In our previous blog post, we discussed the True Value of Institutional DeFi, and why financial institutions should investigate DeFi and incorporate it into their business model.In this article "Designing DeFi for Institutions: What to Consider," we’ll take a look at the design considerations for Institutional DeFi. Financial institutions should not simply replicate what works in the cryptoasset industry when it comes to Institutional DeFi, but instead should evaluate where tokenization and programmability are most important and then design DeFi protocols that are tailored to their specific needs. There is great potential in Institutional DeFi, and this approach can help to maximize its benefits. According to a recent report by the Oliver Wyman Forum, Institutions should design DeFi by considering the following points:
Objectives of Institutional DeFi Solutions
Objectives could include creating new products, reducing data reconciliation tasks, cutting costs, speeding up settlement times, and preparing for interactions with Central Bank Digital Currency (CBDC) frameworks.
Design Choices to Meet Objectives
After firms have established their objectives, they need to make choices in three key areas:
1) blockchain – which underlying network to build on and what information is visible to whom; 2) participation – the mechanisms that determine who can develop and access solutions; and 3) token design – how tokens are issued, transacted, settled, and standardized.
Blockchain (Network type)
No limitations are placed on entry to public permissionless networks like Ethereum and Polygon, opening the door for greater engagement. This openness presents the advantage of improved interoperability with already existing digital assets and DeFi protocols. However, the same openness can also be a source of danger if not accompanied by suitable security measures.
Permissioned public networks, on the contrary, offer the ability to put in place authorized user access and limited view of transactions. This provides a simpler way to implement checks and balances, as well as the capability to trace activities for investigation.
At one extreme, public blockchains often make all transaction data open and visible to everyone. At the other end, users can only see data related to their own transactions. Function-level access management can be used to offer different levels of access to users, while encryption and issuing special viewing keys can provide authorized access. Additionally, data privacy on public blockchains can be bolstered with techniques such as zero-knowledge proofs (ZKP) and private messaging within DeFi protocols.
The permanence and immutability of data stored on a publicly available ledger pose a heightened risk of compromising privacy, particularly with regards to solutions on the public blockchain.
When deploying on the public blockchain, data is stored in an unalterable, open ledger, making it more difficult to keep information private. At one end of the spectrum is a fully open model in which anyone can create and deploy smart contracts, which eliminates many of the restraints for application production and stimulates rivalry. However, this approach carries a greater risk as there is less evaluation and oversight before protocols are launched.
In contrast to the assurance-based model, control and review/approval measures are established to guarantee compliance with certain guidelines before implementation. These regulations may be acknowledged by institutional investors and customers or those dictated through regulatory compliance. One strategy is to give authorization only to particular developers or companies to construct new processes. Another method is to ensure that definite assessments are done on protocols, allowing only verified protocols to be deployed.
The design choice in terms of access and usage involves setting up controls to regulate user access and usage. These restrictions can be applied at the service level (e.g., limiting access to a liquidity pool) or at the level of individual functions (e.g., limiting trading permissions to specific instruments and ticket size). A permissionless participation model allows anyone to access the DeFi protocols and use all of their functions without any limitations (like the Uniswap DEX), whereas a permissioned participation model requires authorized or verified participants to access particular services and utilize selected features. It is worth noting that using access control mechanisms, a permissioned model can still be implemented on a public permissionless blockchain.
Non-native tokens are created to mirror real-world assets, linking to external processes and control mechanisms, such as custody and reconciliation, for verification. Alternatively, real-world assets can be issued as native tokens on a blockchain, for instance through security token offerings (STO).
The recognition of settlement on-chain hinges on whether regulators and transaction participants are legally allowed to treat blockchain records as the official documentation and records of transactions, thereby allowing the blockchain to operate as an ownership ledger. This requires comprehending the applicable commercial law and regulation related to the transaction, along with any contractual agreements in place.
The type of token to be issued will determine what public standards are appropriate. For instance, ERC-721 is created specifically for non-fungible tokens (NFTs). Alternatively, ERC-1155 is a standard that can be used for both fungible and nonfungible tokens, and can be considered when tokenizing assets.
No single Institutional DeFi solution can suit all needs. In light of the current uncertainty, industry participants must take a scenario-based approach to evaluate various potential outcomes while maintaining a consistent set of assumptions. Questions that should be asked in this process include: what are the future industry trends and key indicators to watch, how will the changes affect our clients and competitors, and what does this mean for our portfolio and finances? Moving quickly to utilize the technology and cultivating a talent pool that encourages innovation can give first movers an edge. Institutions should not wait but seize the opportunity to build the future now.