Compared to the trillions of dollars of assets under management (AuM) in traditional finance, the total value locked (TVL) in decentralized finance represents just the tip of the iceberg of what could potentially be the total market for DeFi in future.
2022 has not been a bed of roses for the crypto industry. Bitcoin has fallen by more than 50% YTD while Ethereum has fallen close to 60% YTD. We have seen extreme volatility aggravated by the wipeout of Terra and the bankruptcies of both Celsius, a centralized finance lender, and Three Arrows Capital, a multi-billion dollar hedge fund. What we have observed are unsustainable business practices coupled with inadequate risk management strategies which often come at the expense of investors’ interests. These black swan events have also further triggered increased regulatory scrutiny with the Treasury Secretary of the United States, Janet Yellen, calling for stablecoin rules following the collapse of Terra’s UST. Finance ministers from G7 countries have also called on the Financial Stability Board (FSB) to double down on crypto regulation, especially after the crisis.
In Europe, the Regulation on Markets in Crypto Assets (MiCA) which calls for a harmonized legal framework of digital assets, recently became law. The regulation covers three main areas, namely: asset-referenced tokens, stablecoins and other crypto-assets.
In the US, President Joe Biden has signed an executive order for governments to evaluate the risks and benefits of digital assets. The directive is guided by six main pillars, namely: consumer protection, financial stability, illicit activity, U.S competitiveness, financial inclusion and responsible innovation. Given the significance of the order, we believe more regulatory clarity is expected that will hurt bad actors in the short run but allow sustainable protocols to bolster DeFi’s next leg of growth.
Institutional appetite toward crypto assets remains strong
DeFi, similarly, has not been spared from the marketwide meltdown, with the total value locked decreasing from US$244.55 billion at the start of the year to about US$87 billion now, according to DeFi Llama. However, despite the bleak macro outlook, more institutions are looking to gain exposure to the rapidly maturing DeFi sector. These include:
- FIS, a US$62 billion publicly traded fintech company that offers everything from payments to wealth management services, recently announced a partnership with Fireblocks to offer its capital market clients full access to a suite of crypto services such as trading, DeFi and staking.
- JPMorgan Chase’s Blockchain Unit announced plans to tokenize traditional finance assets to bring trillions of dollars into DeFi.
- The Monetary Authority of Singapore (MAS) has also launched a pilot program called Project Guardian that involves JPMorgan Chase, Marketnode and DBS Bank to examine how DeFi protocols can be used for tokenized bonds and the wholesale funding market.
- In May 2022, Wall Street giant, Jane Street (a borrower on Clearpool), entered into a first-of-its-kind loan agreement with BlockTower Capital to borrow US$25 million, with plans to scale it to US$50 million subject to market conditions.
Onboarding the next wave of DeFi adoption
There exists a small sector within DeFi, particularly in the lending space, that has shown signs of resilience despite periods of stress. These DeFi protocols have continued to see healthy demand in both lending and borrowing activities of institutions as evidenced by the continued growth in total loan origination. Veterans in the lending space such as AAVE and Compound have also ventured into the lucrative institutional lending space. AAVE introduced AAVE PRO while Compound set up Compound Treasury, targeted at meeting the institutional needs to gain DeFi exposure.
This dose of healthy demand comes amidst traditional financial institutions’ clients demanding greater exposure to DeFi. A 2021 report by Fidelity has shown that 40% of crypto hedge funds and venture capitalists have expressed interest in digital assets due to opportunities to participate in DeFi ecosystems. The biggest reason for interest in digital assets, according to Fidelity, is their high potential upside. Unsurprisingly, the higher risk-adjusted return of DeFi lending protocols makes more investment sense in an inflationary environment.
In a Coinbase blog, stablecoin lending, a relatively low-risk play, provides more attractive returns as compared to traditional money market instruments. According to PWC’s 4th crypto hedge fund report in 2022, 41.6% of crypto hedge funds used “DeFi platforms to enhance yield through farming, and/or borrowing and lending of assets, while 78% of crypto hedge funds have invested in the DeFi sector.” Close to 50% of crypto hedge funds are also involved in borrowing and lending. Currently, crypto-native institutions are limited in the amount of funds they can raise through traditional financing methods. To address this issue, many DeFi protocols have paved the way for an alternative financing method for these companies.
Challenges moving forward and the need to be compliant
As we progress into a potentially prolonged bear market, increased regulation is expected to be one of the key headwinds for DeFi, especially given the wipeout of two top 10 coins (UST and LUNA) and the spillover liquidation risks from the once-multi-billion-dollar hedge fund, Three Arrows Capital, which is now in bankruptcy proceedings.
DeFi protocols, which improve upon incumbent systems by leveraging the benefits of cryptography and decentralization, should, in theory, be a welcome sight to regulators who have the end-user in mind rather than the incumbent institutions. The DeFi protocols that have been built with this ethos will no doubt welcome the sight of regulators and be ready to begin a constructive dialogue. However, it is much more likely that regulation in the crypto space will begin around the edges, with exchanges, on-ramps and custodians first invited to the regulators’ table.
Since its inception, the DeFi market has been experiencing exponential growth due to the unregulated nature of this sector that offers attractive risk-reward opportunities. Regulatory uncertainty might deter some institutions from making any plans to invest in this area until enough clarity is provided. However, we have recently witnessed how unsustainable business practices in an unregulated environment can have a costly impact on the market and the DeFi sector as with the case of the collapse of Terra’s Anchor protocol.
Aside from regulatory concerns, many institutions still have internal mandates that restrict digital assets or require regulatory approval to engage in DeFi activities. In a “Digital Assets and Institutional Access” report by Jane Street, there is also a lack of tax or accounting tools to account for this new asset class.
Another hurdle to greater institutional adoption is infrastructure security. Security of digital assets means the safeguarding of private keys and multi-signature capabilities. Institutions manage trillions of dollars on behalf of their clients and security is always at the top of mind before venturing into any investment decisions. Already we are seeing several firms at the forefront of addressing this concern providing services ranging from custody to DeFi solutions with full know-your-customer (KYC)/anti-money-laundering (AML) compliance and institutional-grade security.
Despite regulatory and infrastructural headwinds, DeFi activities in the lending space have remained active with institutions still looking to tap into the healthy risk-adjusted yields offered on these protocols.
As Finance 4.0, dubbed the digitalization of finance, advances, there is an increasing demand to access a full range of digital products and services in tandem with traditional financial services. Amidst the bear market that we are currently in, more emphasis will be placed on infrastructural security, compliance and sustainable business practices. With trillions of dollars looking to leverage on the aforementioned benefits of digital assets, companies that check those conditions can tap into the massive opportunity in TradFi. This bear market will weed out unsustainable business practices and allow strong business models to onboard the next wave of institutional DeFi adoption.