Institutional Capital and DeFi: Appeal, Challenges and Prospects

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By Brian Pasfield, CTO at Fringe Finance

Ever since the very first DeFi project, MakerDAO, launched on Ethereum in 2015, the sector has shown remarkable growth. Several multi-billion dollar protocols have emerged across different  smart contract networks, and innovations like flash loans and yield farming have taken off among savvy users. This all led to, in 2020, the crypto ecosystem experiencing its first “DeFi summer” as the market flocked to farm yields across the nascent DeFi protocols. 

In 2021 and the beginning of 2022, alternative Layer-1 ecosystems like Solana and Terra have seen their own DeFi ecosystems flourish. The total value locked in the DeFi ecosystem topped $250 billion in 2021. A recent study by VALK showed that one third of surveyed investors from eight major sectors invested in crypto assets for the first time in December 2021. Of those who invested, 68% plan to invest in DeFi in the near future.

The increasing presence of institutional investors keeps bringing benefits to the sector. To start with, large financial injections tend to have a positive effect on the health of the overall market. Additionally, the active participation of institutional investors as shareholders benefits project governance, steered by professional hands while remaining owned by decentralized communities. Institutional investors also tend to be more oriented towards long-term investing, which means that the influx of this capital is typically long-living.

Let’s, then, explore the main factors driving the interest of institutional investors in decentralized finance, the challenges they face, and the potential of DeFi investments as a whole.

What Makes Investing in DeFi Appealing?

DeFi offers a non-bureaucratic model, reduced cross-border transaction costs, better transparency, trustlessness, advanced opportunities to profit, attractive yields, and a more inclusive system for all its participants. For these reasons, it’s starting to catch the attention of institutional investors over the traditional market. 

DeFi replicates many of the financial products found in the traditional finance (TradFi) market, such as lending, borrowing, and synthetics, etc. There is a key difference, however, in that anyone with an Internet connection and a blockchain wallet has the ability to participate. In other words, DeFi is permissionless. It removes the red tape and simplifies the process of accessing financial services. 

Lending protocols like Aave, Compound, or Fringe Finance offer a way to capture yields that is not offered by regular banking services. Lending solutions and decentralized credit markets also offer ways for corporations to access capital in a way that isn’t possible for everyday people in TradFi. In DeFi, they only need to provide collateral to access leverage. This is likely to be a game changer once Wall Street and other major players start to embrace a decentralized ecosystem. 

The programmability of smart contracts also offers new ways to put assets to work that were never previously possible. Ethereum’s ERC-20 standard is often described as “programmable money”, and it also acts as the base asset for much of the DeFi ecosystem  today. 

The DeFi ecosystem offers composability because it allows activities to be stacked on top of each other like LEGO bricks. Applications like Compound, Uniswap, and Yearn.Finance are, hence, often referred to as “money legos” by DeFi natives. Composability, powerfully, offers a way to take advantage of the various activities available across the ecosystem in a few steps. For example, a user may put their $ETH down as collateral in Maker to borrow $DAI, swap it for $CRV on Uniswap, and then lock up the $CRV in Convex to earn $CVX rewards. DeFi allows for a quick transition between financial products, as users do not have to go through bureaucracies or red tape to obtain approval to do so.

Much of the DeFi ecosystem of today is also open-source. The code for smart contracts is freely available for anyone to view or use, and public blockchains broadcast every transaction. This creates an open and transparent system that vastly differs from the gated banking system. 

While some smart contracts can suffer vulnerabilities, regular audits ensure that protocols like Aave are robust and secure. The open nature of the sector also makes it easy to spot vulnerabilities and security breaches when they occur. 

Perhaps most notably, DeFi is a permissionless system for accessing financial tools. DeFi users enjoy self-custody over their assets and are empowered to manage their funds as they wish. Millions of people around the world are excluded from the traditional banking system, and recent events like Canada’s move to freeze protestors’ bank accounts have highlighted the importance of decentralization and self-custody. As the world becomes increasingly digital and global, it’s inevitable that decentralized Internet-native money should thrive. This is, in a nutshell, the bull case for DeFi.

DeFi’s Challenges

For all of its benefits, DeFi has a number of hurdles to overcome, particularly within the institutional market. As institutional investors typically need to complete know-your-customer (KYC) procedures to invest capital and DeFi can’t provide them,they are unable to access many of the services available today. However, institutional solutions like Aave Arc, which was created in partnership with Fireblocks and offers access to permissioned pools, are beginning to emerge. 

Institutional investors are known for taking a more cautious approach toward investing than many of crypto’s most fervent believers. As DeFi protocols are still in their nascent stages, there are high risks to investing large sums of capital in liquidity pools. Whereas an Ethereum enthusiast may be happy to risk depositing their funds into a new product in hopes of earning a high yield, institutional market participants are more conservative. While the crypto ecosystem has gotten considerably safer, hacks, scams, and so-called rug pulls are still very common, and the vast majority occur in the DeFi space. A recent Chainalysis report found crypto crime totaled $14 billion in 2021, much of it coming from hacks and other incidents in DeFi. 

Scaling issues are also abundant across Ethereum and the whole  crypto ecosystem. No blockchain has yet solved the so-called “scalability trilemma” and transaction fees for using  projects on the Ethereum Mainnet can go up to  the hundreds of dollars. While similar offerings are available on Solana at a fraction of the cost, making it known as an “Ethereum killer”, the network compromises its decentralization  Scalability is arguably the biggest barrier to adoption today and,until it’s solved, DeFi will struggle to gain usage outside of a core group of believers. 

What’s Next for DeFi? 

While the DeFi narrative is apparently dormant amidst global moments of uncertainty, there is good reason to believe that the space will thrive over the coming years.

DeFi offers many advantages over the traditional finance sector, including trustlessness, higher yields, increased accessibility, and composability. For the institutional market, DeFi could offer a way to put capital to work and capture opportunities in a frictionless, decentralized manner, but there are several hurdles to overcome. 

Institutions will continue to look out for ways to participate in it as it becomes more robust, reducing the risk of issues like hacks and smart contract vulnerabilities. And, when they are ready to enter the market, it’s likely that they’ll go with the most liquid offerings - as well as the growing number of regulated products that are appearing, targeted exclusively at them. 

Like the rest of crypto, DeFi has shown enormous promise, but has faced some teething problems. However, given the huge value of the space and collective brain power working to improve it day by day, it’s a solid bet that DeFi will grow in size over the coming years.

We can only speculate on how long it’ll take institutional investors to fully jump on the DeFi ship… but if there’s one thing we know for sure, it is that they love the promise of good returns.