Coming to prominence in early 2020, DeFi was lucky to grow in lock-step with a flourishing cryptocurrency market. With institutional investors increasingly investing in cryptocurrencies, it was seen as a given that these same investors and institutions would eventually adopt at least some aspects of DeFi solutions. The risks were acknowledged but perhaps not taken so seriously.
Acknowledging the gains that have benefited the DeFi market and wider blockchain ecosystem, the recent extreme instability, categorized by dramatic swings in Bitcoin and major altcoins, means that work needs to be done to show institutional players that the DeFi space is one that can be trusted. Until this occurs, sustainable growth is very unlikely.
In this blog post, we will explore five ways that DeFi can gain and retain institutional players. Is reform possible without alienating existing users? Read on to see our conclusions.
Why institutions are wading into DeFi
As outlined in the introduction, continued institutional adoption is conditional and tentative, rather than an inevitable conclusion. People like to point to the DeFi market cap or Total Value Locked as evidence of success, comparing the numbers to a year ago when DeFi was relatively unknown, but of course, looking at the volatile peaks and troughs shows that investment can quickly drop substantially, as we have seen recently.
That being said, the development and investment in DeFi projects does overall look positive. More people are realizing that DeFi simply sits on a continuum of financial products, ranging from very low-risk government bonds to risky speculative day trading. While engaging with innovative DeFi products can indeed sometimes be riskier than investing in the traditional centralized financial market, there are hundreds of dapps, spanning decentralized exchanges to DeFi lending and derivatives, which mirror the complexity and appetite for risk that exists in the traditional financial world. In the world of DeFi you are of course free to choose lower-risk financial investments that bring about smaller returns but better safeguard against huge drops.
So what are the big benefits for investors in the DeFi space?
Disintermediation – Since the 2008 financial crash, trust in traditional financial institutions has been eroded. Whether it’s outrageous fees, middlemen taking more than their fair share, or the practice of continuing to charge dead people fees, people are looking to have greater control over their funds. This idea is central to DeFi, where middlemen and arbitrators are not required. Smart contracts are the source of truth in any transaction and users maintain full control of their investments, being able to do what they want when they want.
Interest on stockpiled currencies and DeFi yield farming – Even amid the current Bitcoin uncertainty, there has been more and more talk of investors stockpiling the currency. In comparison to smaller short-term traders, institutional players often create a portfolio and hold it over a longer period. In this context, people are seeing DeFi applications as a way to gain interest through staking or yield farming, where a currency is locked up in different liquidity pools to generate the highest return possible. The flexibility and complexity that can arise with DeFi farming is something unique to this space.
High returns – Fortune favors the brave. This common idiom is familiar to investors across the financial spectrum. While the word “crypto” is enough to put conservative investors offside, those that have a better understanding of this new market are willing to help it expand with their funds, in return gaining far more than is offered by safe-haven investments and treasury bonds.
Gaining and Retaining Institutional Investors – Things to Consider
We have established that DeFi comprises a broad spectrum of products. Similarly, investors are not a one-size-fits-all category either. While you may be picturing an aging white man in a well-pressed suit, the truth is, institutional investors can’t be pigeonholed into one age bracket or set of attitudes.
Young and old, male and female, more and less risk-averse; different investors put their money into projects for social, environmental, and ideological reasons. Due to this, the following points are simply options for consideration. There is no magic set of features that will cause all investors to come on board at once.
High returns – This is an obvious one, as profits win almost every time. DeFi can introduce interesting features, become more stable, regulated and user-friendly, but without the returns on investments, people will go elsewhere.
Greater security – As detailed in our blog post, How DeFi became a sweet spot for hackers, the rush to come out with new and creative products is both a source of interest and a curse for the industry, as smart contract vulnerabilities and flash loan attacks have continued to plague the sector throughout 2020 and into 2021. Better security is an obvious way to fix this, which is why compliance, auditing, and DeFi insurance are becoming a larger part of the conversation. It’s hard to argue against this, but it does stray into the area of regulation, which we will look at below.
Incentivization schemes – Already, things like governance tokens and the holding of certain stable coins to provide liquidity are incentivized in DeFi products, providing a greater drawcard for people who are looking to invest. As seen with the success of Compound in mid-2020, the practice of providing DeFi tokens definitely brings in funds. If the platform is safe and it is done sustainably, incentivization helps grow and maintain the DeFi ecosystem while promoting high returns – the best of both worlds!
Trusted oracles – Oracles provide DeFi applications with the real-world information needed to execute smart contracts. The different types of oracles include centralized, decentralized, distributed, delegated proof-of-stake, and prediction market. How the oracle gets its information can make it vulnerable to manipulation, which has led to certain DeFi protocols being taken for millions of dollars just this year.
Leading oracle Chainlink is already highly trusted, but is aiming for full decentralization to improve the reliability and speed of smart contract information. As others follow suit with upgrades, it should help combat oracle manipulations and increase trust.
Regulation and compliance – Many crypto fanatics are hesitant to entertain the idea of regulation, but it is undeniable that some form of regulatory structure will help to bring investors who have until now stayed away from crypto due to its “Wild West” image.
Will there be requirements to take out insurance? Will mandatory code audits be required? Will complicated rules be set in place, necessitating middlemen? What will a more robust KYC/AML landscape look like? These are all interesting questions, and as we will explore below, bringing in some crypto investors through increased regulation could be at the expense of DeFi as we now know it.
Are institutional investors good for the DeFi Ecosystem?
In this blog post, we have given strong consideration to how institutional investors can be funneled into the DeFi money market. However, with changes made to encourage hesitant investors to participate in the sector, it is a real chance that the flexibility, experimentation, accessibility, and yes, even volatility at the heart of DeFi will be erased. Many of the positive elements are likely to be compromised should platforms try to win over more conservative investors and gain governmental approval.
A recent, provocative article appearing in Yahoo! Finance raised the question: Can DeFi do better than traditional financial institutions? The idea here is that DeFi should stick to its guns rather than become more like traditional providers, as it offers something more than the centralized solutions can.
Firstly, DeFi allows the 1.7 billion unbanked adults and those with past credit problems from accessing financial services and DeFi coins on more or less democratic terms. Secondly, although there are certain security problems at present, decentralized systems offer a better hacking-proof perspective when developed and maintained in the right way. Thirdly, small and medium-sized businesses can get access to capital from DeFi in an easier, more efficient way than they could at their banks.
Making DeFi Greater
So is all the prospective change worth it? It comes down to the question of how much DeFi needs investor capital. This answer depends on what you think the DeFi system should be for. Indeed, there are some things that could be changed, such as strengthening processes that make the transfer of illegal funds more difficult, and mandatory auditing of code that makes hacks less likely, but in terms of other types of regulatory action, it depends on whether you think DeFi should be solely a vehicle for expanding profits or a way to participate freely in an ever-increasing array of products.
Most likely there will be a split, where some applications will bend to fit a more mainstream model, incorporating CeFi services, while others will stay true to their more libertarian principles. This case could be a welcome compromise, with DeFi gaining more stability, participation, and investment while also remaining a vibrant and fertile ground for innovation.