The Path to Institutional DeFi: Interpretation of Deutsche Bank Research Report

Decentralized Finance ( DeFi ) holds the potential to create a new financial paradigm in institutional applications, which is built on principles of collaboration, composability, and open-source code, based on an open and transparent network. This article explores the development history of DeFi and its possible future evolution, with a focus on how these transformations impact institutional financial services.

Introduction

The evolution of DeFi and its potential applications in institutional scenarios have garnered significant attention in the industry. Supporters argue that there are ample reasons for the rise of this new financial paradigm, which is based on collaboration, composability, and open-source principles, and is built on open and transparent networks. As a highly regarded field, the path to conducting regulated financial activities using DeFi is gradually being constructed.

Changes in the macroeconomic and global regulatory environment have hindered widespread and meaningful progress, with developments mainly concentrated in the retail sector or through incubation sandboxes. However, in the next 1-3 years, institutional DeFi is expected to take off, combined with the widespread adoption of digital assets and tokenization, which financial institutions have been preparing for over the years.

This development path is driven by advancements in blockchain infrastructure, meeting the operational needs of organizations under regulatory compliance requirements in the form of global layer 1 or interconnected networks. Solutions to key uncertainty issues are also emerging, including compliance and balance sheet requirements, as well as the anonymity of blockchain wallets and how to meet KYC and AML requirements on public blockchains. As these discussions deepen, it becomes increasingly clear that centralized finance (CeFi) and decentralized finance (DeFi) are not binary opposites; rather, full adoption at the institutional end of the financial sector may only be feasible for organizations that have a hybrid model of centralized operational governance within the ecosystem.

In the institutional circle, exploring this field is often seen as a journey of discovery into a realm filled with attractive potential, where innovative investment products can be developed, touching previously untapped new consumers and liquidity pools, and adopting new digital operational models and more cost-effective market structures. Only time and innovation will prove whether DeFi will exist in its purest form, or whether we will see a compromise that allows a certain degree of decentralization to bridge the financial world.

This article reviews the recent history of Decentralized Finance, attempts to unveil some commonly used terms, and then delves into some key drivers in the DeFi space. Finally, we will reflect on the challenges that the institutional financial services community will face on the path to institutional DeFi.

Decentralized Finance Landscape Analysis

1.1 What is Decentralized Finance?

The core of DeFi is to provide financial services on the blockchain, such as lending or investing, without relying on traditional centralized financial intermediaries. Although there is no officially unified definition in this rapidly evolving field, typical DeFi services and solutions usually have the following characteristics:

• Self-custody wallets allow investors to be their own asset custodians.
• Use code to maintain and manage the smart contract custody of digital asset custody.
• A staking contract that calculates and allocates rewards based on deposit value and/or variables using code.
• An asset exchange protocol that allows asset swaps and can be used in lending or decentralized exchanges (DEX).
• Issuing securitization and re-mortgage structures based on underlying "wrapped" assets for different assets.

1.2 What is institutional DeFi?

Institutional DeFi refers to the adoption and adaptation of DeFi structures by institutions, as well as their participation in decentralized applications ( dApps ) or solutions. By exploring this field within the regulatory framework of the financial industry, the advantages of DeFi can be transferred to traditional financial markets, opening up possibilities for new cost efficiencies and effects, while also paving the way for new growth paths. These new paths include the tokenization of physical assets and securities, as well as the integration of programmability into asset classes, leading to the emergence of new operational models.

The differences between institutional DeFi and traditional DeFi are mainly reflected in the following aspects:

• Asset custody: Managed by regulated financial institutions, rather than smart contracts.
• Access: Requires KYC/AML in the form of digital identity, rather than no access.
• Governance: Managed by specialized organizations and professionals, rather than a DAO.
• Regulation: Subject to existing financial regulatory framework
• Objective: Reduce costs, improve efficiency, enhance regulatory transparency

1.3 The history of Decentralized Finance

DeFi-related projects sparked a frenzy in the crypto market in the summer of 2020, marking the beginning of a new era. Due to its high liquidity, expensive assets, and high mining rewards, DeFi rapidly rose during the Federal Reserve's large-scale quantitative easing in response to the COVID-19 pandemic. The total locked value (TVL) in DeFi services increased from 1 billion dollars at the beginning of the year to over 15 billion dollars by the end of the year.

During this period, new Decentralized Finance projects received significant funding support, with a surge in the number of projects and related tokens. By the end of 2021, the number of DeFi users exceeded 7.5 million, a growth of 2550% compared to the previous year, and the TVL reached a peak of $169 billion in November 2021. New concepts such as Uniswap and Yield Farming were introduced into everyday financial life.

In 2022, due to multiple interest rate hikes and a significant rise in inflation, as well as some misconduct within the ecosystem, DeFi experienced many setbacks, including some well-known collapse events. This led the entire market into a cautious and rational phase in the second half of 2022.

This trend became more apparent in early 2023, with private financing in the DeFi sector drying up, reflected in a 69% year-on-year decrease in trading activity from the beginning of the year to now. This led to a decline in the TVL in DeFi systems to less than $50 billion in April 2023, dropping to a low of $37 billion by the end of October 2023.

