Institutional DeFi: The Rise of a New Financial Paradigm

Decentralized Finance ( DeFi ) is expected to create a new financial paradigm in the institutional sector, based on principles of collaboration, composability, and open source code, and built on an open and transparent network. This article will explore the development history of DeFi and its potential in institutional applications, with a focus on how this will impact institutional financial services.

Introduction

The evolution of DeFi and its application potential in institutional scenarios has garnered significant attention in the industry. Supporters believe that a new financial paradigm is emerging, based on cooperation, composability, open-source code principles, and open and transparent networks. As a highly watched area, regulated DeFi financial activities are gradually advancing.

The ongoing changes in the macroeconomic and global regulatory environment hindered large-scale meaningful progress, with major developments concentrated in the retail sector or through sandbox environments. 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 path has been driven by advancements in blockchain infrastructure, providing support for institutions operating under regulatory compliance requirements in the form of a global layer network or cross-chain network. Key uncertainty issues are also being addressed, including compliance and balance sheet requirements, as well as the anonymity of blockchain wallets and how to meet KYC/AML requirements on public chains. As discussions deepen, it becomes increasingly clear that centralized finance (CeFi) and decentralized finance (DeFi) are not mutually exclusive; full adoption by institutions may only be feasible for those adopting a hybrid centralized operational governance model within the ecosystem.

Within the institutional circle, exploring this field is often positioned as entering a new realm filled with attractive potential, where innovative investment products can be developed, reaching previously untapped new consumers and liquidity pools, and adopting new digital operating models and more cost-effective market structures. Only time and innovation will prove whether DeFi will exist in its purest form, or if we will see a compromise that allows a certain degree of decentralization to play a bridging role in the financial world.

This article will review the recent history of Decentralized Finance, attempting to unveil the mystery behind some commonly used terms, and then delve into some key drivers in the DeFi space. Finally, we will explore the challenges that the institutional financial services sector will face on the road to institutional DeFi.

Decentralized Finance Ecosystem Analysis

1.1 What is Decentralized Finance?

The core of Decentralized Finance (DeFi) is to provide financial services on-chain, such as lending or investing, without relying on traditional centralized financial intermediaries. In this rapidly evolving field, there is no official and universally recognized definition yet, but typical DeFi services and solutions usually have the following elements:

• Self-custody wallets allow investors to be their own custodians.
• Use code to maintain and manage smart contracts for digital asset custody.
• Staking contracts that calculate and distribute rewards based on the value of deposits and/or variables using code.
• Allow asset swaps and use for lending or decentralized exchange ( DEX ) asset swap protocols, such as Uniswap.
• Issue securitization and remortgaging structures based on underlying "wrapped" assets, where the issued assets can have secondary market value.

1.2 What is institutional Decentralized Finance?

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 topic within the regulatory framework of the financial industry, the advantages of DeFi can be introduced into 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 integrating programmability into asset classes, leading to the emergence of new operating models.

The differences between institutional DeFi and traditional DeFi are as follows:

1.3 Decentralized Finance 发展历程

In an open environment, DeFi-related projects sparked a frenzy in the crypto market in the summer of 2020, ushering in a new era. Due to its high liquidity, expensive assets, and high mining returns, DeFi rapidly emerged during the Federal Reserve's large-scale quantitative easing in response to the COVID-19 pandemic. The total locked value in DeFi services, ( TVL ), rose 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 substantial funding support, leading to a surge in the number of projects and related tokens, attempting to ride the wave. By the end of 2021, the total number of DeFi users skyrocketed, with over 7.5 million unique users trading in the DeFi ecosystem, an increase of 2550% compared to a year earlier, and the TVL peaked at $169 billion in November 2021. New terms 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, along with some unlawful activities within the ecosystem, DeFi experienced numerous issues, including some well-known collapse events. This forced the entire market to take a step back and enter a cautious and rational phase in the second half of 2022.

