Why DeFi remains attractive to institutions in a bear market

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Compared to the trillions of dollars in assets under management (AuM) in traditional finance, the total value (TVL) in decentralized finance represents just the tip of the iceberg of what the potential total market for DeFi could be in the future.

2022 was no picnic for the crypto industry. Bitcoin is down more than 50% year-to-date, while Ethereum is down nearly 60% year-to-date. We’ve seen extreme volatility, exacerbated by the obliteration of Terra and the bankruptcies of both Celsius, a centralized lender, and Three Arrows Capital, a multi-billion dollar hedge fund. What we see are unsustainable business practices coupled with inadequate risk management strategies that often come at the expense of investor interests. These Black Swan events have also prompted heightened regulatory scrutiny as United States Treasury Secretary Janet Yellen called for stablecoin rules following the collapse of Terra’s UST. G7 finance ministers have also called on the Financial Stability Board (FSB) to double down on crypto regulation, especially in the wake of the crisis.

In Europe, the Regulation on Markets in Crypto Assets (MiCA) recently came into force, calling for a harmonized legal framework for digital assets. The regulation covers three main areas, namely: asset-related tokens, stablecoins and other crypto assets.

In the US, President Joe Biden signed an executive order for governments to assess the risks and benefits of digital assets. The policy is guided by six main pillars, namely: Consumer Protection, Financial Stability, Illicit Activities, US Competitiveness, Financial Inclusion and Responsible Innovation. Given the importance of the order, we believe more regulatory clarity is expected that will hurt bad actors in the short-term but will enable sustainable protocols to bolster DeFi’s next phase of growth.

Institutional appetite for crypto assets remains strong

DeFi hasn’t been spared the market-wide meltdown either, with total locked value down from $244.55 billion at the start of the year to about $87 billion now, according to DeFi Llama. However, despite the bleak macro outlook, more and more institutions are trying to get involved in the rapidly maturing DeFi sector. These include:

  • FIS, a $62 billion publicly traded fintech offering everything from payments to wealth management services, recently announced a partnership with Fireblocks to offer its capital markets clients full access to a range of crypto services including trading, DeFi and staking to offer.
  • JPMorgan Chase’s blockchain unit announced plans to tokenize traditional financial assets to bring trillions of dollars into DeFi.
  • The Monetary Authority of Singapore (MAS) has also launched a pilot program called Project Guardian involving JPMorgan Chase, Marketnode and DBS Bank to study how DeFi protocols can be used for tokenized bonds and the wholesale finance market.
  • In May 2022, Wall Street giant Jane Street entered into a unique $25 million loan agreement with BlockTower Capital, which is expected to expand to $50 million depending on market conditions.

Onboarding the next wave of DeFi adoption

There is a small sector within DeFi, particularly in credit, that has shown signs of resilience despite periods of stress. These DeFi protocols continue to see healthy demand in both lending and institution borrowing, as evidenced by the continued growth in total lending. Credit veterans like AAVE and Compound have also ventured into the lucrative institutional credit space. AAVE launched AAVE PRO while Compound set up Compound Treasury aimed at meeting institutional needs to gain DeFi exposure.

This dose of healthy demand comes amid traditional financial institutions’ clients demanding greater exposure to DeFi. A 2021 report by Fidelity showed that 40% of crypto hedge funds and venture capitalists have expressed interest in digital assets due to the opportunities to participate in DeFi ecosystems. The biggest reason for interest in digital assets, according to Fidelity, is their high upside potential. Unsurprisingly, the higher risk-adjusted return of DeFi lending protocols is a more sensible investment in an inflationary environment.

In a Coinbase blog, stablecoin lending, a relatively low-risk game, offers more attractive returns compared to traditional money market instruments. According to PWC’s 4th Crypto Hedge Fund Report in 2022, 41.6% of crypto hedge funds “use DeFi platforms to increase yield through farming and/or borrowing and lending, while 78% of crypto hedge funds invested in the DeFi sector. ” Nearly 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 funding methods. To address this issue, many DeFi protocols have paved the way for an alternative funding method for these companies.

Challenges in the future and the need to be compliant

As we move into a potentially prolonged bear market, increased regulation is expected to be one of the key headwinds for DeFi, especially given the obliteration of two top 10 coins (UST and LUNA) and the spillover liquidation risks from the former Multi-billion dollar hedge fund Three Arrows Capital, now in bankruptcy.

DeFi protocols that enhance incumbent systems by taking advantage of cryptography and decentralization should, in theory, be a welcome sight for regulators who focus more on the end user than the incumbents. DeFi protocols built with this ethos will no doubt welcome the sight of regulators and be ready to start a constructive dialogue. However, regulation in the crypto space is much more likely to start at the edges, with exchanges, ramps, and custodians being invited to the regulators’ table first.

Since its inception, the DeFi market has experienced exponential growth due to the unregulated nature of this sector, which offers attractive risk-reward opportunities. Regulatory uncertainty could prevent some institutions from planning investments in this area until sufficient clarity is provided. However, we have recently witnessed how unsustainable business practices in an unregulated environment can have costly impacts on the market and the DeFi sector, as in the case of the collapse of Terra’s anchor protocol.

Regulatory concerns aside, many institutions still have internal mandates that restrict digital assets or require regulatory approval to engage in DeFi activity. A Jane Street Digital Assets and Institutional Access report also lacks tax or accounting tools to account for this new asset class.

Another hurdle to greater institutional acceptance is infrastructure security. Security of digital assets means securing private keys and multi-signature capabilities. Institutions manage trillions of dollars on behalf of their clients, and safety is always the top priority before making any investment decisions. We are already seeing several firms at the forefront of tackling this issue, offering services ranging from custody to DeFi solutions with full Know-Your-Customer (KYC)/Anti-Money Laundering (AML) compliance and institutional-level security pass.

Despite regulatory and infrastructural headwinds, DeFi activity in the lending space has remained active, with institutions still looking to take advantage of the healthy risk-adjusted returns offered on these protocols.

As Finance 4.0 advances, also referred to as the digitization of finance, there is an increasing demand for access to a full range of digital products and services in conjunction with traditional financial services. Amid the bear market we are currently in, there is a greater emphasis on infrastructure security, compliance and sustainable business practices. With trillions of dollars trying to take advantage of digital assets above, companies examining these conditions can capitalize on TradFi’s tremendous opportunity. This bear market will stamp out unsustainable business practices and allow strong business models to jump into the next wave of institutional DeFi adoption.

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