Webinar: Driving DeFi Adoption and Innovation – The Role of Institutional Capital
May 8, 2023
DeFi emerged from the same cypherpunk roots as cryptocurrency but has quickly grown to attract substantial liquidity, with Uniswap recently surpassing $1.5 trillion in transaction value since its inception, only a year after reaching the $1 trillion milestone. However, unlocking the barriers to institutional capital could exponentially increase the depth of liquidity and rate of investment in this nascent sector.
Nuant’s founder and CEO, Rachid Ajaja, recently joined a Blockworks webinar as a panel member to discuss how institutional capital can play a role in supporting the adoption and ongoing innovation in decentralized finance. He was joined by Chuck Mounts, Chief DeFi Officer at S&P Global, and Saurabh Sharma, Partner and Head of Investments at Jump Crypto. Graham Perry moderated the discussion on behalf of Blockworks.
Graham opened by putting the first question to Rachid: How do you define institutional capital in the context of DeFi, and in what capacity are institutions getting involved in the space in your experience?
Rachid explained that the concept of DeFi originated with Bitcoin, but expanded in 2019 with the advent of decentralized protocols such as Uniswap. There has been increased interest from entities such as hedge funds, pension funds, investment banks, and private banks, which are engaged in activities such as liquid ETH staking.
Rachid posited that this inflow has the potential to bring credibility and stability to the DeFi ecosystem, but involves greater complexity for DeFi operators, which now need to provide institutional-grade compliance solutions. He also highlighted the recent news that Wall Street giant Franklin Templeton became the first US hedge fund to be run on a public blockchain network (Polygon).
Saurabh elaborated on Rachid’s point by drawing a distinction between financial service providers interested in DeFi, which are focused on the underlying technology as a means of improving settlement and reducing operational overheads, and other types of enterprises such as e-commerce firms, which are seeking to exploit new types of media and business models by leveraging innovations such as NFTs.
Chuck explained the S&P perspective by introducing the concept of client “personas,” which broadens the definition of institutional stakeholders to include parties such as policymakers.
Barriers to institutional entry to DeFi
Graham asked the panel about overcoming the barriers to institutional DeFi adoption. Rachid began by differentiating between regulated and unregulated investors, highlighting that much of the current investment emanates from unregulated entities. Regulated entities remain somewhat cautious about DeFi because of the compliance requirements.
He alluded to upcoming regulations such as MiCA, which will help to reduce the barriers to entry for institutions.
Saurabh added that institutional DeFi adoption poses operational considerations since digital assets do not fit well into existing settlement infrastructure. However, he also pointed out that there are huge opportunities to enhance existing processes like KYC with privacy-preserving technologies such as zero-knowledge proofs. He also mentioned that smart contract security risk represents a further barrier to adoption and that it is incumbent on the industry to equip institutions with the tools and protocols necessary to overcome these barriers.
Graham asked Rachid a follow-up question regarding whether he believes institutions will continue to interact via permissioned DeFi or whether they will eventually move to permissionless protocols. Rachid responded that he believes permissionless systems are the future, but with guarantees provided by zero-knowledge proofs to ensure compliance.
Rachid elaborated on Saurabh’s point about smart contract risk by highlighting several recent incidents where hackers were able to exploit smart contract bugs to steal funds. He also mentioned other economic risks associated with DeFi, such as impermanent loss.
Chuck acknowledged that Rachid and Saurabh had already covered an extensive list of barriers, adding that the S&P approach is to work with both crypto native and traditional finance stakeholders to try to accurately understand, assess and price risk. He also highlighted that some of this work creates new opportunities, such as bringing real-world assets on chain. He added that regulatory developments will affect efforts to make DeFi more accessible to institutions.
Finding institutional opportunities in DeFi
Graham asked the panel whether they think any specific DeFi protocols or applications would interest institutional investors and why.
Chuck contended that the tokenization of real-world assets is the most natural starting point for participants from traditional finance entering DeFi, as it allows asset managers to leverage their existing expertise.
Saurabh reiterated his belief that financial infrastructure is the most interesting element of decentralized technology to institutions, emphasizing that they could derive significant utility from innovations such as smart contract-enabled liquidity pools.
Rachid agreed in principle with Saurabh, but pointed out that while the technical implementation is easy, setting up the requisite regulatory and compliance processes takes more time and effort. He then returned to Chuck’s point about the tokenization of real-world assets, stating that while the topic has been discussed for several years, the necessary infrastructure and liquidity have only recently been put in place.
