Deutsche Bank Research Report: The Road to Institutional DeFi

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Since the Bank for International Settlements (BIS) and the Monetary Authority of Singapore (MAS) respectively launched the "Financial Internet (Finternet)" and the central bank-led infrastructure Global Layer 1, the traditional financial field is welcoming Here comes a huge trend of change: the financial and monetary system is transforming into Tokenisation. Global policymakers, financial institutions and startups have paid unprecedented attention to and researched tokenization, and this topic has become one of the core topics at many important industry conferences.

In addition to the technical process and infrastructure of tokenization, decentralized finance (DeFi), as one of the core innovations in the blockchain industry, has also become a hot topic in the traditional financial field. Therefore, a new concept "Institutional DeFi" emerged at the historic moment. Deutsche Bank recently published a research report on institutional DeFi, and the author also translated the research report.

Different from the characteristics of native DeFi that have no access, assets are kept by smart contracts, and are governed by DAO organizations, institutional DeFi emphasizes the custody of assets by regulated financial institutions, KYC/AML through digital identity, and dedicated Organizations and professionals govern. Traditional financial institutions view this regulated DeFi as a new growth tool that can reduce costs, increase efficiency, and enhance regulatory transparency.

The article also criticized the "illusion of decentralization" phenomenon in the native DeFi field, that is, holding high the banner of "decentralization" to govern in the name of DAO, but in fact it is extremely centralized, and the right to speak and governance tokens are in the hands of a small number of people. The author has long noticed this phenomenon, and most people in the industry have turned a blind eye to it, becoming the "elephant in the room". This is something worth reflecting on.

Some people may think that it seems ridiculous that deintermediation DeFi is used to carry out financial business by "removing intermediaries". But if you think about it carefully, take DeFi lending as an example. Lending in native DeFi involves one group of people providing liquidity of the underlying assets to obtain the income from the loaned assets, and another group of people providing mortgage assets and lending the underlying assets in the smart contract. Pay interest. In this process, the intermediary has only been replaced by smart contracts, and its role has changed, but the intermediary has not disappeared. It is not unrealistic for financial institutions to operate DeFi protocols, but it has reduced many labor costs and process.

In fact, no "credit currency" is generated out of thin air in this process. The ability of traditional commercial banks to derive credit currency through credit is something that native DeFi can technically achieve but is difficult to achieve at a commercial level. This involves the credit evaluation of borrowers and a series of social system constraints, which is a governance issue. It is almost impossible to carry out unsecured credit lending in DeFi without access, and there is a lack of accountability system and legal constraints for users.

And institutional DeFi is the way to solve this problem. Financial institutions can greatly lower the threshold for enterprises and individuals to participate in finance through regulated DeFi protocols, achieve wider financial inclusion, and reduce costs and increase efficiency. From the perspective of central banks and policymakers, this has a profound impact on the entire national society. The economy is a positive thing. This will also be a major trend in the tokenization transformation of traditional financial fields in the future.

To achieve this goal, technology is not the core obstacle, governance and laws and regulations are the key. Today, we can see that more and more central banks and financial institutions have begun piloting a series of tokenization projects and formulating regulatory frameworks. We believe that it is only a matter of time before large-scale applications are implemented.

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Institutional applications of decentralized finance (DeFi) have the potential to create a new financial paradigm based on the principles of collaboration, composability and open source code, And based on an open and transparent network. In this whitepaper, we take a deep dive into the history of DeFi and possible future developments, with a focus on how this impacts institutional financial services.

Foreword

The evolution of decentralized finance (DeFi) and its potential for adoption in institutional use cases has attracted significant interest from industry observers. Proponents see a strong case for the rise of a new financial paradigm based on the principles of collaboration, composability, open source code, and underpinned by open, transparent networks. As a field enters the spotlight, the path to leveraging DeFi for regulated financial activities is under construction.

The changing macroeconomic and global regulatory environment has hindered widespread meaningful progress, with development primarily occurring in the retail space or through incubation sandboxes as a backdrop. However, over the next one to three years, institutional DeFi is expected to take off, coupled with the widespread adoption of digital assets and tokenization, a scenario that financial institutions have been preparing for for years.

