This summer, venture capital firm Andreessen Horowitz launched a $2.2 billion crypto fund. With a16z’s increasing appetite for DeFi (a16z’s crypto portfolio shows that it backs DeFi blue chips like Uniswap, Maker and Compound.), it’s not out of place to speculate a large chunk of this fund would further make its way into decentralized finance (DeFi). Even JP Morgan, which was initially averse to crypto, is now touting the staking business, which currently generates US$9 billion in annual revenue and could be worth over US$20 billion as soon as ETH 2.0 launches in 2022 and US$40 billion by 2025. Sygnum bank has wasted no time becoming the first mainstream financial institution to offer Eth 2.0 staking services.
Institutional investors cannot afford to ignore the breathtaking innovation happening in the DeFi-verse, which is currently home to US$155.7 billion in total value locked. By transferring the trust layer from financial intermediaries to software and code on the blockchain, DeFi provides universal access to financial services.
For context, DEXs — decentralized exchanges, mainly responsible for the tremendous interest in DeFi that we see today — have now marshalled up to US$815 billion in trade volume within the last 12 months. Moreover, the vast majority of these DEXs operate as AMM (automated market makers), aptly ditching the traditional order book approach of matching trades adopted by centralized exchanges. As a result, DEXs have now established themselves as the gateway to DeFi. Although Uniswap has held sway as the biggest DEX, others continue to make inroads with their foray into the sector.
Quite frankly, traditional market yields fall within the ranges of 0-2% in a period where the long term macro outlook isn’t looking particularly hopeful for the financial sector, compared to the insane APYs offered by DeFi protocols, especially if they are the newer kids in the block. The interesting part is that traditional investors are always on the constant search for that “edge,” a piece of mythical information that puts everyone over once found but never seems to be within reach. One would think that the mainstream financial sector would take advantage of the norm where a small amount of capital working in DeFi at a typical DeFi return archetype can achieve significant outperformance for them. But that isn’t exactly the case. So, why aren’t they all swarming in at a record pace?
The common perception is that the DeFi space is laden with mad risks and is largely unregulated. Some even dismiss DeFi as a small fry and not worth their attention because it lacks some of their preferred derivative products for trading. And how about the necessary infrastructure to either accommodate their select investment products or address their perceived risks/barriers? The notion is that the nascent DeFi sector still has a long way to go before most institutional investors can begin to think of keying and moving on auto-pilot as they do within the traditional financial industry.
How valid are these claims?
Trading on DEXs with massive liquidity and perceived risks
Trading assets on a typical decentralized exchange (DEX) has totally changed the game for both retail and institutional-grade actors. Users can swap between regular crypto assets and DeFi derivatives without the usual counterparty risks of a centralized exchange (CEX). Even with a non-custodial approach to trading digital assets on a DEX, drawbacks still exist as barriers for institutional investors. Trading on most DEXs comes with the risks of impermanent losses or the limited range of DeFi derivatives tradable on these DEXs because their mother chain cannot just be wished away. Some argue that for DeFi to be adopted by CeFi entities within major private and public banking institutions, it would require innovative monitoring solutions to help the institutions manage structural financial and compliance risks around DeFi. In other words, more control for the big players, albeit in a non-custodial way.
There are already non-custodial solutions to this dilemma. For instance, there are companies that operate as a DEX but with more control for users, including letting users set up limit orders (take profit, stop loss) by fixed price and offering functionality like trading view charts, market liquidity data and transaction history like a centralized exchange.
Surely the DeFi market is rapidly undergoing its growth phase with innovators racing to further develop the next tool that makes it easier to interpret and manage assets within this sector. It’s only a matter of time before DeFi tools match those of their counterparts in the traditional sector. After all, blockchain is about more transparency and control in our hands.
Privacy and confidentiality concerns
By design, DeFi operates with radical transparency as most assets are traded on-chain. But with this level of openness comes concerns for institutional investors. Most of the operations of traditional financial institutions require some level of secrecy to maintain their business edge. Without on-chain confidentiality, the easy entrance for institutional players to get on board where there is a business requirement for degrees of privacy is jeopardized. Zero-knowledge proofs (ZKPs), which facilitate transmitting sensitive information and authentication without revealing them, solve this. In fact, ZKPs are now finding their way into DeFi projects and indirectly through scaling solutions using zkRollups.
Narrow DeFi derivatives to play around with
Traditional financial markets already boast of some 10x larger than global GDP financial derivative market share. Bitcoin already enjoys massive support from funds, publicly traded companies, private companies, pension funds and family offices. In addition, macro and retail investors and even some cities have embraced mainly BTC. Bitcoin ETFs (exchange-traded funds) have been approved in Europe, Canada and Brazil, which will allow more institutional investors to join the party. However, DeFi derivatives are nothing compared with their mainstream counterparts.
Roughly US$3.4 billion DeFi derivatives market can easily be dismissed as a small fry and not worth institutional investors’ attention. But if there is anything we have seen with the burgeoning DeFi sector, it is that things can happen at neck-breaking speed. For example, Synthetix, a DeFi derivatives platform, grew from a mere $52 million TVL in September 2019 to over $1.2 billion in Synths (synthetic assets). Synthetix is an Ethereum-based protocol for the issuance of synthetic assets. Analogous to derivatives in legacy finance, synthetic assets are financial instruments in the form of ERC-20 smart contracts known as “Synths” that track and provide the returns of another asset without requiring you to hold that asset.
Alternatively, ETFs allow institutions the leverage of not taking direct custody of the underlying asset but trade in managed instruments like indices.
Unsustainably high APY paying protocols
One of the criticisms against the DeFi sector is that most DeFi banks’ yields are not entirely sustainable. Since the advent of DeFi summer that ushered in the craze for food and meme tokens, protocols kept launching — many with unaudited contracts — with a fair distribution mantra seeking to outdo their counterparts in the industry by offering mouthwatering APYs. Unfortunately, some of these ended up too good to be true. The ensuing rug pulls and smart contract failures left most of the investors to hang and dry.
To a large degree, this is not a uniform phenomenon across the industry. APY offerings by DeFi platforms appear to be relative to risk pricing, where new platforms with unaudited and complex smart contracts often generate the highest returns but with the risk of total loss being significant. Various platforms price risk differently.
Although there are valid concerns as to why institutional investors are not aggressively foraging into DeFi, most of their problems are either currently being addressed or have been solved by actors within the space. From DEXs with limit orders, single transaction liquidity rebalancer, better analytics for richer portfolio management or iron-clad transaction reference data, DeFi is staging a showdown to accommodate institutional grade investors.
The long and short is that if institutional investors search well, they’re sure to find their fit of product or service suite currently being offered by a DeFi platform. And if not, then there’s probably a DeFi platform currently undergoing iteration with the hope of plugging such gaps. Goldman Sachs already thinks Ethereum could overtake Bitcoin, especially at the pace with which DeFi continues to move. The pointers couldn’t be more precise — Ethereum is home to some of the most prominent DeFi protocols.
Traditional financial institutions that adopt the DeFi train earlier will most likely enjoy the first-mover advantage we saw with those who embraced Bitcoin during its earliest years. The future of finance is DeFi, and institutional investors must not miss the train twice in less than two decades.