In the summer of 2020, Reuters ran a story detailing one young professional’s plans to retire early.
Mainstream publications run versions of that story every day, but the details in this one were different: No climbing the property ladder, no saving on rental costs by living at home, no moonlighting as a Twitch streamer. This was an early piece of reporting on decentralized finance.
The subject of that story, Paris-based Brice Berdah, told Reuters he had put the majority of his net worth into DeFi assets and had been enjoying returns of 20–25% for most of 2020. Reuters’ reporting in that piece — and most mainstream conversations at that time — focused on whether decentralized finance represented a new avenue for generating wealth, or a bubble that would soon burst. Fourteen months later, that conversation is very different. As billions of dollars have poured into DeFi projects, institutional investors are looking for ways to reap those same kinds of returns.
‘Now, more than ever, institutions are beginning to notice that digital assets are outperforming most of their traditional counterparts, despite their inherent volatility’, Will Hamilton, Head of Trading & Research at TCM Capital, wrote at Nasdaq.com in October.
The most enticing thing for institutional investors, Hamilton pointed out, is how DeFi can ‘add a new layer of financial opportunity through niche product offerings not available in traditional finance’. That’s the same lesson from Berdah’s Reuters story, just on a bigger scale.
Below, we will explore how decentralized finance has given institutional investors new tools to deliver higher rates of return on investments than traditional finance can. The issue for institutional investors now is how to balance their own risks against that potential.
‘The entire financial system is being rebuilt’
As we noted in June, institutional investors have been following digital currencies and decentralized finance for a long time. In late 2020 and into 2021, they began to make their first big splashes in that sector. Currently, there is around a $100 billion stake in DeFi protocols and financial instruments. That represents funding from retail as well as institutional investors, and we expect that number to continue to climb rapidly as the sector matures and more participants enter.
‘Based on ecosystem developments in the first half of 2021, it’s not hyperbole to claim that the entire financial system is being rebuilt from first principles with more security, transparency, and composability across protocols’, Nicole Adarme, James Beck, and Sharmeen Shehabuddin at ConsenSys wrote in September.
Of course, this presents some challenges to institutions, that enjoy and rely on the stability of the traditional financial system. Furthermore, institutions are bound by strict regulations, such as limitations on transactions with known, whitelisted counterparties. A hedge fund cannot simply deposit investors’ money in a staking pool, for example.
Therefore, a current focus throughout the DeFi sector has been building protocols and systems that allow institutions to participate in the emerging methods of saving and earning money.
‘There is a clear feeling that, for the early-adopting financial institutions, DeFi is what crypto was for them around 24 months ago’, Jonathan Knegtel, Co-Founder and Managing Director of Blockdata, wrote in September. ‘Further to that, there is tangible evidence that some banks are proud to be at the forefront of crypto and its additional offerings’.
What does the forefront of institutional DeFi look like?
In June, we cited Goldman Sachs and Bank of America as two pillars of institutional finance that were exploring DeFi projects and investments. In the months since, it’s clear that each is looking for the right DeFi opportunity, but neither has fully warmed to the technologies:
- Goldman Sachs filed its Innovate DeFi and Blockchain Equity ETF with the SEC in July, but as Samuel Haig at Cointelegraph notes, the companies represented in that index fund include Google, Microsoft and Fujitsu. That’s still degrees of separation from real DeFi exposure.
- Further, Goldman Sachs analysts argued in a June report that ‘there are no compelling arguments’ for holding digital tokens in a diversified portfolio, save for security tokens, which clients could think of as analogous to real estate or private equity holdings.
- Meanwhile, Bank of America published a report in October that conceded while we are in the very early days of decentralised finance, our view is that it’s unlikely DeFi will replace the traditional financial infrastructure soon’. Rather, they see it providing ‘near-term efficiencies and increased transparency to existing firms’.
At this stage, institutional investors are proceeding with caution. Still, they cannot deny DeFi’s potential, assuming the sector can be made interoperable with the needs of institutional finance.
Work on that front certainly continues:
- In October, CoinDesk’s Tanzeel Akhtar reported that MetaMask’s institutional division had ‘added custodians BitGo, Qredo and Cactus Custody to help firms meet compliance requirements’.
- A week later, TechCrunch reported that France’s SheeldMarket had raised $10 million in Series A funding. ‘As an EU-registered broker, the company wants to help institutional investors buy and sell crypto assets in a regulated way’, TechCrunch reporter Romain Dillet wrote.
As the architecture of a decentralised finance system comes together to support institutional investors, there are two important trends to keep an eye on — the first of which is hinted at in the SheeldMarket story.
Europe is emerging as the centre for DeFi development
In September, Yahoo Finance’s David Hollerith had an interesting story about DeFi’s rapid growth in Europe. Citing data from Chainalysis, Hollerith reported that transactions across Western, Northern, and Central Europe now account for a quarter of the world’s crypto activity.
‘Large institutional transactions in parts of Europe such as France, the Netherlands, Germany and the U.K, most of all, grew from $1.4 billion in July 2020 to $46.3 billion a year later’, he wrote. ‘The majority of this capital flow was paid in Ethereum (ETH) or wrapped Ethereum (wETH)’.
Hollerith offered three reasons for DeFi’s growth in Europe:
- European VCs were more interested in fintech projects in general than their counterparts in North America. This has given the European fintech sector a slight edge in innovation and perhaps a first-mover advantage in DeFi.
- Europe acts as the largest trading partner for other regions around the world. It’s the crossroads for crypto capital flows.
- Europe’s open banking laws have fostered a better environment for decentralised finance to thrive than in North America, East Asia, or anywhere else.
Central bank digital currencies will have a role to play
DeFi’s growth to this point owes much to stablecoins. Central banks around the world understand this, and they see an opportunity with their own currencies, the ones already backing those stablecoins.
In October, ConsenSys Managing Director APAC Charles d’Haussy wrote at CoinDesk that central bank digital currencies (CBDCs) create two specific opportunities for central banks:
- Banks can build identity and compliance into the coins’ networks.
- Tax collection can nearly be automated.
More than 30 countries, plus the European Union, are currently exploring CBDCs as a way to digitise their financial systems. Now, imagine being able to stake a digital Euro in a pool where everyone has been vetted according to relevant KYC regulations — and where everyone is enjoying double-digit rates of return. That scenario should catch the attention of institutional investors who might otherwise be wary of DeFi at this stage.
Throughout Q3 and into Q4, Appold DeFi continues to see an increase in the number of enquiries from institutions looking to understand more about DeFi with a view to future sector participation. Our perspective remains the same as in June: When the biggest institutions truly commit to the DeFi sector, and begin to invest at an industrial scale, look for them to acquire established firms and begin a process of consolidation.
That moment is still on the horizon, but it is coming into focus more and more. Institutions are watching intently, assessing capabilities, and preparing to adjust business models as needed. Until then, DeFi ecosystems will continue building new channels for the increasingly strong capital inflows as well as creating new opportunities for investors and market participants.
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Co-Founder & Partner of Appold DeFi
Article Source: Institutions look to balance the promise of DeFi against their own limitations