What is institutional DeFi and what are the building blocks?

The Financial Services realm has undergone a sea change in the last decade. From filling up rusty old forms and waiting in long queues in banks' branches to getting everything (mostly everything) done from their couch through the bank's internet portal or mobile app, the user experience paradigm in the BFSI sector has changed for the better.?

This was largely due to a wave of Fintech use cases that emerged through this period. Yet, the Fintech narrative was to fix banking by improving product innovation, making financial services efficient and offering great customer experience. We have a tonne of data to demonstrate that the customer experience box has largely been ticked.

However, operational efficiencies and product innovation is still work in progress even for the Fintech sector. Banks have drawn inspiration from Fintechs, and in some cases partnered with them to improve their customer journeys too. However, banking and capital markets as a whole can get radically better. The transformation is just getting started.

???????? Enter institutional DeFi.

Institutional DeFi does not refer to growing institutional investments in DeFi protocols and decentralised applications (DApps) but rather to large institutions using DeFi protocols to tokenize real-world assets with regulatory compliance and institutional-level controls for consumer protection. Institutional DeFi could be a new paradigm that banks can leverage for product innovation, new pricing models, and operational efficiencies.

Financial services institutions and banks have increasingly engaged with Web3 since 2020. A quick look at Coinbase's quarterly volumes report shows us growth of institutional involvement in this space. However, more interestingly this trend is also true within institutional decentralised finance (DeFi), as several potential use cases have emerged that could trigger a new wave of innovation within these financial services organisations.?

Some institutional defi use cases worth noting are digital asset custody, anti-money laundering using on-chain analytics, tokenization, stablecoins (issued by banks) and payments.

A quick look at the BLOCKDATA chart below highlights investments from top tier banks into this space to ramp up their institutional defi capabilities.

While some banks have partnered and invested into these digital asset firms, others have taken a more adventurous route of building the capability in-house. Standard Chartered's Zodia platform, and JP Morgan's Onyx initiative are just two examples of banks choosing build over buy.

But what efficiencies does Institutional DeFi offer on top of digital banking?

Not long ago, banking was a physical effort where transactions were paper-based, and interactions took place through a network of banks. Digitization added efficiencies by automating services and reducing the burden on bank branches.

The digitization of banks still meant that information was distributed, creating reconciliation overheads. While transactions were executed over digital networks, bookkeeping still had to be performed separately. DeFi would bring the execution of transactions and bookkeeping (settlements) onto the same network. That's the advantage that DeFi provides over plain vanilla digitization.

While banks understand the opportunities that lay ahead with institutional DeFi, there are several hurdles to overcome before benefits can be realised at scale.?

Regulatory compliance for institutional DeFi

In 2019 alone, banks spent over $270 Billion per year to comply with regulatory obligations toward offering mainstream financial services. Banks and financial services firms must collaborate with regulators and get several controls to tap into institutional DeFi.

Banks go through high levels of rigour before offering their products and services to consumers. They are checked for viability through stress scenarios and, more importantly, for conduct issues. For instance, lending products are scrutinised for misselling to customers if the interest rates are very high.

In the DeFi world today, many products wouldn't survive banks' usual degree of due diligence. Several DeFi platforms offer three and four-digit annual percentage yields to their liquidity providers, which is unheard of in mainstream financial services.

The DeFi world also needs more corporate governance. The tokenized world hands over governance to its token holders. While most DeFi ecosystems have high degrees of centralization through uneven token ownership, they often lack sufficient corporate governance. Institutional DeFi offerings that are regulated should be a lot more robust.

The other key focus area for regulatory compliance is when products are launched on-chain. In today's environment, a bond's issuance goes through regulatory approvals depending on the bond's structure. But if the bond issuance is done on DeFi, there is no regulatory framework to rely on or control the process.

Banks must work with each other and with regulators to drive product innovation and regulatory frameworks around native institutional DeFi products.

Legal framework for smart contracts

Smart contracts are a critical aspect of DeFi. They offer the ability to programmatically trigger and settle transactions. However, they are still a nascent technology, and the legal enforceability of a transaction triggered by a smart contract needs to be clarified in many jurisdictions and situations.

There are pockets of guidelines from various regulatory and legal bodies worldwide. For instance, the state of Nevada in the United States has made smart contracts legally enforceable, but there needs to be a broader legal framework that nation-states sign up to so that financial services that rely on programmable money can have robust legal foundations.

Data/Transaction privacy

DeFi applications have not only taken pride in, but also have relied upon the transparency of on-chain transactions. The broader ecosystem has used this feature effectively in understanding market behaviors. For instance, whale activity is regularly tracked by applications to assess market sentiment.

Models like automated market making (AMM) have emerged within DeFi thanks to on-chain transparency. DeFi protocols are able to calculate asset prices based on real-time supply and demand data. Institutional DeFi looks to draw inspiration from these models.

Yet, conventional capital market participants rely on the privacy of transactions. Brokers have acted as proxies for institutions that look to place large market orders. While the market sees large transactions, it can't generally spot the institution behind them.

Institutional DeFi would need to find a good middle ground between the transparent DeFi world and traditional capital markets that are intermediated to create privacy. In the past, banks have tested DeFi using permissioned blockchains that allowed only certain participants to use the chain.

In recent times, however, institutional participants have been more open to trying out permissionless blockchains like JPMorgan's collaboration with Polygon. However, it remains to be seen how they will achieve the required level of privacy of transactions while providing the algorithms with on-chain information for AMM to happen effectively.

AML/KYC controls

Lastly, banks and financial services firms rely on robust Anti-Money Laundering (AML) and Know Your Customer (KYC) controls. Some 10%-15% of the workforce in banks ensure that compliance and risk standards can meet regulatory rigor.

On the other side of the spectrum, a recent Chainalysis report highlighted that as of early 2022, nearly $10 billion worth of cryptocurrencies were held by illicit addresses. According to the report, nearly $8.6 billion worth of cryptocurrencies were laundered by cybercriminals in 2021.

Again, a middle ground needs to be identified where institutional DeFi participants identify themselves through robust KYC processes. To use DeFi services offered by institutions, users must also adhere to any AML controls and on-chain analytics that the institutions mandate.

Other considerations

This list is a partial list of capabilities institutions must have to explore DeFi effectively. Other aspects include aligning standards across banks, jurisdictions, and asset classes. Institutional DeFi can only work if many institutions come to the table in a planned fashion.

Self-custody wallets with very little friction should be in place. For institutional DeFi to go mainstream, user experiences must be seamless. Wallets like Zengo Wallet already onboard users without the need to use private keys. This paradigm should be the norm for institutional DeFi to go mainstream.

On-chain and off-chain interoperability must be in place as the onboarding of institutions to the global banking infrastructure could take decades. Banks must also be open to dialogues when they use different chains and cryptographic technologies that need to talk to each other to achieve an integrated market infrastructure.

The next few decades will be fascinating as controlled, regulated, and intermediated capital markets look to tap into the DeFi "wild west." How banks and financial institutions work with regulators globally will decide whether institutional DeFi can be the utopian middle ground that brings together the best of both worlds.

In this article, I have consciously highlighted the foundational controls framework that banks would need to tap into institutional Defi. The benefits of doing so in terms of efficiencies and product innovation is for another day.