In episode 38 of The Money Movement, Jeremy joins Johann Bornman, Institutional Product Lead at ConsenSys Metamask on a panel hosted by Pierre Legrand, Partner, Consulting & Research, 11:FS, for a lively discussion on the current and future relationship between financial institutions and decentralized finance.
DeFi, or decentralized finance, has quickly taken the blockchain industry by storm as one of the first true use-cases for smart contract infrastructure on public blockchain networks. And while the value invested in DeFi has grown at a remarkable pace driven by pioneering retail investors, institutions have largely remained on the sidelines. What are the next steps needed for DeFi to have its institutional moment?
Compared to the traditional financial system that facilitates value exchange through multiple layers of execution, clearing, settlement, and reconciliation, DeFi radically flattens this process stack, bringing practically all the operational activities inherent to legacy financial rails into the realm of programmatically executed software. Already at this stage, DeFi offers institutions a far more efficient means of storing, routing, and monetizing assets on their balance sheet.
DeFi protocols are powered by public blockchain infrastructure, which means transactions are publicly verifiable and assets can be traced as they move through the system. Such a substantial increase in transparency creates a new paradigm for monitoring and tracking illicit activity on-chain, but is also largely incompatible with the existing framework of enforcing regulations by using transaction information collected by institutional intermediaries.
Since transparency is inherent to DeFi protocols, adoption of regulatory standards that are used in traditional finance today has lagged. This represents the largest single stumbling block for forward thinking institutions that want to get into DeFi in the first place—without a way to know financial counterparties are not bad actors, institutions are unable to interact with any protocol, no matter how efficient or revolutionary.
As it stands, institutional allocation into DeFi protocols represents a tiny fraction of their overall holdings, and will likely remain so until regulators produce new frameworks for shifting the burden of identification away from institutions or the market generates new solutions for verified access to on-chain protocols. On both the regulatory and market fronts many efforts are in motion, but only time will tell if they can unlock institutional investments in DeFi.
In the meantime, emerging communities of DeFi users and developers will continue to bring new ideas and capital formation to the industry and may one day evolve into institutional players in their own right as decentralized autonomous organizations (DAO) quickly gain popularity. DeFi participants are eager for legacy finance and their vast assets to join the party, but could find themselves setting off an institutional moment in their own right.