This path is driven by advances in blockchain infrastructure, in the form of Global Layer 1 or Interlinking Networks, to accommodate organizations operating under regulatory compliance requirements. Issues resolving key uncertainties are also emerging, including compliance and balance sheet requirements, as well as the anonymity of blockchain wallets and how to meet know-your-customer (KYC) and anti-money laundering (AML) on public blockchains. )Require. As these discussions deepen, it becomes increasingly clear that centralized finance (CeFi) and decentralized finance (DeFi) are not binary opposites; and that full adoption on the institutional side of the financial sector may only be beneficial to those in the ecosystem. This is feasible for organizations with a hybrid model of centralized operational governance.

In institutional circles, exploring this space is often positioned as a journey of discovery into an area filled with attractive potential to develop innovative investment products that reach previously untapped new consumers and liquidity pools, and Adopt new digital operating models and more cost-effective market structures. Only time (and innovation) will tell whether DeFi will survive in its purest form or we will see a compromise that allows a degree of decentralization to serve as a bridge to the financial world.

In this whitepaper, we reflect on the recent history of DeFi, attempt to demystify some commonly used terminology, and then take a closer look at some of the key drivers of the DeFi space. Finally, we’ll consider what the institutional financial services community faces on the road to institutional DeFi.

DeFi Landscape Analysis

1.1 What is DeFi?

The core of DeFi is to provide financial services, such as lending or investing, on the chain without relying on traditional centralized financial intermediaries. While there is no official and universally recognized definition in the rapidly evolving space, typical DeFi services and solutions can identify the following elements:

Self-custodial wallets that allow investors to become their own custodians.

Use code to maintain and manage smart contract custody of digital asset custody.

Staking contracts that use code to calculate and distribute rewards based on deposit value and/or variables.

An asset exchange protocol that allows one asset to be exchanged for another and used in lending or decentralized exchanges (DEX), such as Uniswap, one of the early players in the DeFi ecosystem, using smart contract execution trade.

Issue securitization and remortgage structures of different assets based on the underlying "wrapped" assets, where the assets issued can have secondary market value.

1.2 What is Institutional DeFi?

Institutional DeFi - the focus of this article - refers to the institutional adoption and adaptation of DeFi structures, and institutional participation in decentralized applications (dApps) or solutions. By approaching this topic within the regulatory framework of the financial industry, the benefits of DeFi can be transferred to traditional financial markets, opening up possibilities for creating new cost efficiencies and effects, while also paving the way for new growth paths. These new paths include the tokenization of real assets and securities, as well as the integration of programmability into asset classes and the emergence of new operating models.

The difference between institutional DeFi and traditional DeFi is shown in Figure 1.

1.3 DeFi - History

In an open environment, DeFi-related projects inspired 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 quickly rose during the massive quantitative easing (QE) restarted by the Federal Reserve (Fed) in response to the COVID-19 epidemic. The total assets in DeFi services (total locked value, TVL) rose from $1 billion at the beginning of the year to more than $15 billion at the end of the year.

During this period, new DeFi projects received a large amount of financial support, and the number of projects and related tokens was relatively saturated, trying to ride on the momentum. Total DeFi users surged at the end of 2021, with more than 7.5 million unique users transacting in the DeFi ecosystem, a 2550% increase from a year ago, and TVL peaking at $169 billion in November 2021 (based on data from DeFiLlama). New terms and names like Uniswap and Yield Farming were introduced into everyday financial life.

During the year, DeFi experienced its fair share of problems, including some well-publicized crashes, due to multiple interest rate hikes and a significant rise in inflation, along with some bad behavior in the ecosystem. This means that the entire market is forced to take a step back and enter a prudent and rational phase in the second half of 2022.

This trend became even more pronounced in early 2023 as private financing in the Fintech DeFi space dried up as funding costs rose, reflected in a year-over-year decline in deal activity year-to-date (as of Q1 2023, Fintech Global Research) 69%. This caused TVL in DeFi systems to drop to less than $50 billion in April 2023 and to a low of $37 billion at the end of October 2023.

Despite the significant decline and the concurrent "crypto winter" (i.e., the decline in the value of crypto assets), the fundamentals of the DeFi community remain resilient, with the number of users growing steadily, and many DeFi projects persevering and focusing on building products and capabilities. .

At the end of 2023, the market saw growth due to the first approval of a spot crypto ETF product in the United States, widely seen as a major sign of the further integration of digital assets into traditional financial products. More importantly, this opens the door for institutional players to engage more deeply in these emerging ecosystems, which will bring much-needed liquidity to the space.

