Financial services institutions and banks have increasingly engaged with Web3 since 2020. This is also true within institutional decentralized finance (DeFi), as several potential use cases have emerged that could spark a new wave of innovation. within these organizations.
Institutional DeFi does not refer to increasing institutional investments in DeFi protocols and decentralized 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 . A common question that arises is: What advantages does DeFi offer in addition to digital banking?
Not long ago, banking was a physical endeavor where transactions were done on paper and interactions took place through a network of banks. Digitization increased efficiency by automating services and reducing the burden on bank branches. Fintech-driven innovation enabled seamless customer interactions with very few physical touch points.
Digitization of banks still meant information was distributed, creating reconciliation overhead. Although transactions were executed over digital networks, bookkeeping still had to be done separately. DeFi would bring transaction execution and accounting to the same network. That is the advantage of DeFi over simply digitizing.
While banks understand the opportunities that lie ahead with institutional DeFi, there are several hurdles to overcome before benefits at scale can be realized.
In 2019 alone, banks spent more than $270 billion a year to meet regulatory obligations to offer mainstream financial services. Banks and financial services companies must engage with regulators and will need to obtain various checks to take advantage of institutional DeFi.
Regulatory Compliance for Institutional DeFi
Banks undergo high levels of rigor before offering their products and services to consumers. Their viability is checked through stress scenarios, but most importantly, their behavior is also checked. For example, if interest rates are very high, loan products are screened for possible misselling to customers.
In today’s DeFi world, there are products that would not pass the usual degree of due diligence for banks. Several DeFi platforms offer triple and four-digit annual percentage returns to their liquidity providers, something unheard of in mainstream financial services.
The DeFi world also suffers from a lack of corporate governance. The tokenized world relinquishes governance to its token holders. Although most DeFi ecosystems have a high degree of centralization through unequal token ownership, they often lack sufficient corporate governance.
The other key area of focus for regulatory compliance is when products are released on-chain.. In the current environment, the issuance of a bond goes through regulatory approvals depending on the structure of the bond. But if the bond issuance is done in DeFi, there is no regulatory framework to rely on or control the process.
Banks need to work with each other and with regulators to drive product innovation and regulatory frameworks around DeFi-native institutional products.
Legal framework of smart contracts
Smart contracts are a fundamental aspect of DeFi. They offer the ability to activate and settle transactions programmatically. However, they remain a nascent technology, and the legal enforceability of a transaction triggered by a smart contract is unclear in many jurisdictions and situations.
There are some guidelines from various regulatory and legal bodies around the world. For example, the US state of Nevada has made smart contracts legally enforceable, but there needs to be a broader legal framework that nation states subscribe to so that financial services that rely on programmable money can have a foundation. solid legal
data privacy
DeFi applications have not only prided themselves on the transparency of on-chain transactions, but have also relied on it. The broader ecosystem has used this feature effectively to understand market behaviors. For example, the apps regularly track whale activity to gauge market sentiment.
Models like automated market making (AMM) have emerged within DeFi thanks to on-chain transparency. DeFi protocols are capable of calculating asset prices based on real-time supply and demand data. Institutional DeFi intends to take inspiration from these models.
However, participants in conventional capital markets rely on the privacy of transactions. Brokers have acted as proxies for institutions wishing to place large orders in the market. Although the market sees large transactions taking place, it cannot discover the institution behind the operation.
Institutional DeFi would have to find a nice middle ground between the transparent world of DeFi and the traditional capital markets that are intermediated to create privacy. In the past, banks have tested DeFi using permissioned blockchains that only allowed certain participants to use the chain.
Of late, however, institutional players have become more open to trying permissionless blockchains, such as JPMorgan’s collaboration with Polygon. However, It remains to be seen how they will achieve the necessary level of transaction privacy while providing algorithms with on-chain information for AMM to occur effectively.
AML/KYC controls
Last but not least, banks and financial services companies rely on robust anti-money laundering (AML) and know-your-customer (KYC) controls. Between 10% and 15% of the bank staff 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, almost $10 billion worth of cryptocurrency was in the hands of illicit addresses. According to the report, in 2021 cybercriminals laundered nearly $8.6 billion worth of cryptocurrency.
Again, there is a need to identify a middle ground where institutional DeFi participants are identified through robust KYC processes. In order to use the DeFi services offered by the institutions, users must also adhere to the AML controls and on-chain analytics required by the institutions.
Other considerations
This is not an exhaustive list of capabilities entities must have in order to explore DeFi effectively. There are other aspects, such as the harmonization of rules between banks, jurisdictions and asset classes. The institutional DeFi sector can only function if many institutions come to the table in a planned way.
There should be self-custody wallets with very little friction. For institutional DeFi technology to go mainstream, the user experience must be seamless. Wallets like ZenGo already onboard users without the need to use private keys. This should be the norm for institutional DeFi to go mainstream.
There must be interoperability on and off-chain, as the onboarding of institutions into the global banking infrastructure could take decades. Banks should also be open to dialogue when using different crypto chains and technologies that need to communicate with each other to achieve an integrated market infrastructure.
The next two decades are going to be exciting as controlled, regulated and brokered capital markets look to take advantage of DeFi’s “wild west”. How banks and financial institutions work together and with regulators on a global scale will decide whether institutional DeFi can be the utopian middle ground that brings together the best of both worlds.
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