transparent network. In this whitepaper, we delve into the history of DeFi and its possible future developments, with a focus on how this may impact institutional financial services.
Preface
The evolution of decentralized finance (DeFi) and its potential for institutional use cases has generated significant interest among 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 an open, transparent network. As a field entering the spotlight, the path to utilizing DeFi for regulated financial activities is under construction.
The changing macroeconomic and global regulatory environment has hindered widespread meaningful progress, with development occurring primarily in the retail space 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 is becoming 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 space full of attractive potential, with innovative investment products that can reach new, previously untapped consumers and liquidity pools, and adopt new digital operating models and more cost-effective market structures. Only time (and innovation) will tell whether DeFi will exist in its purest form, or if we’ll see a compromise that allows a degree of decentralization to achieve the role of bridging the financial world.
In this whitepaper, we reflect on the recent history of DeFi, attempt to demystify some commonly used terminology, and then take a closer look at some of the key drivers in the DeFi space. Finally, we will consider what lies ahead for the institutional financial services community on the road to institutional DeFi.
DeFi Landscape Analysis
1.1 What is DeFi?
The core of DeFi is to provide financial services such as lending or investing on-chain without relying on traditional centralized financial intermediaries. There is no official and universally recognized definition in the rapidly developing field, and typical DeFi services and solutions can identify the following elements:
Self-custodial wallets allow investors to become their own custodians.
Smart contract escrow that uses code to maintain and manage digital asset custody.
A staking contract that uses code to calculate and distribute rewards based on deposit value and/or variables.
Asset exchange protocols that allow one asset to be exchanged for another and used in lending or decentralized exchanges (DEXs), such as Uniswap, one of the early players in the DeFi ecosystem, use smart contracts to execute trades.
Issuing securitization and re-hypothecation structures of different assets based on underlying "wrapped" assets, where the issued assets can have secondary market value.
1.2 What is Institutional DeFi?
Institutionalized DeFi - the focus of this article - refers to 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 benefits 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.
1.3 DeFi - History
In an open environment, DeFi-related projects inspired the crypto market and ushered in a new era in the summer of 2020. Due to its high liquidity, expensive assets, and high mining returns, DeFi rose rapidly 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 funding, and the number of projects and related tokens was relatively saturated, trying to ride the wave. At the end of 2021, the total DeFi user base surged, with more than 7.5 million unique users trading in the DeFi ecosystem, an increase of 2550% from a year ago, and TVL peaked at $169 billion in November 2021 (based on data from DeFiLlama). New terms and names such as Uniswap and Yield Farming were introduced into daily financial life.
Over the course of the year, DeFi experienced its fair share of problems, including some highly publicized crashes, due to multiple interest rate hikes and a significant rise in inflation, along with some malfeasance in the ecosystem. This means that the entire market is forced to take a step back and enter a prudent and rational phase 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 DeFi systems to fall 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 contemporaneous “crypto winter” (i.e., the decline in the value of crypto assets), the fundamentals of the DeFi community remain resilient, with the number of users steadily growing, and many DeFi projects persevering and focusing on building products and capabilities.
At the end of 2023, the market saw growth due to the first spot crypto ETF product approved in the United States, which was 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 field.
1.4 Fulfilling the Early Promise of DeFi
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, usually 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 financial techniques to manage demand, supply and prices.
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.
Pioneer Institutional DeFi Activities
There are many institutional use cases that can be extracted from the DeFi space, leveraging the tokenization of real assets and securities.
Here are some examples that attempt to outline how financial services products are combining with technology and regulation 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 achieve a distributed asset custody model while providing a comprehensive and independent digital account (address) that can be used for transaction flow, settlement, and reporting. An important use is the smart contract bridge that connects different blockchains to achieve interoperability and avoid fragmentation caused by blockchain selection.
Suitability: Serves as a connection point between public, permissioned, and private networks to minimize fragmentation while allowing high levels of access and participation.
Example: https://www.mas.gov.sg/-/media/mas-media-library/development/fintech/guardian/interlinking-networks-technical-paper-vfinal.pdf
Case 2: Using Stablecoins to Refinance Tokenized Financial Instruments, 2023 DeFi systems can also be used for financing in traditional industries, although they have not yet been 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 blockchain, directly open to qualified investors, and maintain investor records on-chain, while smart contract facilities allow for fast or near-instant 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=AQAAAKT37GXfe84hphq0iMK6yzh 8B9rXpnPwpnPonYy1t7sBzLgpCAdM7Lo3TaQqzplg62uy34Nlh0QwotmrfATOLgFLlUWOrM4Jx6Qe_tYFQCjpr-QpS6ZxvYQnBEdUPH-6CKs8nbkAE5BmfHIgpOqxxSbEJEelcA7SBtbiMeDxsokm&_guc_consent_skip=1720507214
The evolution of DeFi institutional market structure
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.
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 performed. While this may seem to contradict 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 leaner than the one we have today, as there is a significant reduction in organizational intermediation. As a result, ordered interactions will become more parallel and parallel. This in turn will help reduce the number of interactions between entities, thereby increasing operational efficiency and reducing costs. Under this structure, regulatory activities, including anti-money laundering (AML) checks, will also become more effective – as fewer intermediaries will increase transparency.
