In 2020, crypto stood out among other assets so much so that it was initially perceived as a financial bubble. But this time it is here to stay in the market. The biggest factor responsible for crypto growth is its adoption by financial institutions. Cryptocurrencies, especially bitcoin, witnessed a large sum of institutional interest and money flowing into them.
Top firms like Grayscale, Microstrategy, Square, Massachusetts Mutual Life Insurance, Ruffer, CoinShares, One River Digital Asset Management, Skybridge Capital, Galaxy Digital Holdings, and 3iQ were among many institutions that invested in Bitcoin in 2020.
Following the momentum in 2021, bitcoin is embraced or likely to be from Wall Street giants such as JPMorgan, Tesla, Morgan Stanley, Bank of New York Mellon, and BlackRock. Soon Mastercard will begin allowing its customers to use some cryptocurrencies as a payment method.
This has created a market trend and increased the adoption of cryptocurrencies as a new asset class.
According to a recent survey by JPMorgan covering 3400 investors from 1500 institutions, 58% believe that crypto is here to stay. Though the investor community is still divided on the future of crypto, the parabolic rise in Bitcoin has garnered the attention of both institutional and retail investors alike. The main reason behind this frenzy is the prospect of high returns from the investments. Analyzing the market trends, bitcoin provides an excellent hedge against inflation and currency devaluation. Many investors are interested in the technological potential of blockchain and would like to explore the new market.
But there are many hurdles in the way too. The financial market is a heavily regulated industry. As they manage funds for other people it is required by law to fulfill rules regarding financial investments. However, the infrastructure of the legacy system is slow and tedious to transform and adapt to rather unregulated crypto space.
Interest in DeFi Space
DeFi refers to the peer-to-peer financial services that enable trading, loans, derivatives, and more capabilities in the crypto ecosystem.
A few giant players have moved forward from investment in Bitcoin towards investing in DeFi products. According to the year 2020 survey by Fidelity Digital Assets among 800 U.S. and European investors, it is revealed that almost 80% of institutional investors surveyed in the U.S. and Europe believe that digital assets should be a part of their investment portfolios. The survey included financial advisors, family offices, pensions, crypto and traditional hedge funds, high net worth investors, and endowments and foundations. 36% of them are currently invested in digital assets directly and via futures.
Financial institutions find digital assets appealing as they are uncorrelated to other asset classes and have high potential upside. Some investors feel that it is good these assets are free from government intervention. Other factors that help are the low transportation, transaction, and storage costs, and unique return drivers.
Some of the most experienced trading firms in Chicago are joining forces to promote decentralized finance (DeFi). TD Ameritrade, Cumberland, CMT Digital, DV Trading, and Jump Capital, venture capital firm Volt Capital, and the DeFi startup Compound, all joined forces in the Chicago DeFi Alliance (CDA) to provide advisory services to crypto startups. The alliance’s mission is to connect traditional proprietary trading firms with rising start-ups in the DeFi space to build long-term, mutually beneficial relationships. The opportunity also helps DeFi start-ups to educate traditional trading firms on technical advancements, unique opportunities, and risks associated with this new financial frontier.
Again helping is Bitwise Asset Management, which has recently launched the world’s first DeFi crypto index fund. The new Bitwise fund holds a portfolio of crypto assets that power these DeFi services and seeks to track the Bitwise Decentralized Finance Crypto Index. Holdings are screened for important risks, weighted by market capitalization, and rebalanced monthly.
Some fintech firms are coming up to build DeFi products as well. One such example is xSigma, which is a stable coin exchange and a liquidity mining platform backed by Nasdaq-listed company ZK International Group.
Lattice Exchange (LTX), a decentralized platform, is supported by institutional funds such as GDA (Global Digital Assets), Hillrise Capital, Moonrock Capital, Alphabit Fund, and FBG Capital.
Daniel S. Loeb, the founder of a New York-based hedge fund, Third Point, retweeting on the growth of NFTs, said that he has been doing a deep dive in crypto lately.
Attractive Features of DeFi
DeFi provides a unique opportunity for financial investors to put their crypto funds to use. Many DeFi applications of lending and borrowing allow bitcoin investments to be used rather than simply holding. It simply provides a good opportunity for investors looking for higher yield opportunities. The DeFi space is attracting investments by the promise of providing high return yields.
