Ever since Bitcoin was first invented and the term “cryptocurrency” was introduced, the number of people getting into the digital assets space has been steadily growing, with the landscape of opportunities in DeFi growing massively over the few years. More recently, they have been joined by financial institutions and governments. Despite the instability of the global economy, the gap between traditional finance (TradFi) and crypto seems to be closing with each passing day.
From wealth management and foreign exchange (forex) trading, to the issuers of government securities, TradFi is having a serious look at digital assets and how to leverage blockchain technology into their products. For instance, leading banks such as HSBC and UOB have been issuing tokenised bonds on SGX's new digital platform. Additionally, JP Morgan and DBS Bank announced during the recent Singapore FinTech Festival that they have conducted trades using DeFi protocols on a public blockchain as part of the Monetary Authority of Singapore’s (MAS) first pilot of Project Guardian, which explores the potential of DeFi for financial institutions.
What is driving this new wave of interest in digital assets and adoption among TradFi institutions?
Institutions keep building
Despite recent blow-ups and a slump in the markets, investor appetite for crypto seems unabated. A KPMG survey published in October 2022 found that 58% of family offices and high net worth individuals (HNWI) in Singapore and Hong Kong already have capital allocated to digital assets, while 34% expressed interest to invest in cryptocurrencies such as Bitcoin, Ethereum, and stablecoins, as well as explore DeFi opportunities.
Many traditional hedge funds are already invested in this new asset class. This is supported by findings from a research piece by PricewaterhouseCoopers (PwC) in June 2022, which discovered over 300 specialised crypto hedge funds that see HNWIs and family offices as their biggest investors. Singapore is home to 6% of crypto hedge fund managers, according to the same report, only behind the US (30%) and the UK (10%).
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While crypto trading, the use of derivatives such as options, swaps and futures, as well as stablecoins are already well developed, the industry is now on the lookout for the next investment opportunity. Earning yield through DeFi is shaping up to be the next big thing if the burgeoning interest from TradFi institutions is anything to go by.
The DeFi opportunity
Radical financial innovation and growth, layered with attractive returns, have resulted in the recent surge in institutional adoption of DeFi. DeFi has already attracted many of the world’s leading financial institutions, funds, exchanges, and family offices, with yields that outweigh those in traditional finance.
In 2022, almost US$200 billion ($262.6 billion) had been committed to DeFi at the top, compared to less than US$1 billion at the start of 2020, according to data provider DefiLlama. Trading via decentralised exchanges (DEXs) and lending are currently the most popular services with US$23 billion and US$14 billion locked in, respectively.
DEXs rely on so-called automated market makers (AMMs), a protocol that creates the liquidity for these peer-to-peer trades. Crypto holders can temporarily move their coins into one of these liquidity pools to help improve the system. They earn a fee—or yield—in return.
In the above-mentioned pilot, JP Morgan and DBS Bank executed trials for foreign exchange transactions and government bond trades using modified public lending protocol Aave and Uniswap, which popularised the AMM model. It allows for faster execution, more transparency—as trades are locked into a smart contract on the blockchain—and lowers settlement risks by removing the central keeper of the order book
The possibility of earning a return on their crypto capital is especially appealing to investment funds, as they are no longer just speculating on the appreciation of the asset. Lending protocols such as Compound and Aave have been offering double-digit annual yields on certain cryptocurrencies.
DeFi is not only about yield chasing, it also comes with real-world usage that changes the way financial transactions are carried out. Project Guardian shows that the AMM model, which came from DeFi, is superior to the traditional order-book based exchange TradFi is used to. AMM allows for much better rates when exchanging (e.g. swaps) due to a much larger, available pool of liquidity. The catastrophic events of Three Arrows Capital, Celsius, Hodlnaut, and most recently, FTX, highlight the fragility of centralised finance providers and remind us of the importance of DeFi. A meltdown of this magnitude could not, and would not, have happened to a decentralised and transparent protocol. DeFi will revolutionise global finance by adding transparency, stabilisation, and efficiencies, empowering TradFi institutions with fast, trustless global finance in the safest way possible.
Now, where are the risks?
There are still some technology-related risks, however. Software code can have errors that might open the door to hackers. There are risks associated with the blockchain the protocols are built on. With that said, as technology improves and usage increases, protocols should become unassailable.
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True DeFi also eliminates infrastructure risk, as users control and manage their own keys. The popular industry saying "not your keys, not your crypto" is resonating more than ever, especially with institutions that are becoming increasingly sophisticated in their ability to identify and choose the right tools to access DeFi protocols.
The right setup will give firms a complete overview on how much they keep in their wallets, how much they have loaned out or added to a liquidity mining pool. They can manage access rights for the funds and create multi-signature wallets.
For now, TradFi institutions may just be trialling and testing the wide array of tools that decentralised finance offers. Many institutions are using a mix of consumer tools, sacrificing full institutional policy compliance in the process But very soon, DeFi literacy could open up bright new revenue perspectives with an increasing array of tools that are built specifically for institutions, to bring about banking-grade infrastructure to DeFi.
U-Zyn Chua is the CTO and co-founder of Cake DeFi. All views are his own.