This trend became more evident at the beginning of 2023, as rising financing costs led to a depletion of private financing in the financial technology DeFi sector, reflected in a 69% year-on-year decline in trading activity in the first quarter of 2023. This resulted in a decrease in the TVL of DeFi systems to less than $50 billion in April 2023, and it dropped to a low of $37 billion by the end of October 2023.

Despite experiencing significant declines and the "crypto winter" at the same time, the fundamentals of the DeFi community remain resilient, with the number of users steadily increasing. Many DeFi projects persistently focus on building products and capabilities.

By the end of 2023, the market saw growth as the United States approved spot cryptocurrency ETF products for the first time, widely regarded as an important sign of digital assets further integrating into traditional financial products. More importantly, this opens the door for institutional participants to engage more deeply in these emerging ecosystems, bringing much-needed liquidity to the field.

1.4 Realizing the early commitments of Decentralized Finance

In the field of native crypto assets, the DeFi movement has spawned coding structures, demonstrating how DeFi operates without the involvement of certain intermediaries, typically involving smart contracts and/or peer-to-peer (P2P) infrastructure. Due to low access costs, DeFi services were rapidly adopted in the early stages and quickly 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 re-engineers 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 for providing these new financial services. Therefore, the existing market structure may change.

Institutional DeFi Pioneer Event

Many institutional use cases can be extracted from the DeFi field, utilizing the tokenization of real assets and securities.

The following are some examples that attempt to summarize the connection between financial services products and the combination of technology and regulations to create new value, illustrating why institutional Decentralized Finance is attractive.

Case 1: Interoperability, 2023 By utilizing DeFi constructs in the institutional sector, self-custody wallets can achieve a distributed asset custody model while providing a comprehensive and independent digital account ( address ), which can be used for trading liquidity, settlement, and reporting. An important use case is the smart contract bridge, connecting different blockchains to achieve interoperability and avoid fragmentation caused by blockchain choice.

Applicability: As a connection point between public, public permissioned, and private networks to minimize fragmentation while allowing for high access and participation.

Case 2: Using stablecoins to refinance tokenized financial instruments, 2023 Decentralized Finance systems can also be used for financing in traditional industries, although they have not yet been widely adopted. For example, security tokens representing certain real-world financial instruments can be placed as collateral in a smart contract "vault" to obtain stablecoins, which can then be converted into fiat currency.

Case 3: Tokenized Funds in Asset Management, 2023 Tokenized fund units or tokens can be distributed via blockchain, open directly to qualified investors, and maintain investor records on-chain, while smart contract facilities allow for the fast or near-real-time subscription and redemption using regulated stablecoins. Furthermore, tokenized fund units representing high-quality liquidity traditional financial instruments can serve as collateral.

The Evolution of the Market Structure of 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 much debate about how DeFi might 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 DeFi, 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 because the intermediary activities in 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—because the reduction of intermediary institutions can enhance transparency.

2.2 The potential of new roles and activities

The pioneering use cases listed in Section 1.4 of the institutional DeFi ecosystem highlight how today's market structure may evolve into the next wave of DeFi innovation.

In this way, public blockchains can become de facto industry utility platforms, similar to how the Internet serves as the delivery infrastructure for online banking. There have already been certain precedents for launching institutional blockchain products on public blockchains, particularly in the money market fund sector. The industry should look forward to further advancements, such as in the tokenization space: virtual funds, asset classes, and intermediary services; and/or with a permissioned layer.

Participate in the Decentralized Finance Market

Operate on public, private, or permissioned blockchain networks.

For institutions, the nature of DeFi 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 of the advances in the institutional digital asset space have occurred in the realm of private or permissioned blockchain networks, where trusted parties act as "network operators" and owners are responsible for approving participants into the network.

In contrast, public blockchain networks have the potential for open scalability, low entry barriers, and readily available innovation opportunities. These environments are essentially