Another interesting reason for investments in DeFi is the growth of creative products and fast-paced innovations in the DeFi space. Popular DeFi projects provide alternatives to many traditional financial services, which include lending and borrowing of assets, decentralized exchanges, arbitrage trading, margin trading, creation of stable coins, derivatives, and liquidity pools. It also provides unique investment opportunities with innovative use-cases which were not possible earlier like flash loans, synthetic assets, and yield farming.
Issues in the Adoption of DeFi
Despite the promising returns and cutting-edge technology, the road to adopting DeFi is not quite easy for the established institutions. DeFi is a relatively new market and is quite immature to be jumped into. Moreover, the characteristics of these open-finance crypto-assets like decentralization, open-source, and anonymity do not necessarily comply with the heavily regulated financial industry.
While the popular DeFi products like Synthetix and dYdX require higher risk tolerance, the newer products lack the desired liquidity. Making these investments have considerable risks involved. Institutional managers face significantly more pressure and accountability, given that they are managing millions of dollars of other people’s money.
The Crypto market is suffered from a high degree of price volatility, and most companies are not just ready for such swings of double digits in a matter of days. The market can be driven by a high sentiment value regarding cryptos and shows signs of easy manipulation by some techie or views of governments or central banks, making it riskier.
The operational and regulatory risks involved in the governance of DeFi products are not helping either. The primary concern of any investment is legitimacy and compliance. DeFi products are decentralized, backed by no central compliance authority, and supposed to be self-governed. But in reality, it is difficult to know the truth and seems sketchy to the investing agencies.
The possibility of malicious actors exploiting the system is also high. The nature of smart contracts and decentralized protocols makes them subject to exploits and hacks, occasionally leading to significant losses for affected users. For eg, there have been some flash loan hacks that exploit weaknesses or loopholes in the smart contracts that govern protocols, allowing malicious actors to drain millions of dollars from their liquidity pools.
Most DeFi products are built on the Ethereum blockchain platform. Lately, the network has suffered from dynamic processing fees issues and has been backed up, and is quite unusable for higher transaction volumes required by big institutions. They require a platform that takes lower processing fees and provides quick transaction clearances. Investments by financial institutions require high-grade and sophisticated services. DeFi platforms should provide institutional grade trading services in cryptocurrency, the same as in traditional investments.
For the institutional level adoption, an equilibrium is required between tech-based, decentralized crypto-backed DeFi and the regulated fiat-based financial institutions.
First of all, a clearer stance on legality, accounting, and taxes from the government regulator bodies would be a great help. Right now, some governments have completely banned crypto trading while some are still unclear on their standing.
Some services need to be provided by DeFi to attract major players. Any investment would require trusted oracles to ensure the quality and integrity of data. DeFi requires the support of such decentralized oracles, which provide sophisticated analytics to monitor investments and on-chain activity.
Requirements of a frictionless, decentralized, and self-governing system in DeFi protocols would garner more trust from big players. The infrastructure services have to be streamlined by providing faster transactions and more stable fee models. This could be fast-tracked by the development of institutional-ready blockchain solutions like Conflux Network and Constellation Network which are capable of handling higher traffic from the institutional trading in the DeFi universe.
There have been new offerings of insurance protocols and products against any theft or hacks in the DeFi protocols. Financial institutions require regulated and trusted partners to store digital assets securing them against any theft. Decentralized insurance acts as a safety net for the DeFi ecosystem. From wallet insurance to smart contract insurance, the assets are protected in the case of a bug or a hack creates peace of mind for crypto investors. Popular insurance options are provided by Nexus Mutual, Etherisc, CDx, Grayscale, and many more.
Many companies such as BitGo, Orion Protocol, Quantstamp, and Trustology have been offering complete solutions for institutional investors to enter the world of open finance. They offer services like digital asset custody, risk management against theft, and many more institutional-grade trading services, the same as they used to get in traditional investments. Some digital asset management firms like Arca getting approval from the SEC has also helped greatly.
DeFi space can greatly benefit from institutional investments to increase liquidity, reduce price volatility, and raise the value of digital assets. More investments from big firms will provide more credibility by building recognition and trust.