2.2 Potential for new roles and activities
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 could become the de facto industry utility platform, much like the internet became the delivery infrastructure for online banking. There is 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 areas of tokenized or virtual funds, asset classes and intermediary services; and/or with a permissioned layer.
Participate in the DeFi market Run on public, private or permissioned blockchain networks
For institutions, the nature of DeFi itself is both daunting and compelling.
Participating, operating, and transacting 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 known and risks are accepted based on appropriate levels of disclosure and due diligence. This is one of the reasons why many advances in the institutional digital asset space to date have occurred in the realm of private or permissioned blockchain networks, where trusted administrators act as “network operators” and owners are responsible for approving participants to enter the network.
In contrast, public blockchain networks have the potential to be open at scale, with 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 one way that participants – as validators – can contribute and be rewarded in what we think of as the “blockchain economy.”
3.1 Participation Checklist Outline
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 measured by factors such as the availability of expertise, vendor dependency, accessibility, liquidity scale, and the cost of creating, maintaining, and running a private chain, which can make or break a project. 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 the existing technology stack.
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 which side of DeFi you are on, asset custody and safekeeping are critical. The key is to understand novel approaches – such as assets held by smart contracts as an extension of custody – and to substantively address the gray areas in these areas, which can help reduce risks and regulatory issues.
As another example, identity is very important and deploying verifiable credentials is one of the fundamental elements in the process of institutionalizing DeFi. These credentials will facilitate governance and provide assurance to institutions when participating in these open blockchain ecosystems. Verifiable credentials enable anyone to prove their identity using cryptographic proof without directly sharing personally identifiable information (PII), while storing such PII material off-chain or in an encrypted decentralized manner for added protection.
Therefore, under such digital identities in the "DApps" layer, centralized governance can enable reliable customer due diligence (KYC), sanctions checks and money laundering prevention in areas such as investor entry and exit of 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 converged to bring together certain key attributes in order to successfully achieve a regulatory balance.
In recent years, early institutional development and evaluation of blockchain has 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 fits into 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 while taking into account regulation? This is the trillion-dollar question facing DeFi institutions.
Regulatory hurdles
4.1 Framework without intermediaries
There is no doubt that the road ahead is long and filled with innovation, exploration, and review/reflection. The DeFi system requires regulators, standard setters, and policy makers to rethink their traditional supervisory frameworks, which are built around intermediaries. Given the potential lack of regulatory and supervisory access points for decentralized systems, DeFi is undoubtedly driving a paradigm shift.
4.2 Market Integrity and Investor Protection
Since late 2023, momentum and cross-jurisdictional progress in this area has been growing: in December, IOSCO published its Policy Recommendations for DeFi, which outlined nine key policy recommendations that address core risks to market integrity and investor protection.9 This followed the publication of IOSCO’s Policy Recommendations for Cryptoassets in November 2023, which were 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 IOSCO’s 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, and not 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.
4.3 Careful handling
The impact on the balance sheet of participation in the digital asset space is another challenge in terms of regulatory evolution. The final Basel Committee (BCBS) standard on the prudential 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 (which essentially includes DeFi), and defining disclosures and required safeguards. The Basel Committee's standards also address the need to broadly 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. Recently, on May 16, 2024, the Basel Committee announced that the implementation date would be postponed by one year to January 1, 2026. In these cases, how to classify institutional DeFi remains to be substantively tested.
These are important milestones in the industry’s journey of discovery. They are the culmination of years of intensive public sector and industry advocacy work 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 aligning 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 improving regulatory clarity.
Many use cases demonstrate that innovative technologies, combined with the right regulations, can be a very powerful force for change, reshaping and rearranging business models and markets.
5. DeFi: What’s next?
The light bulb did not develop from successive improvements in candles, but rather from successive improvements in alternative technologies that addressed the shortcomings of wax candles.
If we think about the above questions 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 beliefs, standards, and prerequisite capabilities to build the structure of the ecosystem. In fact, only then will institutional players adopt it as a new growth tool and move forward with sufficient guarantees and regulatory certainty.
After what has been 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 institutional interest in and pace of adoption of the digital space. Arguably, DeFi amplifies the challenges of risk management, anti-money laundering, and information privacy. However, when considered in conjunction with the opportunities presented by institutional DeFi, including financial inclusion, it is difficult to ignore the potential benefits it brings to new products, services, and operating models in a future digital-first financial industry.
The technology itself is maturing and people are becoming more and more well-understood. Regulations are becoming clearer, and as lessons are learned from pilots, it is now easier to acquire the necessary expertise. For example, the increase in regulations and expertise in control functions such as compliance and auditing will help introduce DeFi technology to the financial industry.
The industry is currently in the “post-proof-of-concept” phase and needs to upgrade visible and successful “live” products to scaled commercial products. This transition will help achieve cost efficiencies or new growth and further the path of institutional development. We will wait and see how the factors covered in this article will influence or inhibit the development 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 needed 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.
