The True Value of Institutional DeFi

November 18, 2022
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DeFi, or decentralized finance, is a term used to describe financial services that are provided via automated computer code on a blockchain as the settlement layer. These services can include payments, lending, trading, investments, insurance, and asset management. The crypto-asset industry that DeFi is a part of is largely unregulated.

Programmable business processes that can be executed automatically can be used to interact with any asset that has been tokenized. This code can greatly reduce the number of middle and back-office operations required by businesses and intermediaries.

Some of the notable benefits of DeFi are:

  1. Atomic settlement provides a secure method of delivering securities for payment, thereby reducing risk
  2. Real-time value movement and cheaper settlement are possible with mutualized and transparent ledgers
  3. In addition to being composeable (able to interact with one another), DeFi protocols allow seamless collaboration across multiple services at the same time
  4. A more globally integrated finance industry is enabled by the interoperability of asset classes and markets
  5. Automating multi-party operational activities through programmable logic reduces middle- and back-office overhead, such as transfers and post-trade reconciliations
  6. The business logic being transparent and automated enables new product features, such as liquidations for collaterals and new product offerings.
  7. Innovative DeFi solutions make it easier to trade tokens and tokenized real-world assets by reducing the amount of money needed to participate, such as decentralized exchanges, synthetic assets, and flash loans.

If the technology were applied to streamline transactions in foreign exchange, equities, bonds, and other real-world assets, it would have a lot of potential. This would require creating digital representations, or tokens, of real-world assets so that they can be used on the blockchain. Doing this could save a lot of money and create new business opportunities for issuers and investors, as well as for financial institutions that can adapt their technology and business models.

Firms that want to use DeFi in their client offerings must have the same, or even better, levels of safeguards and security standards that have been developed over decades in the finance industry.

Institutional DeFi is a system that uses DeFi protocols while also meeting regulatory compliance and customer-safety requirements. This includes anti-money laundering (AML), know your customer (KYC), and combatting the finance of terrorism (CFT) requirements. Cybersecurity is another major risk, as recent high profile hacks demonstrate. There is also limited, if any, recourse for investors should something go wrong.

The design choices made will have an impact on aspects such as privacy and transaction efficiency, how fast users will adopt the system, and how well it will work with other digital assets. The key choices to be made are in three areas: the blockchain platform that will be used and who will have access to what information; the mechanisms for determining who can develop and use the system; and how the digital tokens will be issued, traded, and settled, as well as how they will be standardized.

In May 2022, the Monetary Authority of Singapore launched Project Guardian in order to test the feasibility of applications in asset tokenization and DeFi while also managing risks to financial stability and integrity.

The study also found that two key factors are essential for this process: 1) using regulated institutions to act as “trust anchors,” issuing and verifying credentials of participating entities to establish the identities of transacting parties and connect with existing legal frameworks, and 2) the need for an agreed set of technical standards around business logic and token standards for interoperability. These findings can help drive adoption and improve transaction efficiency for a globally integrated finance industry by providing legal clarity, adoption incentives, and technical standards alignment.,

Institutional DeFi will likely vary by jurisdiction and market structure, and we suggest three ways financial institutions should start responding:

  1. Develop a house view on Institutional DeFi implications
  2. Decide on a participation strategy
  3. Get the organization ready

The financial services industry is based on trust and information. This trust is held by financial intermediaries who are responsible for keeping accurate records of ownership, liabilities, conditions, and covenants among other things, across multiple ledgers that are not connected to the means of communication. Since each intermediary has a different piece of information, the system requires a lot of coordination after a transaction takes place in order to reconcile the different ledgers and settle the transaction. For example, many securities transactions, especially those that cross international borders, can take anywhere from one to four days to settle.

The technology behind distributed ledger technology (DLT) creates a shared ledger of transactional and ownership information. Tokenization converts assets such as stocks and bonds into digital representations on a blockchain. Institutions can further increase efficiency by adopting DeFi protocols, which use software code to automatically execute financial transactions in accordance with current rules and conditions.

Institutional DeFi can be defined as the use of DeFi protocols to tokenize real-world assets, with appropriate safeguards to ensure financial integrity, regulatory compliance, and customer protection.(Institutional DeFi does not refer to institutional players participating in crypto DeFi.)

To reconcile their books and finalize settlement, financial intermediaries have to record transactions on siloed ledgers and communicate with each other. Using smart contracts, lending business logic can be codified transparently, ensuring adherence to rules and automating settlement processes.

Fig 2. History of Asset and Money Representation.

Here are a few examples of how big institutions are transitioning from Digital Finance to Institutional Finance:

  1. J.P. Morgan leverages tokenization to offer intra-day repo solutions for clients on its Onyx Digital Assets platform, and DBS Digital Exchange offers corporates a platform to raise capital through the digitization of their securities and assets, with options to offer smaller denominations. These tokenization benefits are also welcomed by asset managers, as 70% of institutional investors expressed willingness to pay extra for increased liquidity and faster asset turnover, according to a recent survey conducted by Celent
  1. On the public sector side, a 2021 survey of 81 central banks by the Bank for International Settlements (BIS) found that 90% of central banks were investigating the potential of central bank digital currencies (CBDCs), including 26% that were actively developing CBDCs or conducting pilot projects. 
  1. Japan also passed a bill providing a legal framework for stablecoins that allows licensed banks, money transfer agents, and trust companies to issue them. 
  1. DBS has successfully issued the DBS Digital Bond in May 2021 via security token offering (STO)
  1. Mata Capital, a French asset manager, tokenized €350 million ($343 million) worth of funds according to a case study by Consensys Codefi. 
  1. Last year, Switzerland implemented a so-called DLT Act granting tokenized securities the same legal status as traditional ones according to a Coindesk article.

This is the time for financial institutions to explore DeFi protocols and how to implement them into their business model. Institutional investors are still interested in digital assets even though the market is down. They are willing to pay more for digital assets that have increased liquidity and faster transactions.

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