Despite experiencing significant declines and the "crypto winter" during the same period, the fundamentals of the DeFi community remain resilient, with the number of users steadily increasing, and many DeFi projects persistently focusing on product and capability development.

By the end of 2023, the market has seen growth due to the United States' first approval of spot crypto ETF products, widely regarded as a significant milestone for the further integration of digital assets into traditional financial products. More importantly, this has opened the door for institutional participants to engage more deeply in these emerging ecosystems, which will bring much-needed liquidity to the space.

1.4 Realizing the Early Commitments of Decentralized Finance

In the native cryptocurrency asset field, the DeFi movement has led to the emergence of coding structures, demonstrating how DeFi operates without the involvement of certain intermediary institutions, typically involving smart contracts and/or peer-to-peer (P2P) infrastructure. Due to low entry costs, DeFi services were rapidly adopted in the early stages and proved their value in providing efficient asset pools and reducing intermediary fees, while applying economic behavioral financial technology to manage demand, supply, and prices.

These new advantages are realized because DeFi redefines or replaces existing intermediary activities through smart contract programming, achieving higher efficiency, thereby changing workflows and transforming roles and responsibilities. In the "last mile" with investors and users, DeFi applications ( DApps ) are the tools that provide these new financial services. As a result, the existing market structure may change.

The Evolution of Market Structure for DeFi Institutions

The market concept driven by DeFi presents an intriguing market structure that is essentially dynamic and open, with its native design challenging the norms of traditional financial markets. This has led to widespread speculation about how DeFi will integrate or collaborate with the broader financial ecosystem, as well as the forms that new market structures may take.

2.1 Governance, Trust, and Centralization

In the institutional field, there is a greater emphasis on governance and trust, requiring ownership and accountability in the roles and functions played. Although this seems to contradict the decentralized nature of Decentralized Finance, many believe that it is a necessary step to ensure regulatory compliance and provides clarity for institutional participants to adapt to and adopt these new services. This situation has given rise to the concept of "decentralized illusion," as the need for governance inevitably leads to a certain degree of centralization and concentration of power within the system.

Even with a certain degree of centralization, the new market structure may be more streamlined than our current market structure, as the intermediation activities within organizations have been greatly reduced. As a result, orderly interactions will become more parallel and concurrent. This, in turn, helps to reduce the number of interactions between entities, thereby improving operational efficiency and lowering costs. In this structure, management activities, including anti-money laundering ( AML ) checks, will also become more effective -- as the reduction of intermediaries can enhance transparency.

2.2 The potential of new roles and activities

The pioneer use cases listed in the institutional DeFi ecosystem highlight how today's market structure may evolve in the next wave of DeFi innovation.

In this way, public blockchains can become de facto industry utility platforms, just as the internet became the delivery infrastructure for online banking. There have already been some precedents for launching institutional blockchain products on public blockchains, particularly in the money market fund sector. The industry should look forward to further progress, such as in the areas of tokenization, virtual funds, asset classes, and intermediary services; and/or with permissioned layers.

Participate in the Decentralized Finance market

For institutions, the nature of DeFi itself is both daunting and convincing.

Participating, operating, and trading in the open ecosystem provided by DeFi products may conflict with the closed-loop or private environments of traditional finance. In traditional financial environments, clients, counterparties, and partners are well-known, and risks are accepted based on appropriate levels of disclosure and due diligence. This is also one of the reasons why many advancements in the institutional digital asset space have occurred so far in private or permissioned blockchain networks, where trusted administrators act as "network operators" and owners are responsible for approving participants to enter the network.

In contrast, public chain networks have the potential for open scalability, low entry barriers, and readily available innovation opportunities. These environments are inherently decentralized, built on the principle of no single point of failure, and user communities are incentivized to "do good." Maintaining the security and consistency of the blockchain is achieved through consensus protocols such as ( Proof of Stake ( POS ) and Proof of Work ( POW ), which may vary across different chains. This is a way for participants -- as validators -- to contribute and earn rewards in what we consider the "blockchain economy."

) 3.1 Participation in the Verification Table Outline

When evaluating any digital asset and blockchain ecosystem participation, the main considerations should include the maturity of the blockchain and its corresponding roadmap, achievable final settlement consensus, liquidity, interoperability with other on-chain assets, regulatory perspectives, and adoption status; it is also necessary to assess the risks of network technology, network security, continuity planning, and the core community and developer participants of the network. The degree of technological standardization and a common understanding of the taxonomy can also pave the way for the development of applications.

On this basis, private chains appear to be less risky and more attractive. However, the lower risk level of private chains compared to public chains should also be assessed by the following factors: availability of expertise, vendor dependence, accessibility, scale of liquidity, and the costs of creating, maintaining, and operating a private chain, which can determine the success or failure of a project. Imagine if every bank had to run its own private internet to support its online banking applications; cost would be a critical factor, especially during the transition period when blockchain would operate alongside existing technology stacks, which needs to be taken into special consideration.

Ultimately, companies must adapt to what they can accept.