Since 2020, banks and financial institutions have become more involved with Web3 than ever before. The same holds true for institutional decentralized financing (DeFi), where there are many potential use cases that could spark a new wave in innovation.
DeFi institutional does not refer to increasing institutional investments in DeFi protocols or decentralized apps (DApps), but rather to large institutions using DeFi to tokenize real world assets with regulatory compliance. Institutional-level controls are also used to protect consumers. The common question is “What benefits does DeFi provide over digital banking?”
In the past, banking was a physical process. Paper transactions were used and interactions were made through a network bank. Digitization improved efficiency and reduced the workload on banks branches by automating service. The fintech-led innovation allowed seamless customer interactions with very few physical touchpoints.
However, the digitization and distribution of information in banks meant that reconciliation overheads were still present. Although transactions could be done over the internet, bookkeeping had to still be done separately. DeFi would enable transactions and bookkeeping to be performed on the same network. That’s the advantage that DeFi provides over plain vanilla digitization.
While institutions are well aware of the benefits of institutional DeFi, there are many hurdles that must be overcome before these benefits can be realized on a large scale.
In 2019 alone, banks spent To meet regulatory obligations to offer mainstream financial services, it costs over $270 billion annually. To tap into institutional DeFi, banks and financial service firms will need to collaborate with regulators.
Compliance with regulations for institutional DeFi
Before they offer their products and services to the public, banks undergo strict controls. They are not only checked for viability under stress, but are also checked for misconduct. Lending products that have very high interest rates will be examined for mis-selling.
In the DeFi world today, there are products that wouldn’t survive banks’ usual degree of due diligence. Many DeFi platforms offer liquidity providers three- and four-digit percentage yields, which is rare in mainstream financial services.
A lack of corporate governance is another problem in the DeFi world. Tokenized world gives governance over to tokenholders. DeFi ecosystems tend to have high degrees of centralization due to uneven token ownership. However, they often lack sufficient corporate governance.
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Another important area of regulatory compliance is when products go on-chain. In today’s environment, a bond’s issuance goes through regulatory approvals depending on the bond’s structure. However, if the bond is issued on DeFi there is no regulatory framework that can be relied upon or controlled.
To drive product innovation and regulatory frameworks for native institutional DeFi products, banks must collaborate with regulators and each other.
Smart contracts: Legal framework
DeFi is reliant on smart contracts. Smart contracts allow you to programmatically trigger transactions and then settle them. These smart contracts are still very new technology and it is not clear whether a smart contract can be used to enforce a transaction that has been triggered by one.
There are many guidelines provided by different regulatory and legal bodies all over the globe. Smart contracts have been made legally enforceable by Nevada, USA. But there should be a more comprehensive legal framework that all states can agree to in order to ensure that financial services that are dependent on programmable currency have strong legal foundations.
Data privacy
DeFi apps have taken pride in, and have relied on the transparency of transactions on-chain. This feature is used effectively by the wider ecosystem in order to understand market behaviors. Applications that assess market sentiment use whale activity to monitor whale activity.
On-chain transparency has allowed models like automated marketmaking (AMM) to emerge within DeFi. The DeFi protocols can calculate asset prices using real-time demand and supply data. These models can be used as inspiration for Institutional DeFi.
Conventional capital market participants, however, rely on the confidentiality of transactions. Brokers can act as intermediaries for large-market orders placing institutions. The market may see large transactions, but it is impossible to identify the institution behind them.
Institutional DeFi will need to find a compromise between the decentralized DeFi world and traditional capital markets. Traditional capital markets are used to maintain privacy. Banks have used permissioned blockchains to test DeFi in the past. This allowed certain participants to access the chain.
In recent times, however, institutional participants have been more open to try out permissionless blockchains like JPMorgan’s collaboration with Polygon. It remains to be seen if they can achieve the required level privacy for transactions while still providing the on-chain information necessary to make AMM work effectively.
AML/KYC control
Banks and financial service firms depend on strong Anti-Money Laundering and Know Your Customer (KYC), controls. Bank employees make sure compliance and risk standards are met by between 10% and 15% of their workforce.
Chainalysis recently released a report on the other end of the spectrum highlighted As of early 2022, almost $10 billion worth of cryptocurrency was held by illegal addresses. According to the report, cybercriminals lacked $8.6 billion worth cryptocurrencies in 2021.
It is important to find a middle ground where institutional DeFi participants can identify themselves through rigorous KYC processes. Institutions require that users adhere to all AML controls and on chain analytics in order to be able to use DeFi services.
Considerations
This isn’t a complete list of the capabilities institutions should have to be able to use DeFi effectively. Aligning standards across different jurisdictions and asset types is another aspect. Institutional DeFi is only possible if all institutions are willing to work together in a coordinated manner.
It’s important that self-custody wallets are easy to use. User experiences are essential for institutional DeFi to become mainstream. ZenGo, a wallet that allows users to be onboarded without the use of private keys, is already in place. This should be the norm in order for institutional DeFis to become mainstream.
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As the integration of banks to the global banking infrastructure may take years, interoperability needs to be available on and off-chain. To achieve an integrated market infrastructure, banks must also be open for dialogues with other cryptographic and chain-based technologies.
The next couple of decades is going to be fascinating as controlled, regulated and intermediated capital markets look to tap into the DeFi “wild west.” How banks and financial institutions work together and with regulators globally will decide whether institutional DeFi can be the utopian middle ground that brings together the best of both worlds.