As Matt Ridley famously noted, innovation is the child of freedom and the parent of prosperity. DeFi is an ecosystem where freedom leads to radical innovation. Since June 2020, we have seen a Cambrian explosion of this innovation. The entire financial system is being rebuilt from first principles with more security, transparency and interoperability—in weeks and months rather than years and decades. With radical financial innovation and growth comes radical investment returns and opportunity, leading to more and more institutional capital flooding into this space.
Regulation plays a fundamental role in institutional adoption cycles. Larger, more regulated entities have more onerous compliance and regulatory monitoring, reporting and oversight. This is why DeFi has seen strong early adoption within small and mid-cap Crypto Funds (with AUMs of less than $1B). Driven to take advantage of the exceptional investment returns, but also able to do so from a regulatory and compliance perspective, more regulated institutional investors are now stepping into this space. PWC reports 47% of traditional hedge fund managers, representing $180B of AUM, are looking at investing in crypto. An Intertrust survey found hedge funds are expected to hold 7% of their assets, equating to $312B, in cryptocurrency in 5 years. Investment firms will no doubt lead the adoption of DeFi, however for these and other larger and more regulated institutions to cross the chasm, the required DeFI infrastructure will have to be built. Quite excitingly, this is exactly where the market finds itself.
The user needs of institutional finance can be mapped using the capital allocation cycle—from research, pre-trade compliance, and best execution, to monitoring, reporting and custody. Over the last 6 months, there has been an explosion in products and services in all these categories, with capital flooding in to build the necessary DeFi infrastructure. Crypto custodians, for example, have raised large rounds, taken on strategic investments, or been acquired. Compliance, trading and data analytics are attracting capital to build and scale institutional crypto access. However, it’s not only the tooling and infrastructure around DeFi that is being built. DeFi itself is also innovating to provide access to institutional finance—from permission lending pools that ensure only KYC’d participants, to on-chain asset management, MEV resistant best execution protocols, and decentralised identity—more and more institutional focused projects are coming to market, and more will no doubt accelerate with Layer-2 scaling.
The institutional DeFi world is at an incredibly exciting moment in its adoption cycle. Larger regulated crypto funds, hedge funds, and traditional fund managers will lead the early majority. And the infrastructure is currently being built for the heavily regulated late majority. With the unparalleled innovation in DeFi also focusing on the institutional world, it is certainly only a matter of time before Institutional DeFi becomes Institutional Finance.
Tracking the Surge
At the beginning of 2021, US 10-year treasuries were yielding little higher than 1% per annum. When these returns are compared to US stablecoins that yield between 2% and 12%, and more exotic DeFi protocols that yield north of 250%, it is clear why 80% of institutions across the US and Europe have expressed interest in digital assets and cryptocurrencies.
The journey towards institutional adoption of DeFi will not occur instantaneously. As with all emerging technology, familiarity will pave the way to increased adoption. Businesses will enter the world of DeFi by trading Bitcoin futures, buying digital assets, and holding these assets on the balance sheet. As they familiarize themselves with the latter, and once proper infrastructure has been deployed to meet institutional requirements for security, operations, and compliance—we expect institutional investors to delve deeper into experimentation with DeFi.
Early adopters have gained significant first-mover advantages after recognizing the shift of traditional financial service institutions moving towards the adoption of Bitcoin, other cryptocurrencies, and institutional blockchain use cases. In 2021 alone, several leading financial service institutions took big steps in this direction:
Goldman Sachs relaunched its trading desk for digital assets, and aims to offer a "full spectrum" of investments across the emerging asset class to its wealth management clients.
Morgan Stanley similarly announced it would offer its clients exposure to digital assets.
America’s oldest bank, BNY Mellon, confirmed they will support and custody digital assets, and launched a series of tokenisation development projects, including a new unit focusing on cryptocurrencies.
Prominent hedge fund manager, Carl Icahn, expressed interest in entering crypto in a “big way”, potentially allocating more than $1B to invest in the space.
HSBC planned to move the settlement of $20B in assets onto a new blockchain-based custody platform. This represents more than a third of the bank’s eligible assets.
JPMorgan is developing a digital token and blockchain platform which allows clients to transfer payments instantaneously.
In June 2021, Microstrategy added more Bitcoin to their balance sheet, bringing their total to over 105,000 Bitcoin. CEO Michael Saylor recognized the role of Ethereum in the disruption of traditional finance.
BlackRock, the world’s largest asset manager with $9 trillion in assets under management, disclosed they have been trading digital asset related products for months. This represents a significant shift from BlackRock CEO Larry Fink’s comments in 2018 when he said that not a single client was interested in digital assets.
As of Q1 2021, HSBC, JP Morgan, Citigroup, Mitsubishi UFJ Financial Group, Barclays, UBS, Goldman Sachs, Commerzbank, BNY Mellon, Signature Bank, and SBI Holdings are all pursuing blockchain related projects, ranging from cryptocurrency custody and trading, to payments and trade execution.
~24 governments (including the US, the UK, and Canada) are actively researching Central Bank Digital Currencies,
~13 governments (including Brazil, China, and Hong Kong) are in the midst of development
~23 governments and international bodies (including Australia, France, Singapore, Japan, and the European Central Bank) have launched pilot projects.
As covered above, traditional financial institutions and crypto-enterprises are increasingly recognizing the innovations of the open-source Ethereum community in creating new ways to save, store, send, and earn money—whether as CBDCs or stablecoins and assets that comprise the emerging DeFi ecosystem.
Another clear signal of this is the $65M external investment Consensys raised from a balance of global financial services firms like J.P. Morgan, Mastercard, and UBS, along with crypto companies and VCs including Protocol Labs, the Maker Foundation, Fenbushi Capital, and Alameda Research. In funding Consensys, traditional institutions are helping build DeFi infrastructure while also gaining visibility into Web3 applications being developed on the Ethereum blockchain.
The increasing deployment of institution-focused DeFi tools, infrastructure, products, and services, coupled with the surging adoption of both Bitcoin and institutional blockchain use cases, indicates that mass institutional adoption of DeFi is imminent.
This is a chapter from Consensys' 'DeFi for Institutions' report. Download the full report to learn more about...
The numerous opportunities emerging in the DeFi space
The challenges of institutional engagement in DeFi
Different ways in which institutions can get started accessing, investing, and participating in DeFi
DeFi solutions by Consensys