1.4 Realizing the Early Promise of DeFi

In the native crypto asset space, the DeFi movement has led to coding structures that demonstrate how DeFi can work without the involvement of certain intermediaries, often involving smart contracts and/or peer-to-peer (P2P) Base. Due to low access costs, DeFi services were rapidly adopted in their infancy and quickly proved their value in providing efficient asset pools and reducing intermediary fees, and applying economic behavioral finance techniques to manage demand, supply and price.

These new advantages are realized because DeFi redesigns or replaces existing intermediary activities to be more efficient through smart contract programming, thereby changing workflows and transforming roles and responsibilities. In the “last mile” with investors and users, DeFi applications, or DApps, are the tools that provide these new financial services. Therefore, existing market structures can change.

Pioneering Institutional DeFi Events

There are many institutional use cases that can be extracted from the DeFi space, leveraging the tokenization of real assets and securities.

Here are some examples that try to outline how financial services products combine with technology and regulation to create new value; illustrating why institutional DeFi is attractive.

Case 1: Interoperability, 2023 By using DeFi constructs in the institutional field, self-custody wallets can implement distributed asset custody models while providing comprehensive and independent digital accounts (addresses) that can be used for transaction flow and settlement and reports. An important use is as a smart contract bridge, connecting different blockchains to achieve interoperability and avoid fragmentation caused by blockchain choice.

Applicability: Serves as a connection point between public, publicly licensed, and private networks to minimize fragmentation while allowing a high degree of access and participation.

Example: https://www.mas.gov.sg/-/media/mas-media-library/development/fintech/guardian/interlinking-networks-technical-paper-vfinal.pdf

Case 2: Use Stable Coin refinancing tokenized financial instruments, 2023 DeFi systems can also be used for financing traditional industries, although it has not yet been applied on a large scale. For example, a security token representing some real-world financial instrument can be placed as collateral in a smart contract "vault", earn a stablecoin, and then be converted to fiat currency.

Reference: https://www.sgforge.com/refinancing-dai-stablecoin-defi-makerdao/

Case 3: Tokenized funds in asset management, 2023 Tokenized fund units or tokens can be passed through the zone The blockchain conducts the distribution, opens it directly to accredited investors, and maintains investor records on-chain, while smart contract facilities allow for fast or near-instantaneous subscription and redemption using regulated stablecoins. Further, tokenized fund units representing high-quality liquid traditional financial instruments can serve as collateral.

Example: https://finance.yahoo.com/news/blackrock-launches-first-tokenized-fund-222700828.html?guce_referrer=aHR0cHM6Ly93d3cuYmluZy5jb20v&guce_referrer_sig=AQAAAKT37GXfe84hphq0iMK6yzh8B9rX pnPwpnPonYy1t7sBzLgpCAdM7Lo3TaQqzplg62uy34Nlh0QwotmrfATOLgFLlUWOrM4Jx6Qe_t YFQCjpr-QpS6ZxvYQnBEdUPH-6CKs8nbkAE5BmfHIgpOqxxSbEJEelcA7SBtbiMeDxsokm&_gu c_consent_skip=1720507214

The evolution of DeFi institutional market structure

The market concept powered by DeFi proposes a fascinating market structure that is dynamic and open in nature, and its native design will challenge the norms of traditional financial markets. This has led to divergent opinions on how DeFi integrates or cooperates with the broader financial industry ecosystem, and what form new market structures may take.

2.1 Governance, Trust and Centralization

In the institutional world, there is a greater emphasis on governance and trust, requiring ownership and accountability in the roles and functions performed. While this may seem contradictory to the decentralized nature of DeFi, many believe it is a necessary step to ensure regulatory compliance and provide clarity for institutional players to adapt and adopt these new services. This situation has given rise to the concept of "the illusion of decentralization", because the need for governance will inevitably lead 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 less efficient than Our market structures today are more streamlined because organizational intermediation activities are significantly reduced. As a result, orderly interactions will become more parallel and parallel, which in turn helps reduce the number of interactions between entities. Operational efficiency, reduced costs. Under this structure, administrative activities including anti-money laundering (AML) checks will also become more efficient – ​​as the reduction of intermediaries can increase transparency

2.2 Potential for new roles and activities

The pioneering use cases listed in Section 1.4 of the Institutional DeFi Ecosystem highlight how today’s market structures may evolve the next wave of DeFi innovation

In this way, public blockchain can become the de facto practical platform for the industry, just like the Internet became the delivery infrastructure for online banking. There is already some precedent for launching institutional blockchain products on public blockchains,7 especially in the field of money market funds. The industry should look forward to further developments, for example in the area of ​​tokenization. or virtual funds, asset classes and intermediary services; and/or with a licensing layer.

