The Road to Institutional DeFi: A Commentary on Deutsche Bank's Research Report

Decentralized Finance ( DeFi )'s institutional applications have the potential to create a new financial paradigm based on the principles of collaboration, composability, and open-source code, built on an open and transparent network. This article explores the history of DeFi and its potential future developments, focusing on how it may impact institutional financial services.

Introduction

The evolution of DeFi and its potential applications in institutional use cases have garnered significant interest in the industry. Supporters argue that there are strong reasons for the rise of this new financial paradigm, which is based on collaboration, composability, and open-source code principles, and is built on open and transparent networks. As a highly watched area, the path to utilizing DeFi for regulatory financial activities is under construction.

Changes in the macroeconomic and global regulatory environment have hindered widespread meaningful progress, with developments mainly occurring in the retail sector or through incubator sandboxes. However, in the next one to three years, institutional DeFi is expected to take off, combined with the widespread adoption of digital assets and tokenization, as financial institutions have been preparing for this situation for years.

This pathway is driven by advancements in blockchain infrastructure, accommodating organizations operating under regulatory compliance requirements in the form of Global Layer 1 or Interlinking Networks. 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 and AML requirements on public blockchains. As discussions deepen, it becomes increasingly clear that CeFi and DeFi are not binary opposites; rather, full adoption on the institutional side of finance may only be feasible for those organizations with a hybrid model of centralized operational governance within the ecosystem.

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

Decentralized Finance Landscape Analysis

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. In this rapidly evolving field, there is no official and universally recognized definition. Typical DeFi services and solutions can identify the following elements:

• Self-custody wallet, allowing investors to be their own custodians.
• Use code to maintain and manage smart contract custody of digital assets.
• A staking contract that calculates and allocates rewards based on the deposit value and/or variables using code.
• An asset exchange protocol that allows one asset to be exchanged for another and used in lending or decentralized exchanges (DEX).
• Issue securitization and re-mortgage structures based on underlying "wrapped" assets of different assets, where the issued assets can have secondary market value.

What is institutional DeFi?

Institutional DeFi refers to the institutional adoption and adaptation of the DeFi structure, as well as the institutional 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 transferred to traditional financial markets, opening up possibilities for creating new cost efficiencies and effects, while also paving the way for new growth pathways. These new pathways 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.

Decentralized Finance - History

In an open environment, DeFi-related projects ignited 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 rose during the Federal Reserve's large-scale quantitative easing in response to the COVID-19 pandemic. The total locked value in DeFi services, (TVL), increased from 1 billion USD at the beginning of the year to over 15 billion USD by the end of the year.

During this period, new DeFi projects received substantial funding support, and the number of projects and related tokens became relatively saturated, trying to capitalize on the momentum. By the end of 2021, the total number of DeFi users surged, with over 7.5 million unique users trading in the DeFi ecosystem, a 2550% increase compared to a year earlier, and TVL peaked at $169 billion in November 2021. New terms and names such as Uniswap and Yield Farming were introduced into daily financial life.

In 2022, due to multiple interest rate hikes and a significant rise in inflation, coupled with some unlawful activities within the ecosystem, DeFi experienced quite a few issues, including some well-known collapse events. This meant that the entire market was forced to take a step back and entered a cautious and rational phase in the second half of 2022.

This trend became more apparent in early 2023, as rising financing costs led to a depletion of private financing in the fintech DeFi sector, reflected in a year-on-year decrease of 69% in trading activity from the beginning of the year to date. This resulted in the TVL in the DeFi system dropping to less than $50 billion in April 2023, and falling to a low of $37 billion by the end of October 2023.

Despite experiencing a significant decline and the "crypto winter" during the same period, the fundamentals of the DeFi community remain resilient, with a steady increase in user numbers. Many DeFi projects persistently focus on product and capability development.

By the end of 2023, the market experienced growth due to the United States' first approval of spot cryptocurrency ETF products, widely regarded as a significant sign of digital assets further integrating 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 field.

Early Commitment to Decentralized Finance

In the native cryptocurrency asset sector, the DeFi movement has led to an encoding structure, demonstrating how DeFi operates without the involvement of certain intermediaries, often involving smart contracts and/or peer-to-peer (P2P) infrastructure. Due to low access costs, DeFi services were rapidly adopted in their early stages and quickly proved their value in providing efficient asset pools and reducing intermediary fees, applying economic behavioral financial technology to manage demand, supply, and prices.

These new advantages are realized because Decentralized Finance reprograms or replaces existing intermediary activities through smart contracts, achieving higher efficiency, thereby changing workflows and transforming roles and responsibilities. In the "last mile" with investors and users, DeFi applications (, namely DApps ), are the tools for providing these new financial services. Therefore, existing market structures can change.

The Evolution of Market Structure in DeFi Institutions

The market concept driven by DeFi presents an engaging market structure that is inherently dynamic and open, with a native design that challenges the norms of traditional financial markets. This has led to much discussion about how DeFi will integrate or collaborate with the broader financial ecosystem, as well as the forms that new market structures may take.

Governance, Trust, and Centralization

In the institutional realm, 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 also a necessary step to provide 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 intermediary activities of organizations are greatly reduced. The result is that 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. Under this structure, management activities, including anti-money laundering ( AML ) checks, will also become more effective—because the reduction of intermediaries can enhance transparency.

The potential for new roles and activities

The pioneering use cases listed in 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, just as the internet has become the delivery infrastructure for online banking. There have been certain precedents for launching institutional blockchain products on public blockchains, particularly in the money market fund sector. The industry should expect further advancements, such as in the area of tokenization, or virtual funds, asset classes, and intermediary services; and/or with a permissioned layer.

Participate in the Decentralized Finance market

For institutions, the very nature of DeFi is both intimidating 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 finance, 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 the realm of private or permissioned blockchain networks, where trusted managers act as "network operators" and owners are responsible for approving participants' entry into the network.

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

) Participate in the verification table outline

When assessing participation in any digital asset and blockchain ecosystem, 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 evaluate the risks of network technology, network security, continuity planning, and the involvement of the core community and developer participants of the network. The degree of technical 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 lower risk and more attractive. However, the lower risk level of private chains compared to public chains should also be assessed through the following factors: availability of expertise, vendor dependency, accessibility, liquidity scale, and the costs associated with creating, maintaining, and operating private chains, which may determine the success or failure of a project. Imagine if every bank had to run its own private internet to support its internet banking applications; cost would be a key factor, especially during the transitional period when blockchain operates in parallel with existing technology stacks, which needs to be considered particularly.

Ultimately, companies must adapt to the level of transparency and new working methods that they can accept and manage, while maintaining a strong focus on data and asset protection for themselves and their respective clients' interests. Regardless of which side of Decentralized Finance you stand on, asset custody and security are crucial. The key is to understand novel approaches—such as assets held by smart contracts as an extension of custody—and to substantively address the gray areas in these fields, which helps mitigate risks and regulatory issues.

Another example is that identity is very important. In the process of institutionalizing Decentralized Finance, deploying verifiable credentials is one of the essential elements. These credentials will facilitate governance and provide assurance for institutions participating in these open blockchain ecosystems. Verifiable credentials allow anyone to use cryptographic proofs to verify their identity without directly sharing personal identifiable information ### PII (.