Maintaining decentralization against institutional adoption
Graham asked the panel how DeFi operators and protocols can attract institutional inflow without compromising on the principle of decentralization.
Rachid started by pointing out that full anonymity will never be compatible with regulatory compliance. On the other hand, full disclosure of identities between parties is not necessarily a requirement in a blockchain environment given the existence of privacy-preserving technologies. He cited the fact that Aave operates both permissioned and permissionless pools as evidence that a protocol can reach a satisfactory compromise. He also contended that more of these types of services would attract a greater number of institutional participants.
Rachid added that blockchain technology can help to automate and streamline procedures such as KYC for institutions by storing proofs on-chain that are renewed periodically according to predefined rules, and by scanning wallet addresses for suspicious activity such as coin mixing.
Saurabh pointed out that institutional DeFi is still nascent in terms of development and adoption. He made a case for a cautious strategy, using extensive testing in closed environments while adopting a progressive, open-minded approach to decentralization.
Chuck highlighted a recent announcement regarding S&P’s participation in a $6 million funding round for Credora, a provider of institutional credit infrastructure that straddles DeFi and centralized finance. He used this as an example of how DeFi can offer the same kind of robust monitoring of creditworthiness available in centralized markets, without compromising on decentralization.
Rachid pointed out that rating methodologies and peer-to-peer default probabilities will enable under-collateralization – something that has been missing in the DeFi sector to date precisely because of the opacity of counterparty risk. Developments such as this will also facilitate the tokenization of real-world assets.
Chuck agreed, pointing out that macro drivers such as interest rate rises are also helping to spark interest in decentralized technologies and drive adoption.
Closing thoughts and questions
Graham opened the stage for closing comments or any other points the panel would like to raise. Rachid mentioned the emerging field of quantitative analysis in DeFi, noting that there are still very few tools to quantitatively analyze factors such as yield or risk. He emphasized that such tools are necessary to foster greater institutional adoption.
Saurabh agreed that this is a gap, but contended that it should be expected given the relative infancy of the sector. Chuck also concurred, adding that there is often a tendency to think in terms of incremental improvements, but he believes there is room for a more transformational mindset in institutional DeFi.
The panel then moved on to audience questions. Graham asked what key challenges other than regulatory uncertainty currently face institutions when adopting DeFi protocols. Rachid mentioned smart contract security risk, blockchain performance, interoperability between blockchains, and user experience as a few of the challenges facing institutions. Automated on-chain execution would also be a significant advantage, as well as the ability to stress-test.
Another questioner asked whether the lack of restrictions on financial product listings posed problems for institutions in DeFi. Rachid answered that the same rules of permissioned participation could be applied to listings and liquidity provision, thereby making it compatible with how institutions operate.
Saurabh concurred, pointing out that a protocol is merely a set of rules. Thus, DeFi founders could choose to program compliance if there is a demand for it. While the current, largely unregulated market proves the technological potential of DeFi, it could also be set up to comply with requirements.
Graham posed another question: Do you see a future where verified individuals could provide liquidity to a pool, such as one that tracks the S&P 500, and earn a yield? Rachid stated that he believes it could be possible, referring back to the conversation about the tokenization of real-world assets and how DeFi technology can facilitate this.
A final question was put to Saurabh regarding how to leverage decentralization to improve institutional workflows. Saurabh referred to the fact that there is a huge amount of replicated data and effort across different institutions when reconciling ledgers of assets. Simply having a shared settlement layer and point of truth would create many ways to streamline transactions and introduce operational efficiencies.
Institutional Involvement in DeFi: Bridging Traditional Finance with Decentralized Technology
Institutional involvement in DeFi could mark a turning point for the sector, bringing greater liquidity and stability to the ecosystem, while also providing new opportunities for traditional finance stakeholders to leverage the benefits of decentralized technology. However, as the panelists noted, there are significant barriers to institutional adoption, including compliance requirements, operational considerations, and smart contract risk. Addressing these challenges will require collaboration between DeFi operators and traditional finance stakeholders, as well as ongoing innovation in privacy-preserving technologies and regulatory frameworks. Despite these challenges, the potential benefits of institutional involvement in DeFi make it an area to watch closely in the coming years.