Participate in the DeFi Market Run on a public, private or permissioned blockchain network

The nature of DeFi itself can be both daunting and compelling for institutions.

Participating, operating and transacting in the open ecosystem provided by DeFi products may conflict with the closed-loop or private environment of traditional finance, where customers, counterparties and partners are all publicly known , risks are also accepted based on appropriate levels of disclosure and due diligence. This is one reason why much of the progress in the institutional digital asset space to date has occurred in the private or permissioned blockchain network space, where a trusted administrator acts as a "network operator" and the owner is responsible for approving participants to enter. network.

In contrast, public chain networks have potential open scale, low entry barriers, and ready innovation opportunities. These environments are decentralized in nature, built on the principle that there is no single point of failure, and user communities are incentivized to "do good". Consensus protocols (Proof of Stake (POS), Work Proof of Work (PoW being the main example) may vary on different chains. This is one way that participants – as validators – can contribute and receive rewards in what we consider the “blockchain economy”.

3.1 Participation Checklist Outline

When evaluating participation in any digital asset and blockchain ecosystem, key considerations should include the maturity of the blockchain and its corresponding roadmap, achievable final settlement Consensus, liquidity, interoperability with other on-chain assets, regulatory perspective, and adoption; also need to evaluate the risks of network technology, network security, continuity plans, and technical standardization of the network’s core community and developer participants. Degree 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 than public chains. It should also be measured by factors such as: availability of expertise, vendor dependence, accessibility, liquidity scale, and the cost of creating, maintaining, and running a private chain. These factors may determine the success or failure of a project. Imagine if every Each bank will have to run its own private internet to support its internet banking applications, and cost will be a key factor, especially during the transition period where blockchain will operate in parallel with existing technology stacks. This needs to be considered. Ultimately, businesses must adapt to the level of transparency and new ways of working that they can accept and manage, while maintaining a strong focus on their own and their respective customers’ interests when it comes to data and asset protection, asset custody and security. Custody is critical. The key is to understand novel approaches – such as assets held by smart contracts as an extension of custody – and substantively address the gray areas in these areas, which can help reduce risk and regulatory concerns.

Another example is that identity is very important and in the process of institutionalizing DeFi, deploying verifiable credentials is one of the fundamental elements that will facilitate the governance provided to institutions when participating in these open blockchain ecosystems. Assurance. Verifiable credentials enable anyone to prove their identity using cryptographic proofs without directly sharing personally identifiable information (PII), while storing such PII material off-chain or in an encrypted, decentralized manner for added protection.

Thus, under such digital identities in the “DApps” layer, centralized governance can enable reliable customer due diligence (KYC), sanctions checks and prevention of money laundering in areas such as investor entry and exit from institutional DeFi structures. In addition, trading market abuse detection and other market integrity measures (such as investor suitability) will be new safeguards that can be implemented. Digital identities help identify risk patterns while maintaining transaction confidentiality and banking privacy.

In this way, the core advantages of DeFI in terms of cost-effectiveness and innovative value are retained and converged to bring together certain key attributes in order to successfully achieve regulatory balance.

In recent years, blockchain has been championed for its early development and evaluation in institutions. It is worth noting that the multi-stage industry-level “Guardian Project” was launched in June 2022 by the following organizations. The Monetary Authority of Singapore (MAS) seeks to make progress on the path to institutional-grade DeFi. Develop "open and interoperable" networks and explore the potential of the Internet market.

This is in line with the broader industry innovation vision to achieve scale, liquidity and new market connections through the use of blockchain-based technology without compromising the financial stability and integrity of the ecosystem. How to achieve this goal while taking into account supervision? This is the trillion-dollar problem facing DeFi institutions.

Regulatory obstacles

4.1 Framework without intermediaries

There is no doubt that the road ahead is long and full of innovation, exploration and review/reflection. The DeFi regime requires regulators, standard setters, and policymakers to rethink their traditional oversight frameworks, which are centrally established with intermediaries. Given that decentralized systems may lack regulatory and oversight access points, DeFi is certainly driving a paradigm shift.

