What Is Institutional DeFi? The Future of Finance

Decentralized Finance (DeFi) was initially created to be a replacement or alternative to the traditional financial system. Bitcoin’s original philosophy was that centralized, opaque financial institutions made decisions that weren’t in the public interest, setting off the banking crisis and other issues. Bitcoin moved away from this by creating a decentralized, transparent financial system, and DeFi built on this foundation to offer many of the products and services of the traditional financial system in a decentralized fashion.

However, over time, DeFi and traditional finance (TradFi) have become increasingly interconnected. Instead of replacing TradFi, blockchain and DeFi have offered it a means of modernizing and improving its service offerings. Institutional DeFi is when TradFi institutions adopt blockchain technology and DeFi systems to leverage the power of DeFi while maintaining compliance with financial regulations.

How DeFi Has Evolved: From Retail to Institutional Adoption

Initially, DeFi was designed as a “retail” ecosystem where individuals could engage in peer-to-peer financial transactions and services without traditional intermediaries. This aligned with the original blockchain and DeFi ethos and has been wildly successful, with DeFi’s total value locked (TVL) having peaked at over $100 billion.

The success of DeFi has caught the interest of major TradFi organizations, who see it as an opportunity to expand their offerings and modernize their systems. However, DeFi, in its current state, is often a poor fit for the financial sector, which is subject to various strict regulations. As a result, Institutional DeFi is on the rise to merge blockchain technology with regulatory-compliant processes and practices.

What Defines Institutional DeFi: Key Features and Elements

Institutional DeFi has the challenge of fusing traditionally cypherpunk DeFi systems with the very organizations that they were created to disrupt. At the same time, they also need to ensure compliance with regulatory requirements, which can vary significantly from one jurisdiction to another. Some of the key elements that define Institutional DeFi and differentiate it from traditional DeFi include the following:

KYC and AML in Institutional DeFi: Ensuring Compliance

Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations are some of the most common laws in the financial sector across different jurisdictions. While the details may vary, the goal is to ensure that financial institutions know who they are doing business with and to prevent the use of banks for money laundering or funding criminal activities.

One of the defining features of blockchain technology is that it provides a level of anonymity to its users. Blockchain accounts are identified by an address derived from a randomly generated number. While this doesn’t provide complete anonymity, users can take steps to make it difficult to link their real-world identities to their on-chain accounts.

Institutional DeFi addresses the disconnect between blockchain anonymity and KYC requirements by working through centralized organizations that perform proper KYC. By only transacting with verified accounts, the institutions can meet regulatory requirements while operating on-chain.

Strengthening Institutional DeFi: Security and Risk Management Best Practices

Historically, DeFi has been known for its relatively lax approach to security and frequent hacks. Many DeFi protocols have experienced cyberattacks with values in the millions due to a failure to properly audit code before release or to secure the private keys used to manage high-value blockchain accounts.

The traditional financial sector, on the other hand, has strict requirements for the security of money and the applications that manage it. While TradFi institutions can get hacked, they are held to a much higher bar for security than their DeFi counterparts.

A key part of Institutional DeFi is bringing the security and risk management standards of the financial sector to the DeFi space. This includes ensuring that organizations appropriately manage risk and perform audits and penetration testing of all code—both on-chain and off-chain—to identify and correct vulnerabilities before attackers can exploit them.

How Institutional DeFi Builds Trust and Protects Investors

DeFi and blockchain platforms often operate under a policy of DYOR (do your own research). The decentralization ethos of blockchain also extends to limited responsibility for projects to protect their users from fraud, theft, etc. While reputable projects commonly attempt to make users whole after a security incident, rug pulls, and similar threats are also common in the industry.

TradFi institutions have a greater duty to protect their investors and establish trust in themselves and their processes. Some of these responsibilities are informal and based on remaining competitive in the marketplace, while others are codified by various regulations. For example, the Sarbanes Oxley Act (SOX) in the U.S. requires public companies to publicly disclose risks that could threaten their financial viability, including cyberattacks. Many other regulators mandate that companies publicly disclose significant data breaches and other incidents.

Achieving compliance with these regulations requires TradFi institutions to ensure that their investors are protected against potential risks, including fraud and cyberattacks. In addition to ensuring the security of their software, organizations need to vet third-party providers and partners to ensure that they don’t introduce undue risk to investors.

The Future of Institutional DeFi: Merging TradFi and Blockchain

Institutional DeFi is still in its relative infancy. However, many large organizations, such as J.P. Morgan and Deutsche Bank, have demonstrated interest in crypto in general and DeFi in particular. The massive success of Bitcoin exchange-traded funds (ETFs) has demonstrated that investors have an interest in the space but want access via traditional investment vehicles rather than directly owning their own crypto.

The growth of Institutional DeFi has significant impacts for DeFi and TradFi alike. By introducing new participants into the crypto space, Institutional DeFi has the potential to dramatically increase on-chain liquidity and expand the potential user base for DeFi protocols. TradFi also benefits because it can leverage the various benefits provided by modern, blockchain-based technology and systems.

Another potential impact of Institutional DeFi is an increased focus on security and risk management in the space. Currently, DeFi is known for its relatively poor security standards and frequent hacks. As highly-regulated TradFi organizations enter the space, they have the potential to raise the bar for DeFi security as a whole as other projects try to keep pace and maintain competitiveness in the market.

Security is vitally important to protecting DeFi projects and their users against cyber threats and potential breaches. For help in securing your protocol against attack, reach out to Halborn.