4.2 Market Integrity and Investor Protection

Momentum and cross-jurisdictional progress in this area has been growing since late 2023: In December, the International Organization of Securities Commissions published Policy Recommendations for DeFi, outlining nine major policy recommendations targeting core risks in market integrity and investor protection. 9 Prior to this, the International Organization of Securities Commissions released the "Crypto-Asset Policy Recommendations" in November 2023, which is positioned to complement policy recommendations involving DeFi. With these two interoperable global policy recommendations, an activity that is not bound by one norm will be bound by the other. 10 As a result, the regulatory landscape is now clearer and will become clearer as IOSCO’s recommendations are implemented globally by its members.

This clarity is also driven by global regulatory principles of same activities, same risks, same regulations and technology neutrality. This means that a tokenized traditional financial instrument should be regulated based on its nature as a financial instrument, rather than being treated differently just because it is tokenized. Since tokenization is a technical process, existing technology risk regulations will apply. Financial institutions' management of their assets and liabilities exposed to new technologies is increasingly influenced by how they understand and calculate the risks arising from the unique characteristics of that technology.

4.3 Dealing with Prudence

The balance sheet impact of participation in the digital asset space is another challenge in terms of regulatory evolution. The Basel Committee’s (BCBS) final standards on the prudential treatment of cryptoassets by banks are also being released for comment in December 2023. The focus is on recognizing the market's mix, which is epitomized by recognizing the market, credit and liquidity risks inherent in crypto-asset-related activities (which essentially includes DeFi), and defining disclosures and required safeguards. The Basel Committee's standards also address the need to broadly group asset types into Groups 1 and 2 based on classification criteria that reflect the underlying risks that need to be managed. Another consultation on disclosure requirements under the Basel Accord ends on January 31, 2024. Most recently on May 16, 2024, the Basel Committee announced that it would postpone the implementation date by one year to January 1, 2026. How institutional DeFi is classified under these circumstances remains to be substantively examined.

These are important milestones in the industry’s journey of discovery. They are the culmination of years of intensive joint public sector and industry advocacy work to understand, discuss, calibrate and arrive at agreed interpretations that may pave the way for further progress as markets and technologies evolve in tandem. Establishing and harmonizing an understanding of how to consider new digital domains, including the risks associated with participating in them, will be an important foundation and guardrail for innovation, while increasing regulatory clarity.

Many use cases demonstrate that innovative technologies combined with appropriate regulations can be a very powerful force for change, reshaping and rearranging business models and markets.

5.DeFi: What’s next?

The light bulb didn’t evolve from the continuous improvement of candles, but from the continuous improvement of alternative technologies that solved the shortcomings of wax candles.

If we think about the above issues and believe in the potential power of a broadly regulated or institutional version of DeFi, we must acknowledge that it requires a set of core tenets, standards and prerequisite capabilities to build the structure of the ecosystem. Indeed, only then will institutional players embrace it as a new growth tool and move forward with sufficient safeguards and regulatory certainty.

2024 will be a turbulent time for all forms of DeFi, and after this, 2024 will be a defining moment. The implementation of regulation is a driving force that will continue to determine institutional interest in and the speed of adoption of the digital space. It can be said that DeFi expands the challenges of risk management, anti-money laundering and information privacy. However, when considered in conjunction with the opportunities presented by institutional DeFi, including financial inclusion, it is difficult to ignore the potential benefits it will bring to new products, new services and new operating models in the digital-first financial industry of the future.

The technology itself is becoming more mature, and people’s understanding of the technology is getting deeper and deeper. Regulations are becoming increasingly clear, and as lessons are learned from pilots, it is now easier to obtain the necessary expertise. For example, increased regulations and expertise in control functions such as compliance and auditing can help introduce DeFi technology to the financial industry.

The industry is currently in the "post-proof-of-concept" stage and needs to upgrade visible and successful "live" products into scaled commercial products. This shift will help achieve cost efficiencies or new growth and further drive The path of institutional development. We will wait and see how the factors covered in this article will affect or inhibit the development trajectory of institutional participation in regulated DeFi

In terms of cross-chain interoperability, oracles, digital or decentralized ID solutions and trust anchors, etc. The continued maturation of technology, innovation, and regulation in key areas will only add fuel to the momentum of adoption needed to reach critical mass. While the path to institutional DeFi may not take us to the “moon,” it certainly will. An exciting journey that takes us to a new and fascinating destination.

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